Energy & Resources, Talking Point

Copper to come a cropper?

Debate on true extent of Chinese copper demand could hit the metal’s price

Copper to come a cropper?

China wants this: the Equinox copper mine in Lumwana in Zambia

Domiciled in Canada, listed in Toronto and Sydney, with an operating focus in Zambia and Saudi Arabia, and soon to be China-owned?

Senior executives at Equinox Minerals must rack up the air miles. They may soon be accumulating a few more on trips to Hong Kong and Beijing, following Minmetals Resources C$6.3 billion ($6.27 billon) bid for the base metals firm.

The offer was firmly rejected by Equinox as “opportunistic” and “low-ball”. But as the biggest bid yet by a Chinese miner for a full takeover – and the first time a Chinese buyer has ever gone ‘hostile’ – the move is drawing wider attention.

One take is that the Middle Kingdom’s M&A may have come of age, after a less-than-impressive track record. Admirers say that Minmetals waited patiently to pounce, only doing so once Equinox had left itself vulnerable with an unsolicited bid of its own for Vancouver’s Lundin Mining. Because Equinox’s main assets are a copper mine in Zambia and a base-metal project in Saudi Arabia, the transaction is less likely to generate political controversy in Canberra or Ottawa.

But there’s also a wider interpretation: that the bid is a vote of confidence in copper. If the deal goes through copper would account for almost two-thirds of Minmetals’ production, up from a quarter today. Is that a pragmatic punt, or a risky bet on a red metal future?

A metal down from its high?

True. Copper was one of the best performing commodities in 2010 (up 31%) and it reached an all-time high of $10,190 per tonne in mid-February this year.

But since then prices have slipped, and were down 3.6% on their peak at the start of this week.

China now accounts for close to 40% of global copper demand (which reached a little under 20 million tonnes in 2010), so signs of declining Chinese imports in recent months have also come in for scrutiny.

The numbers for February show that imports were off by 35% compared to January levels (they usually fall in February due to China’s Lunar New Year holidays, although this year the decline was greater than usual). March saw shipments up 29% on February but still a third down on the equivalent month last year.

Industry watchers take that as a sign that Chinese buyers are pulling back from the market at existing prices, preferring instead to dig into existing stockpiles, smelt more at home, or source copper scrap.

But copper bosses seem calm…

The industry line is that prices are taking a breather. Chinese monetary tightening (the recent round of interest rate hikes, plus increases in bank reserve ratios) is designed to cool the domestic economy in general, and copper is feeling the impact too.

But confidence was still robust at the industry’s CESCO gathering of metals bosses in Santiago last week. Andrew Harding, chief executive of Rio Tinto’s copper unit, was typical: “Ultimately China is using its tools for domestic reasons,” he told Dow Jones Newswires, “but it will still need to buy copper for its roads, buildings and electronic equipment.”

Further encouraging industry optimism on pricing: depleted reserves. During the global financial crisis, mine investment dried up. Although demand has since raced back, it takes much longer to crank up additional production. Only one major project will start operations this year (Antofagasta’s Esperanza mine in Chile) with other heavyweight newcomers, like Mongolia’s Oyu Tolgoi and the Tampakan mine in the Philippines, not slated to start delivering until 2013 at the earliest.

Then factor in that many of the older mines are struggling to maintain output (Codelco, the world’s largest copper producer, has reported a fall in production in five of the last six years).

Others have already worked their way through much of their higher-grade reserves. “The world’s copper mines are like little old ladies lying in bed waiting to die. They require very high prices to be kept on oxygen,” Robert Friedland, chief executive of Ivanhoe Mines, crowed to Reuters last year.

He would have been buoyed by Ivanhoe’s two-thirds stake in upcoming behemoth Oyu Tolgoi. But Friedland is not alone in his forecast. Consensus opinion at the CESCO conference (not the most disinterested of groups, admittedly) was for a continuing copper deficit for the foreseeable future, with a shortfall of at least 400,000 tonnes this year.

Any contrarian opinion?

Not really too much, although there are a couple of interpretations that question whether current demand for copper is quite as pressing as the bulls believe.

The first is that a chunk of China’s copper purchases is purely speculative, and so does not reflect demand from the underlying economy.

