Don't Count Copper Out Just Yet

By James Brumley | May 11, 2011 AAA

While all eyes were on the demise of silver prices last week, more important news from the copper industry has proverbially been swept under the rug. (For related reading, see 5 Metals That May Be Brighter Than Gold.) There has been somewhat of a silent implosion of copper prices and, by extension, the pullback of copper mining stocks like Southern Copper (NYSE:SCCO), FreePort McMoRan (NYSE:FCX) and the iPath Dow Jones-UBS Copper ETN (NYSE:JJC).

Those two stocks along with the ETF and their peers recently accelerated an already-existing pullback that can be dated back to January. Freeport has given up 19% for the year and the Southern has fallen by 28% year-to-date. The fund is off 9%. As has been the case since the beginning of the pullback, the latest round of lower lows was prompted by China's state officials working to cool inflation by ratcheting up the country's bank-reserve requirements; it was the fourth such crimp from the country this year. The significance of China can't be understated, given that the country uses about 40% of the globe's copper supply each year.

When is the slide going to end? The likely answer is soon, barring a catastrophe.

TUTORIAL: Commodities Guide: Copper

Doctor Copper
Unlike gold or silver, copper actually has a great deal of industrial utility. Yes, gold and silver are ideal in a few electronics applications, but some forecasters suggest global demand for copper is expected to reach 24.8 million metric tons by 2015. Gold, on the other hand, saw demand of only 3,812 tons last year.

That demand disparity tacitly underscores a key theme - while speculation on silver and gold prices may be a bit of a game led by irrational traders, the supply/demand dynamic and ensuing prices for copper are ultimately dictated by the economy. Indeed, some analysts use copper price trends as an economic barometer, so much so that it's sometimes called "Doctor Copper."

Using copper as an indicator of economic health has historical merit. Copper prices plunged in late 2008, but actually began their recovery at the beginning of 2009 - a few months before the equity market started to rally. Moreover, copper prices started to hit lower lows in early 2001, well before that recession was officially acknowledged as such. In short, copper activity can be a good early-warning system.

Impact on Stocks
The profits of copper miners have followed the lead of copper prices. Freeport McMoRan's most profitable year ever was 2007's $4.92 per share. This record was achieved when copper prices were persistently high, hovering around $3.50 per pound for most of the year. The following year was the worst in a long time, as copper prices hit a multi-year low that took them back to the prior recession's prices. It's a similar story for Southern Copper - a great 2007, then a couple of tough years with the light at the end of the tunnel only showing up in 2010.

It wasn't just the miners' crimped margins that hurt investors. Suppliers also got whacked when the bottom fell out of the copper market. Encore Wire (Nasdaq:WIRE) earned $4.86 per share in 2006. By 2007 - before copper prices fell - demand for copper had already slumped, leading to a mere profit of $1.30 per share that year. That struggle only started to fade last year.

So,copper falling back from its peak of around $4.60 (per pound) in February to the current price around $3.90 is nothing to dismiss, especially if it's really an indication of waning demand. The thing is, it's not an indication waning demand.

The Sweet Spot
The alarm bell may have been ringing a little too loudly last week. Yes, copper prices have fallen about 15% over the last three months. They also fell back from multi-year highs that, bluntly speaking, shouldn't have been reached in the first place. In that regard, China's overseers made a reasonably-wise call.

The price implosion may have had as much to do with the rising U.S. dollar as it did actual copper demand. The fact is, copper at $3.90 per pound is still on the high end of the sustainable range, which as we saw in 2006, 2007 and 2010, is in the "not too hot, not too cold" $2.80-$3.90 area. So, don't sweat the dip or the size of the pullback.

Bottom Line
The International Copper Study Group's review of Q1's activity indicated not a slump in demand, but rather a kink in the supply chain. And, Credit Suisse expects the price dip to be seen as a buying opportunity by purchasing managers, suggesting copper prices could rise from the mid-$8000's per metric ton now back to more than $10,000/MT in the second half of the year.

Almost on cue, demand has already swelled since the beginning of April. Yes, copper is still alive and kicking, and copper's investors may have less to worry about than they think.

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