Buy the Copper Dip?

In this article I am going to try and put together some thoughts on the copper market covering, possible short- and medium-term price directions, thoughts on supply and demand, the influence of electrification on this balance, and finally take a look at some ASX listed stocks.

Possible Price Drivers

So, let’s start this tale by taking a look at the old enemy – the US Dollar. At the moment USD is king and is one of the biggest drivers behind price movement in all commodities and not just copper. The monthly chart below shows that DXY (the USD Index) has been in an upwards trend channel for a decade now. The next move is probably critical for where we see commodities headed. If DXY breaks the median line and heads for the upper trend line we likely see 110 sometime in the next 18 months and this will be a big negative for commodities. If we see it rejected at the median line and head back towards the lower trend line this will be a positive for commodity pricing. At the moment I am reluctantly favouring the USD bull case which means there is an element of short-term pessimism. And thus, comes the title of this article.


Moving onto looking at Cu itself. The next move on copper is more than likely going to be largely dependent on the move in DXY. If we see DXY break northwards and copper break down we might see a washout back to the low 2’s. This is when things get really interesting. Average cash costs for producing copper is around $1.10-1.20/lb. If we see a washout down to $2.00-$2.10 that means margins will be reduced to c. 90c per pound and sentiment will be extremely low, leaving attractive valuations of miners for a rebound to $3.00+. Note: We are talking medium term time ranges for this action, with the lows possibly happening in 2020 before what I consider a strong long-term shift upwards. Of course, if DXY breaks down then copper could rally without seeing a washout low.

Supply

Now let’s talk about the supply situation in copper.

The above chart from the International Copper Study Group (ICSG) shows a couple of important aspects. Firstly, it shows us that over 2018-2020 that refined copper usage is exceeding refined copper production which shows we are in deficits. This probably doesn’t surprise anyone but is important nonetheless. The other thing of note is that this table shows growth in copper demand decreasing YoY from 2018-2020 and to me this says that it is already factoring in slowing world growth, the perception of which has already had a price impact on copper. If world growth doesn’t slow this might be accentuated.

Something that isn’t necessarily apparent by looking solely at the Cu price chart is that most of the world’s supply is coming from countries that don’t have USD denominated currency and in particular from EM markets like Africa and LatAm and Asia. This means that as the USD rises and the EM currencies sell-off that domestic Cu prices in these countries might be remaining quite steady or even rising. So, whilst it is expected that falling Cu prices will affect supply and in return increase price this could take much longer than expected to play out as falling local currencies can mean many of these mines retain viability and supply might not be as constrained at lower prices than one may expect.

However, the flip side of this is that the longer current brownfields projects can meet demand needs and the longer prices stay low the harder it is to incentivize new projects into production as they have largely completed feasibilities at higher prices. This might not affect supply now but it will in the future as there is a lag time of a number of years from funding to real world production

Looking at the chart below we can see that discoveries of new mines have been lacking over the last 10 decade and it hasn’t been for a lack of exploration budgets.

Looking at some of the projects we are talking about as significant it becomes apparent that $2/lb copper can’t be a long-term prospect.

Let’s first look at the Los Pelambres expansion – remembering that this is a brownfields project. This is a $1.3bn expansion to produce 60ktpa of copper (in contrast to supply/demand of 25,000ktpa) and a pre-tax IRR of 13% with Cu prices at around $2.70/lb. That is quite a marginal expansion when you consider it is entirely debt funded.

Secondly let’s take a look at Cascabel (SOLG) as one of the bigger discoveries of the last few years.

Let’s look at some of the issues with this:

  1. There is the large capex bill (upfront and sustaining that needs to be funded). This will heavily influence what the appropriate NPV discount will be based on how the project is funded.
  2. More importantly let’s take a look at the input price assumptions used – $3.30/lb Cu, $1,300/oz Au and $16/oz Ag. Copper and Silver are the most problematic of these. With Cu currently trading at $2.70/lb and Ag at $14.50/oz this makes the cashflows of Cascabel considerably worse than they do right now. For example, post tax, undiscounted cashflow would be reduced 40% with Cu at $2.70/lb. This makes the project look considerably less attractive.