Mostly that’s about pure-play speculators looking to cash in on price rises. It’s also a trend that gets turbo-charged during periods of easy credit. Hence back in late 2009, when stimulus cash was fully available, the Chinese media was also reporting that warehouses were filling up rapidly as speculators bought up supply with cheap financing. This wasn’t genuine industrial demand; it was a cheap-money bet on a boom in base metals.

That may also explain why import flow has fallen in recent months, as low-cost credit becomes more difficult to obtain.

But a second debate, tracked extensively in the last month by the Financial Times, sees tighter Chinese credit conditions having a different impact.

The argument here is that, rather than a commodity feeding the industrial economy, copper has been bought up as a financing tool.

The technique works like this. Buy up a stock of refined copper on a 180-day letter of credit. Park it in a warehouse, and then borrow against it from a bank. Invest the proceeds in what you expect to be a higher-yielding asset. Six months on, pay off the bank loan with the proceeds of your secondary investment, and then sell the copper itself (hopefully, it has gone up in price too). Then settle up on the original letter of credit.

It’s hard to know exactly how much copper has been bought on this basis. Official data on country-wide inventories is patchy, so industry watchers must make estimates by touring warehouses or piecing together figures from different government sources.

But at the end of March, South Africa’s Standard Bank offered an anecdotal estimate. It thought something like 700,000 metric tonnes worth was in bonded warehouses, or about 11% of China’s total refined copper consumption. It also said bonded stocks were up 300,000 metric tonnes since the beginning of the year, and as much as 80% of the total could be linked to letter-of-credit borrowing.

The industry has picked up on it too. “There is something going on,” Diego Hernandez, boss at Chile’s Codelco, told reporters on the sidelines in Santiago. “Stocks are high and some people believe they are being used as a financing tool.”

Further, China Securities Journal reported last week that SAFE, the Chinese foreign exchange custodian, has grown increasingly concerned that copper financing is providing another channel for hot money flow. Supposedly, SAFE is now pushing for new rules that would make similar contracts much more expensive to maintain.

Why care about the stockpiling?

Back to the deficit argument: an estimate of 700,000 tonnes of surplus in Chinese bonded warehouses (which doesn’t include stocks at official metal exchange facilities in Shanghai) exceeds the consensus view on this year’s global copper shortfall.

Plus, if these stocks start being released rapidly into the market, prices in general might then begin a deeper retreat. And as Chinese property firms are said to be some of the biggest players on the copper-financing client list, there could also be a double-whammy effect. Any wider downturn in real estate prices would hit copper demand generally (less need for wiring in construction etc). But it could also force the developers to run for cover, and sell down their copper holdings before prices fall further. That could trigger a wider sell-off, as warehouses empty.

The impact on market psychology could be a little disproportionate too – demand for copper is generally seen as a leading indicator of economic health (hence its “Dr Copper” sobriquet).

But no need to panic…

Even if the reports on the stockpiling turn out to be true, most analysts say the fundamental outlook for copper as a commodity remains a healthy one.

First, the immediate forecasts: April and May are usually stronger months for copper sales, as manufacturers boost production of items like air conditioners and household appliances for summer.

Next, look at Beijing’s policy agenda. What about the impact of government pledges for 36 million new homes under the affordable housing plan (lots of copper wiring there) or the planned $230 billion upgrade to the national electricity grid under the latest five year plan (looking good for copper producers too)?

And then, the much bigger picture: that we can expect Chinese copper consumption per capita to rise towards levels seen in its more developed Asian neighbours.

In 10 years time that would mean Chinese demand closer to 20 million tonnes – or a little above total worldwide production for the whole of last year. John MacKenzie, head of Anglo American PLC’s copper business, predicts China will account for half of the world’s copper demand by 2020.

This final theme is best illustrated with an everyday example. Late last year Bloomberg reported on an elderly Hunan couple who had moved from their mud-brick house into a new home, paid for by their son. The report calculates how much additional copper this change in lifestyle had required, from the newly built apartment (13kg of copper wiring), through the various appliances that the couple were enjoying for the first time (a gas stove with 4.6kg of copper, a new fridge with 2kg, and air conditioners with 6kg each).

In total at least 41 additional kilograms of the metal had been required.

For the copper bulls, this is the real story. Supply looks like being short for a while. But as millions of Chinese upgrade their homes and lifestyles, demand for the reddish metal shows few signs of being similarly short…

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