Copper and gold miner Freeport-McMoRan (FCX 3.24%) is having a great 2021 so far. Its stock is up 47% year to date. The key reason comes down to its exposure to the rising price of copper. The price of the shiny metal used across the industrial economy has gone up from around $3.50 per pound at the start of the year to around $4.50 per pound today. The question now is whether the stock's run can be sustained. Here's what you need to know before buying in.
The investment case for Freeport-McMoRan
The thesis behind buying the stock rests on the idea that copper prices can continue to rise over the long term and that Freeport is positioned to take advantage of it. Notwithstanding the usual pricing volatility along the way, I think there's a good chance that both of these things are likely, and here's why.
Long-term demand trends
Freeport's recent first-quarter earnings call was fascinating because management spent time discussing the long-term fundamentals behind the business. That's unusual because most companies' earnings calls focus on the minutiae of the quarter's numbers. However, investors in commodity stocks should always focus on the long-term demand and supply trends, as they determine the price of copper.
CEO Richard Adkerson's discussion of the demand trends was particularly enlightening. He described three "eras of copper demand." The first relates to how copper demand used to be largely tied to economic growth in developed countries, with the price oscillating in concert with the growth cycle in the developed world. Indeed, copper is still seen as the most cyclically aligned commodity in the market.
The second, post-2000 era came with the growth in China's economy. As Adkerson noted:
China emerged and now for almost two decades has dominated new demand growth. It's all come from China when you look at it. The rest of the world has kind of been flat.
As such, when investors assessed copper demand trends over the past couple of decades, the first question was always around the marginal increase in demand coming from China.
The third era is characterized by ongoing demand from China, although not at the same torrid rates of growth as before, combined with global growth and rising living standards in the undeveloped world. Copper remains a key component of economic development, as 28% of demand for it comes from the construction industry, with 27% coming from electrical networks, 21% from consumer and general applications, 13% from transport, and 11% from industrial machinery.
Moreover, copper is a major beneficiary of the clean energy revolution. Solar and wind power (notably offshore wind) installations will significantly add to copper demand. At the same time, electric vehicles typically require three to four times the amount of copper as an internal combustion engine vehicle.
Supply side constraints
Turning to supply considerations, Adkerson believes that "supply to meet this growth is severely challenged." This is due to a number of reasons, including the necessity for "meaningfully higher prices to support mine investment." At the same time, Adkerson sees the pipeline of new copper supply as being thin and negatively impacted by the difficulty of obtaining permits.
If Adkerson is right, then a combination of rising demand and constrained supply is highly likely to lead to higher prices.
Can Freeport-McMoRan take advantage?
One of the key concerns facing investors right now is the fear that rising raw material costs will eat into many companies' margins. However, this is arguably not likely to have a major impact on Freeport. There are two main reasons for this. First, copper is one of the major commodities contributing to rising inflation. It is so precisely because of its exposure to the economic cycle and the clean energy transition discussed above.
Second, as Adkerson noted, "Some important elements of our costs are correlated to copper prices." This point is highlighted because management raised its estimate for its net unit cash costs in 2021 from an original estimate of $1.25 per pound to $1.33 per pound. This is the cost per pound of copper for the company in plain English.
While it's disappointing to see costs rising, Freeport's copper price assumptions have also gone up from $3.50 per pound to $4 per pound. Also, some of the increase in costs comes down to increased royalty payments and labor costs due to the rise in the price of copper itself. For example, for a $0.50 per pound increase in the price of copper, Freeport-McMoRan will have to pay $0.02 in cash cost per pound in royalties and duties.
All told, the end demand environment looks favorable for copper, and if Adkerson is right about the supply side, then higher prices look likely over the long term. Moreover, given that a large part of the increased demand coming for copper is coming from a structural and secular shift in the economy (the clean energy revolution), it's likely that copper will do well even if the economy slows, and Freeport-McMoRan will make money from it. The stock remains attractive for long-term investors.