So while the obvious case might be we need to see higher Cu prices (and I think long term we do) there is definite potential for Cu price to fall in the short term and remain there for an extended period

Demand

I won’t do this to death but will just touch on a few points that could have a considerable impact on Cu demand over the next decade and further influence the supply demand balance.

Firstly the bear case.

The below chart is a projection of the copper market balance to now and forecast out for the next 3 years showing widening supply deficits as we move out the graph. However, I will present a counter point to this. Currently Chinese Cu demand is almost half of global demand at about 12,000-13,000ktpa. This means only a 3-4% reduction in Chinese demand would see the global Cu market in balance and would make Cu price rises a moot point. This example alone shows how dependent on global growth the Cu investment thesis is and how Chinese demand reactions to trade war discussions and other influencing factors is to the ongoing outlook for Cu.


From there we will take a look at the opposite side and investigate the bull case.

Let’s talk about some of the impact of electrification and ‘green energy’. This is a thematic that will have a growing impact on copper. It is not hugely significant yet but as these demand avenues move into exponential growth (with supply constraints) this may become important.

If we take a look at wind power, it is estimated that per MW of installed capacity approximately 4,000/lb of Cu is required. In 2018 there was 53,900MW (53.9GW) of installed wind power. This is a global usage of 98kt of Cu. If this grows at CAGR of say 5% this is an increase in demand of 27ktpa over 5 years and 61kt in 10 years. For perspective this is 1-2 small mines.

Now let’s talk about EV’s. An EV requires approximately 183 lb’s of copper in contrast to an ICE vehicle requiring 30 lb’s of copper. This means that in 2018 with 2m EV’s sold (replacing ICE sales) that was an extra 136kt of Cu. If we assume 30% CAGR growth of EV’s this means an increase of demand of 37ktpa of Cu over 5 years and 85ktpa over 10 years.

Again, these numbers aren’t massive compared to a market of 25,000ktpa but when we start talking about supply constraint then this becomes a moving factor.

Another factor to consider when looking at the demand side of the picture is countries such as India and China increasing in class status towards first world standards.

The above chart gives us a lot of information to work with. What we can see is from this chart is that first world standards have approximately 500-600/lb of installed Cu per cap person (This seems to hit a point of inelasticity from Real GDP of USD$35,000 per capita onwards.

Now if we consider China and India, both of these nations are sitting at something like 175lb per person of installed Cu. If we look at a move of even 25lbs per person (not even getting close to first world standards) this incremental demand of approximately 28,409kt of Cu or over an entire year’s current supply. If we consider moving China all the way to first world standards, we are talking 9x this amount. Therefore, even if it takes another 50 years for China and India to reach that standard that would still require a 20% p.a. increase global Cu supply.

Charts

I will close by taking a look at some of the charts of ASX copper names


OZL (OZ Minerals)

OZL is an ASX100 company with a current market cap of ~A$3bn and their flagship assets located in Australia. It produces ~100ktpa of Cu at an AISC of $1.15/lb after gold credits or around $1.85/lb without credits. It has $342m in cash, long LOM and strategic investments in a number of juniors looking to increase their production possibilities

SFR (Sandfire Resources)

SFR has a current market cap of ~A$1bn with $170m in cash. SFR also have their flagship assets located in Australia. They will produce ~65kt of Cu in FY2019 at AISC of $1.20-1.30/lb after gold credits or around $1.60 without credits.

SFR has a low LOM at their flagship Degrussa and are looking for project expansion options.

MOD (MOD Resources)

MOD has a current market cap of ~A$89m. MOD has recently completed it’s DFS providing a pre-tax NPV8 of US$368m with an IRR of 33% at Cu of $3.08/lb and AISC of $1.56/lb on it’s flagship T3 resource.

They have further exploration potential across a wide land holding in the Kalahari Belt in Botswana.

Conclusion

From this I see no immediate urgency to buy any of these names but it is something to watch develop over the next 6-12 months especially as the USD story develops and we get more of an idea on the direction of Cu.

While I am favouring the bearish case on Cu price movements in the short term for reasons outlined the fundamentals of the supply and demand case in my opinion favour a larger bull run in copper prices over the longer term starting from the early 2020’s but this is very dependent on world growth being maintained and other bullish inputs like electrification themes and increased installed Cu in China and India. Therefore, if we see a washout low, I think there will be some great buying opportunities across leading copper names but this might be some time off yet.

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