Copper - A Market Divided Apr, 2008 John Gross | COMEX

The real turning point began to emerge in earnest during 2004 however...

What is a pound of copper worth? The simple answer, as Economics 101 tells us, is that copper like anything else is worth what a buyer is willing to pay for it.

Just five years ago, the market deemed copper to be valued at 75¢ per pound, a far cry from the near record high $3.80 being paid today. The question that begs asking, of course, is how and why the market changed so dramatically and perhaps just as importantly, where do we go from here?

The answer to the first part lies within the inherent characteristics of the copper market that is and has historically been subject to the swinging pendulum of economic cycles. We’ve seen the phases many times before however, but by any measure the current environment has raised the bar exponentially, thereby creating a deep schism over what in fact is really driving the market. Is it the fundamentals of supply and demand that has taken the market to new heights, or is it the result of speculative money that has flowed into and completely overwhelmed all commodity markets? The real answer is probably somewhere in the middle of the two extremes.

Fundamentally, supply and demand get out of synch largely because each side of the equation is driven by different factors. The planning, financing and development of a mining project is a massive undertaking, that once in place and operational, does not lend itself to fine tuning of output in response to demand which is subject to shorter term economic influences.

As a case in point, during the last recession in 2001 following the bursting of the dot com bubble, global consumption fell almost 200,000 metric tonnes, or 1.3% to 14.9 million mt, while production that year climbed 852,000 mt, or 5.8% to 15.6 million mt, thereby generating a surplus of almost 700,000 mt. Thus inventories held in Comex and London Metal Exchange warehouses soared to 1 million mt by year end, and the price was trading in the low 60¢ range. 2002 saw little improvement, despite cut backs in output as well as a pick up in demand, the market generated an additional surplus of 125,000 mt, pushing Exchange held inventories up to a record high 1.27 million tonnes, while total inventories to include those held by producers and consumers swelled to 2.05 million tonnes and prices remained locked in the 70¢ range, well below the long term trend. In fact, to demonstrate the severity of the situation, for the first time since the great depression of the 1930s, copper had fallen below its twenty year moving average price.

By 2003, the global economy was finally regaining its footing and needing more copper. But production fell further that year due to continued price weakness, thereby creating a global deficit and requiring that metal be drawn from warehouses to meet demand. For the first time in nearly three years, prices began to show some improvement as copper approached the lofty 80¢ level by the third quarter of 2003.

The real turning point began to emerge in earnest during 2004 however, as record low interest rates sparked strong growth throughout the global economy resulting in a 1.13 million tonne increase in consumption and depleting the market of any excess metal. Consistent with the drawdown of global stocks of copper, prices improved steadily with Spot Comex closing above $1.00 just as the year got underway, representing the first time since 1997 that we had seen this level.

Because the market had been depressed for such a protracted period of time however, the thinking by many was that it wouldn’t be too long before production would be ramped up to take advantage of the higher prices, and the market would again revert to a surplus and correspondingly, lower prices once again. Thus, many were reluctant to cover forward price exposure for fear they would be buying at the highs, while others thought the market had risen too far too fast and felt a correction was in the cards. Still others saw the market as a selling opportunity with the price trading at $1.50 in mid 2005, more than double where it had been not long before. Only with the benefit of hindsight do we now know that these were the wrong approaches to be taken, as they contributed in large part to the explosive move in prices that ensued.

Those who hadn’t covered forward risk exposure were being forced to buy into a rising market, while others who took on outright short positions saw losses mount steadily. Consistent with rising prices, the market had also been trading in a backwardation, wherein the Spot, or Cash price trades at a premium to forward values. This aspect of the market structure makes it virtually impossible to hedge inventories properly and carries a significant cash requirement, resulting in even more buying as short hedges are covered and closed out.

By the end of 2005, while the fundamentals for copper had decidedly improved, they nevertheless took a back seat to the real action of deep pocketed speculative hedge funds. Indeed, following two years of near record low interest rates that spurred strong growth in home building, real estate activity, and construction spending overall, the cost of money began to rise, resulting in a down turn in demand within the United States and Europe that was offset in part by continued growth in Asia. Thus, global demand declined marginally in 2005, signaling to some that the bull market had run its course and was headed for a fall. Aiding and abetting this view was the flow of metal back into Comex and LME warehouses that had doubled from a low of 41,000 mt in June of 2005, to some 96,000 mt by year end.

Despite the increase in inventories, however, prices continued moving higher, with Spot copper trading in record high territory and now above the psychologically important $2.00 level in November 2005.

As 2006 got underway, inventories held in exchange warehouses rose steadily, with more than 150,000 mt on warrant by the end of the first quarter, yet prices continued climbing along with the excess metal, prompting many to conclude that the market was now in the hands of well funded speculators. Indeed, if one is guided by the history of markets, there was some rational to this line of thinking. Traditionally, markets that are driven primarily by the fundamentals will have a tendency toward gradual movements in the direction of the underlying trend, barring of course any unexpected events occurring. But the market at that time was seeing anything but gradual movements. From the end of March 2006 when Spot copper was trading at $2.50, the market moved up almost vertically, as it crossed the $3.00 level in mid April; hit $3.50 by early May and soared to a high of $4.15 on May 11, 2006, with the Spot price on Comex closing that day at $4.03.

Over the following seven days, the price fell almost 40¢, implying perhaps that the storm had finally passed, but in reality, we were just in the calm eye of the hurricane. On May 23, the market did an abrupt about face with a force never seen, as the price rocketed up almost 44¢ in one day alone to close and post the record high close of $4.0755 on Comex. Shortly thereafter, the price fell precipitously, hitting $3.10 just one month later and closing out 2006 at $2.85, off $1.23, or 30% from the high. Clearly, this was not the work of the fundamentals alone. Since then we have continued to experience extreme volatility with the Spot price ranging from a low of $2.40 during February 2007, to a recent high close of $3.99 in March 2008.

