For thousands of years man has been mining copper. The versatile metal's myriad of uses has made it a desirable commodity over those years. With its superior electrical conductivity, resistance to corrosion, and efficient heat transfer attributes, copper continues to be a key ingredient in building the infrastructure necessary for a growing economy.
Because its usage is mainly industrial in nature, its price is swayed by the whims of the global economy. This results in a price that's both volatile and cyclical. When both demand and price are high, those that mine copper can reap a windfall of profits.
View from the street
As we look out into 2013 all signs point to volatile but rising copper prices. Back in October, Goldman Sachs reiterated its forecast on copper with a six-month price target of around $4 per pound, or about 10% higher than its current price. The bank calls copper its "most preferred base metals exposure." The reason is simple; demand from China still remains strong.
Goldman noted that Chinese consumption will be driven by "late stage" construction demand -- think copper wiring and pipes that are installed after the basic structure is built. Couple this with the stability and even a slight recovery in the U.S. housing market, and the stage is being set for copper to have a good year. Goldman's not alone in its bullishness, as most of the Street sees strong copper pricing over the next year.
Worldwide pullback in growth projects
Few companies are as dependent on copper prices remaining strong than Freeport-McMoRan Copper & Gold (NYSE:FCX). As the world's second-largest copper producer, a 10-cent move in the price of copper can affect the company's cash flow by upwards of $275 million. It's one reason why the company recently decided to diversify away from copper by acquiring two oil and gas exploration companies.
Another potentially more troubling reason for the company's shift away from copper is that it sees limited future growth opportunities. In the acquisition conference call, CEO Richard Adkerson noted that new copper investments "were limited by the time frame that's required to take resources and take them into development stage and turn them into cash flow projects. External growth projects were limited for factors that [the investment community] is well aware about." Basically the time and money required to turn new copper projects into shareholder returns are so limited the company is looking elsewhere for growth.
Freeport's not the only one that's having a hard time justifying the investment required for new copper projects. Earlier this year BHP Billiton (NYSE:BHP)put its $20 billion Olympic Dam project on the shelf. The project would have been capable of producing 750,000 tonnes of copper a year, but weakening Chinese demand has forced the company to scale back its ambitious growth initiatives.
While copper is 100% recyclable and 80% of the copper ever mined is still in use, we still need to keep mining it to meet future demand. According to Rio Tinto (NYSE:RIO), copper demand will grow by 6.5 million tonnes by 2020 to around 25.5 million tonnes, with 19 million of those tonnes coming from mined copper. Several trends are emerging which will continue to pressure the supply side of copper.
As we've exhausted our best mines over time, the average yields of copper that is mined have fallen 30% over the past decade. Further, only 6% of copper resources have been upgraded to reserves over the past decade. Finally, a bulk of the large new discoveries are coming from countries with higher political risk. Over the long term, these themes, coupled with continued Chinese demand, will likely push copper prices higher.
In the near term, Rio Tinto, the world's fifth-largest copper producer, expects to see first commercial production from its massive Oyu Tolgoi project in Mongolia later this year. The mine is expected to be a top-10 copper producer for decades to come, but getting it into production wasn't easy. Rio Tinto and partner Ivanhoe Mines have had to work closely with the Mongolian government to get the project into production.
Mining in countries with high political risk isn't going to change as more of the world's reserves are found in these less politically stable countries. With operations in Mexico and Peru, Southern Copper (NYSE:SCCO) boasts the world's largest reported copper reserves of 58.8 million tonnes. However, those reserves reside in less ideal politically unstable countries. The company needs to work very closely with these governments in order to meet the world's growing copper demand.
While the company sees short-term macroeconomic concerns in both the U.S. and Europe, together they represent just 28% of copper's demand despite being more than 50% of the total global economy. While the pace of growth in China and other emerging market counties is slowing, it's still substantial -- China is expected to grow from 39% of the world's demand to 45% of demand within five years. Finally, the company notes that there is limited production upside; combined with falling grades, the result is likely a deficit market in the future. Further, over the past 12 months, inventories have fallen by 34%. All of this bodes well for future copper pricing.
The dark horse
Despite the tepid global economic outlook there is a dark horse that could drive copper prices higher over the next year. Earlier this year the SEC gave permission to JP Morgan (NYSE:JPM) to create an exchange-traded fund that's backed by physical copper. If that fund draws enough interest it could spur an increase in copper prices as these funds have done in the past with other commodities like gold and silver. While it remains to be seen how this new ETF will affect prices, it's something to watch over the coming year.
Foolish bottom line
All signs are pointing to 2013 being a solid year for copper prices worldwide. Even as growth slows down in China, and the rest of the world's economies remain stagnant, there's enough demand to keep copper prices headed higher over the next year. Investors looking to profit from this trend should consider taking a closer look at No. 2 producer Freeport-McMoRan. Despite the company's questionable diversification into energy, shares are cheap at a little over 11 times earnings.