Is There A Copper Top To Freeport McMoran? (FCX)

By Hans Wagner | September 10, 2007 AAA

As the world's largest producer of copper, Freeport McMoran Copper & Gold (NYSE:FCX) has benefited from the rapid rise in the price of the metal.

Specifically, global demand for copper has greatly benefited the company as it expands its production capability.

However, Freeport McMoran is susceptible to a slowdown in global growth that would cause the price of copper to fall further than expected. In past economic cycles, the price of copper has been a good barometer economic growth. When growth slows the price of copper historically has fallen. In this article we'll examine how Freeport McMoran could be hurt by slowing global growth.

Background
Freeport McMoran is not only the world's largest copper producer, but it also has lowest production costs. And it also is one of the largest producers of gold. In 2007, it acquired Phelps Dodge, another large copper producer. Finally, the company is large producer of molybdenum as well as other metals.

The company is best known for its controversial Grasberg mine in the Papua province of Indonesia where it has a contract to mine a defined area until 2041. Charges of bribing local officials, hiring the military to protect its facilities and operations, and polluting the local environment have dogged the company. While not admitting to any of these charges, it has responded by establishing agreements with local Papuan tribes and working to improve its environmental record.

In 2007, Freeport McMoran completed the acquisition of Phelps Dodge Corporation. This acquisition added extensive copper and molybdenum mining operations in Arizona, Colorado, New Mexico, Chile and Peru. This acquisition made it the world's largest copper producer.

Freeport McMoran's second-quarter 2007 performance reflects the continued strong prices for copper as will as the increased production the higher prices are driving. The production of gold also increased significantly, partly driven by the sustainable higher price for that metal. The pro forma for 2006 includes Phelps Dodge results before the completion of the merger.

As you can see from Figure 1, Revenues climbed by 31.4% in the second quarter 2007 to $5.8 billion, up from $4.4 billion in the same quarter a year ago. Gold contributed $410 million of this increase while copper $1.3 billion.

Figure 1

Production of Metals
As indicated in Figure 2, Freeport McMoran expects to see growing production of copper through 2009, as indicated in the chart below while gold production will be relatively flat during this period. The expanding production comes from the new Safford mine in Arizona coming online, added capacity at the Morenci mine, mill expansion of the El Abra and Cerro Verde facilities in South America, and expansion of mine development in Indonesia.

This expanded production is based on sustained demand for copper and the ability to maintain the high price of the metal. When the price of copper is high, it is beneficial to produce copper from lowering yielding deposits. This adds to the total supply of copper as well, which can also help contain the rising price of the metal.

Figure 2

Price of Metals
The price of a metal is a key driver of the success of any mining company. With the acquisition of Pheleps Dodge, Freeport has greatly benefited from the rapid rise in the price of copper as shown in Figure 3. As noted the price of copper has risen dramatically to all-time highs during the latest global economic expansion. In the past, copper has risen and fallen with the growth and contraction of the world's economies. This dramatic increase in the price of copper is driven by the strong global growth of many of the world's economies. The question investors considering Freeport McMoran must consider is will this expansion continue to sustain the very high price of copper, or will we see a move down. The answer depends on the ability of the important global economies to sustain their growth and as a result the demand for copper. The risk is definitely to the downside.

So, what happens to Freeport McMoran's financial performance if the price of copper falls? Fortunately, the company provides some information we can use to ascertain the impact on EBITDA and Operating Cash Flow (OCF), two important ways to measure financial results.

As shown in figure 3, there will be a substantial drop in the EBITDA and OCF should the price of copper fall to $2.00/lb. When examining the long-term price of copper, $2.00/lb is a significantly higher price than has been seen in the past. If the price of copper falls to $1.00/lb, near the high reached in past economic expansions, it would cut revenues, EBITDA and Operating Cash Flow dramatically, causing the stock price to fall appreciably.

Figure 3

Figure 4 shows the impact a $0.20/lb change in the price of copper would have on EBITDA, net income and operating cash flow. As you can see, each $0.20 drop causes a significant fall in all three measures. For example a fall from the current price of $3.40/lb to $1.00/lb would reduce EBITDA by $9.6 billion, net income by $5.1 million and OCF by $6.0 billion. This would be a major shock to Freeport McMoran's stock price.

Figure 4

Can the price of copper fall to $1.00/lb? As mentioned earlier, this was the high in previous economic expansions. We have had some inflation, so the inflation adjusted price would be higher today. But not that much higher. The price of copper has been driven by the extraordinary demand from many countries, especially China, India, Russia and Brazil. If these economies experience a slowdown, the demand for copper will fall and so should the price. How far copper will fall is much more difficult to tell. However, any fall in the price will hurt the price of FCX.


The Bottom Line

Freeport McMoran is very well positioned to take advantage of the high demand for copper from economies across the globe. As long as demand remains high it will help to keep the price of copper at the current, extremely high levels. The price of copper is more than three-times above its level in 2004. However, if demand were to fall, the price of copper is also likely to fall causing the financial performance of Freeport McMoran to deteriorate. Investors considering or owning Freeport Morgan stock need to pay attention to the price of copper.

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