Where do we go from here? Obviously, there are no easy answers, and, as always seems to be the case, the complexities of the markets are greater today than ever before, with many conflicting and contradictory influences at work in the market simultaneously.

There is a strong contingent that believes we are now and have been in the midst of a long term ‘super cycle’ in commodities wherein both industrial and emerging economies are competing for raw materials that are becoming ever scarcer in a growing global environment. And this applies not only to metals, but to energy and agricultural commodities among others. As relates to copper, their view is that still higher prices are on the horizon and given recent events, their assumptions can not be dismissed entirely. To this point, prices on the London Metal Exchange did in fact trade to a new record high of $8,881 pmt, ($4.0284) on March 6, 2008, thereby surpassing the LME Cash high price of $8,788 ($3.9862) set on May 12, 2006 and the market remains in a deep backwardation.

Nevertheless, perhaps the parallel here is the view of the real estate market just two years ago when all was well in the economy. The period of ultra cheap money from 2002 to 2004 spawned an environment of rapidly escalating home values throughout much of the United States as well as in many parts of the world. Year after year new homes were built with starts in 2005 totaling 2.068 million, up 30% from five years earlier and approaching the record high set in 1972 when 2.38 new homes were built. Sales of existing homes rose even more sharply with record levels of activity being posted each year from 2001 until the peak in 2005 when 7.08 million homes changed hands. And as the degree of activity rose, so did prices, to levels we thought were never possible. So strong was the market, that people could easily “flip’ properties almost effortlessly and be richly rewarded. But with the new era of wealth and the assumption that values could only go in one direction, prudent lending practices took a back seat to getting the deal done, with artificially low rates of borrowing being promoted that made little if any economic sense.

Today, we are paying the price for that carelessness with staggering losses in the billions of dollars being reported by leading financial institutions, and we ask ourselves ‘how could we have been so blind to the obvious’? Sadly, however it was the same realization we came to in 2000 when the dot com bubble finally burst, sending equity markets spiraling downward and contributing to the recession in 2001.

Going back a bit further, the same could be said for the copper market in 1994 when prices rose to $1.35 initially on the basis of strong fundamentals, but then escalated further on the assumption that continued strong demand was going to persist and hold prices aloft for several years to come. Unfortunately, this logic was also found to be without merit when it was finally revealed that unauthorized trading by a major market participant was the real, but faulty foundation upon which the pyramid was built. In very short order, prices collapsed violently from $1.45 in July 1995 to $1.10 by December and 85¢ in July 1996.

This is not to suggest we are witnessing a repeat performance in the copper market now, but the lesson was instructive. When it appears all too obvious that we have entered a new world order, the end of the cycle can’t be too far off in the distance.

We are well served to listen to the opinions of the ‘super cycle’ theorists, but it is equally important to maintain an objective view, balanced by historical precedence and the recognition that commodity markets are highly leveraged. With the credit crisis still spreading like a firestorm throughout the financial community, those investors and banks that provide the credit for speculative trading may finally come to the realization that the heightened level of risk, is no longer worth the potential reward.

Playing the devils advocate, the current fundamental environment for copper does provide some support for those who see sharply higher prices. Over the past five years, the global copper market generated a cumulative deficit of 1.24 million mt, despite a near 20% increase in production over that same period. Indeed coming into 2007, it was widely believed we would see a surplus emerge, however the supply side was adversely affected by labor issues, production problems and power shortages, but the more significant impact on the market last year was from the demand side of the equation. Globally, consumption of refined copper rose 1.12 million mt, or 6.6% to 18.2 million mt. Within those figures demand from China alone rose 1.3 million mt, or 36% to a record high level of 4.93 million mt.

By any measure, this is a staggering development and its very magnitude is cause for concern. There is no question that China, with the world’s largest population has been growing rapidly and we have seen their share of global consumption of refined copper climb steadily from 9.7% of the market in 1997 to 27% last year. Over that entire period however, the largest year over year increases in consumption occurred in 2001 and 2002 with gains of 480K and 418K mt respectively. Necessarily, we have to wonder whether the 2007 figure was in fact real consumption, or if some portion found its way into inventories. Alternatively, if the metal was actually consumed to support their growing economy and infrastructure needs, will we see further increases on this order going forward?

Interestingly, contrary to the market in China, consumption of refined was down in most other industrial economies. Japan the world’s third largest consumer saw a 2.4% decline and Korea was off 1.8%. On the European side Germany was down 0.4%, Italy -4.6% and France slid 18.5%, with the EU overall posting a 6.0% decline. Further, if China were taken out of the numbers the global copper market would have seen a 1.4% drop in consumption rather than the 6.6% gain for 2007.

From an entirely different point of view, it is time well spent to examine long term copper price performance in isolation to gain a better perspective of how the market behaves. Figure 1 illustrates the actual annual average price of copper on Comex against a base price from 1970 adjusted and compounded annually by 2.5%. Here we can see that prices tended to vacillate around the adjusted price, albeit without any regularity until the late 1990s following the collapse in prices resulting from the trading scandal at that time. It was not until 2005 that prices finally approached the trend line and once through it rose dramatically. This isn’t to say that prices can’t go higher still, but rather to suggest that there will be a return to the trend at some point.

Using similar logic, Figure 2 is the monthly average price of copper on Comex as compared to the cumulative monthly average beginning in January 1970. Here again we can see each of the four previous bull markets climb sharply from the trend line, but ultimately return to, or fall below it.

There is little point in attempting to debate how, why, or when the market will return to trend, but if history is our guide, return it will. Only then will we know if a super cycle did in fact exist.