Copper Bulls' Hopes Pinned On China Stimulus Plan

Like the rest of the commodities complex, copper prices have pulled back sharply since hitting an all-time high of $4.07 a pound at the beginning of July. Recently, copper for December delivery on the New York Mercantile Exchange's COMEX division traded as low as $3.15 a pound, its lowest price point since January 28. While prices have since nudged back to $3.27 a pound, the price of this key industrial metal is still about 19% short of its recent highs.

For the major mining companies like Southern Copper Corp. (NYSE:PCU), Freeport-McMoran (NYSE:FCX), Teck Cominco (NYSE:TCK) and Rio Tinto PLC (NYSE:RTP), which have significant exposure to copper, this recent bout of weakness in the yellow metal has only added downside momentum to the price slump these shares have been experiencing since mid-year.

Market Fundamentals Have Now Shifted to Surplus
While the slump in oil and gold and the corresponding surge in the U.S. dollar have had an impact on speculative sentiment for copper, bearish fundamentals continue to press the compelling case for lower prices.

Warehoused stocks of copper on the London Metals Exchange (LME) have been building steadily so far this year due to weaker demand brought on by the slowdown in global economic growth, particularly in major copper consumer China. LME copper stocks now stand at their highest levels since January, up 64% since the recent low in May.

The build in inventories on the LME appears to be confirmed by data compiled in a recently released study by the International Copper and Study Group (ICSG). According to the ICSG, global copper use in the first five months of 2008 was essentially unchanged from the same period in 2007, while total global production was up 1.3%. The net result has been a shift to a seasonally adjusted production surplus of 31,000 tons for the first five months of this year compared with a seasonally adjusted deficit of 80,000 tons for the same period in 2007. Moreover, demand by the top four users of copper (China, the EU, the United States and Japan), which collectively account for 66% of world demand, showed a 1.3% decrease. (For more on the relationship between supply and demand, read the Economics Basics Tutorial).

Bulls Now Forced To Pin Their Hopes Solely On China
With increasing signs that economic growth is rapidly decelerating in the U.S., the EU and Japan, copper bulls are now obliged to pin their hopes on any recovery in the metal on an anticipated post-Olympics surge in use in China; which accounts for 26% in total demand and whose growth in demand has been largely behind the dramatic five-year bull run in copper. But so far thus year, Chinese demand has been a disappointment. In the first half of this year, Chinese demand for refined copper dropped 23.1% to 687,013 tons.

With the return of a positive price spread between the Shanghai Futures Exchange and the LME due to the steepening of backwardation in Shanghai, hopes have been raised that an incentive for restocking is now in place that could be a key source of near-term support for prices. Shanghai inventories are now at their lowest levels in three years and enough for only two days of Chinese consumption. Unfortunately, the extent of any restocking demand remains unclear as Chinese official statistics fail to include unreported stocks. Some have speculated that these unreported stocks could be enormous and, furthermore, any rise in Chinese domestic demand need not necessarily lead to an increase in imports as domestic supplies are rising due to increased mine output and a rising preference for scrap use.

Longer-term hopes continue to be pinned on the belief that China's surging economic growth will continue to keep demand for copper growing at above-trend rates for the foreseeable future. In a recent very bullish report, Citigroup's Australia metals team of Alex Tonks and Alan Heap predicted that copper prices would hit $5 per pound by 2010 as weakening export demand prompts Beijing to boost domestic economic growth by launching a massive infrastructure spending program. JPMorgan Chase (NYSE:JPM) recently told clients that the government was studying a massive public-works-focused fiscal stimulus package worth 200 billion to 400 billion yuan (US$29 billion to $59 billion) as evidence accumulates that the Chinese economy is slowing. China's GDP growth fell to 10.1% in the second quarter from 11.9% in all of 2007. In June, China's exports grew more slowly than America's, up just 17% from a year earlier compared with 23% in the United States. However, with the huge looming costs associated with providing healthcare and retirement benefits for its 1.3 billion population, there is a limit to the size of any stimulus program that Beijing can bring to bear in an effort to maintain growth. (Learn the underlying theories behind these concepts and what they mean for your portfolio in The Importance Of Inflation And GDP.)

The Bottom Line
If Beijing fails to play its stimulus packaged trump card, then all bets would be off for copper and copper shares. It wouldn't be unreasonable to expect a sharp break in price given the dramatic shift in sentiment such a disappointment would produce. The dramatic drop in oil prices provides an object lesson about the excessive speculation that has dominated commodity markets lately.