No. 29/2011 ● 12 December 2011
COPPER: GAME, SET AND MATCH An outlook to 2016 by Simon Hunt, Simon Hunt Strategic Services
In our earlier reports on the copper industry we have drawn attention to the large involvement of the financial sector which has both purchased physical metal and been involved in the forward markets on a scale never before seen. Unlike the history of the metal, prices are no longer determined by the industry’s fundamentals, as set by the differences between changes in global consumption and world production, but by the activities of banks and others. Moreover, by warehousing much of their purchases outside the reporting system, markets are given the appearance of a tightness which in reality does not exist.
Manufacturing companies that use copper in size, such as the utilities, the automobile industry and appliance makers, together with their fabricator friends, fully understand the ‘game’ which is being played by producers and the financial sector. Prices are way beyond true economic fundamentals given what they understand to be real consumption and not the ‘demand’ data put out by producers, banks and analysts.
These prices are playing havoc with working capital, margins, working inventories, as well as with changes in the structure of consumption as these companies attempt to design copper out of their systems or, at least, minimise its use through improved designs and tighter specifications. One does not have to look beyond Figure 1, which shows world average cash costs compared with prices, to appreciate that something is indeed seriously out of whack.
Figure 1: World Average Cash Costs versus Prices 1980-2010
Source: SHSS
No. 29/2011 ● 12 December 2011
As we write, global refined copper consumption is falling quarter-on-quarter and year-on-year, yet prices remain stubbornly high. Analysts point to the high copper imports into China in October and thus conclude that business is robust without stating that most of the imported copper was for financing requirements, not destined for furnaces but going into unreported warehouses. Since September, actual business is weak and getting weaker which is now being reflected in both the HSBC and government PMIs.
In the rest of Asia, refined consumption is extremely weak, one could almost say collapsing with order books falling more in the 20-50% ranges than at single digit levels. It is not much better in Europe, even in Germany with some large mills telling us that in January they are likely to go on short-time working.
It is, however, developments in financial markets which will determine what prices will do. We are fast approaching the moment when world financial markets will be hit by a second and arguably more dangerous credit bust than that of 2008/9. That will be the moment when it will be game, set and match for copper, the moment when the 4 million tonnes plus that is mostly warehoused outside the reporting system will be forced onto world markets as its holders will want cash not copper or some other fixed asset.
This will be the start of a world of deflating asset values. It will entail also large losses throughout the financial system. When these sales start to hit the market it will finally demonstrate the extent to which the game players have interfered with the market’s fundamentals. The short-termism of producers who have played along with the financial players will turn into long-term problems for producers as substitution in its fullest meaning will turn many of today’s end uses for copper into skeletons or be obliterated by new technology. It won’t be supply which will be the constraint on the industry, but consumption.
This report, thus, sets out how we get to that position, what is happening to copper now and what the future price profile is likely to be for the industry up to 2015. As always, these are our own views and may well differ from those of our good friends at Asianomics Limited.
First, though, since copper is an essential component in global manufacturing activity we set out our macro-views to 2015 because what happens to the world economy will have a direct influence on copper consumption Economic outlook: The ugly truth
“Four years into the crisis it is surely time to accept that the underlying problem is one of solvency not liquidity – solvency of banks and solvency of countries. Of course, the provision of additional liquidity support to countries and institutions in trouble can buy valuable time. But that time will prove valuable only if it is used to tackle the underlying problem...... But the
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underlying problems of excessive debt have not gone away. As a result, markets are now posing new questions about the solvency of banks and indeed governments themselves.” Mervyn King, Governor of the Bank of England, 18th October 2011.
Truth can be ugly and solutions often painful. The world is at the start of a balance sheet depression as Professor Kenneth Rogoff of Harvard University stated in a recent German interview. But, policy makers will not own up to this simple description of the world economy, preferring to put band aids on gaping wounds. The truth is that the world is heading towards its second and, arguably, more serious credit crisis within five years of the first.
Each of the principal pillars of the world economy, the USA, Europe and China, has their own problems, but they boil down to two simple ingredients: debt and demographics. They may be special to their own countries/region but the impact is global because of the feedback loops from the financial sector, which is global in structure, into the world economy.
Few, if any, countries will be spared from the rolling recessions and deflation which have started, will intensify and probably not end until around 2018. One example of this interrelationship is that European banks are and have been the principal providers of international lending. They have accounted for more than 50% of international bank lending in all the major regions of the world, except Asia where it is just under 45%.
Markets are signalling that these banks are under stress with one or more having to be rescued by central bank activities. They are scaling back their international lending activities and are likely to be doing so in some size. Banks in Asia will not be immune to this development with the risk that in some areas of Asia banks will be undertaking serious layoffs early in the New Year.
As the global balance sheet depression takes hold, the world is moving from one crisis centre to another. It was only a few months ago that the market’s focus was on the USA; then it was China and now it is the eurozone (EZ). All three have their problems, but it is the EZ which is the epicentre of weakness today.
Today’s EZ problems were caused by trying to cement together a ragbag of countries into the European Monetary Union (EMU), which included Germany on the strong side and Greece, Ireland, Portugal, Spain and Italy on the weak side.
Herein lay the fault lines. The weak members were able to get a German credit rating which meant that they could borrow to consume goods and finance industry as well as infrastructure that otherwise would not have been possible. Banks, too, were happy to lend to the governments of these countries because they could take the loans to the ECB and use them as
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collateral for even more borrowing. A credit frenzy followed which has resulted in today’s debt crisis.
Figure 2 shows just how critical is the financial condition of so many countries in the OECD. There are three countries whose debt is above the BIS ‘safety’ threshold for all three categories – the UK, Canada and Portugal – and ten whose debt is above that level in two of them.
Figure 2: Household, Corporate & Government Debt as % of Nominal GDP
Source: Bank for International Statistics
The severity of the problem facing the eurozone is well illustrated in Figure 3. As a percentage of GDP, the refinancing required over the next few years is at an alarmingly high level: for Greece 30%, Italy 26%, Portugal 19% and Spain 16% for next year alone.
Figure 3: EUR 1,500bn to be financed in peripheral euro area states between now and 2014
Source: Pictet, Decision Time for Monetary Union, November 2011
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Germany’s choice is a harsh one. It is either to allow the ECB, the IMF and/or some combination to pour liquidity into countries which are essentially insolvent and so buy more time or to restructure the eurozone. The eurozone countries (plus six) now look as if they have agreed a fuller fiscal union, policed only by themselves, but it is unclear whether or not this will lead the ECB to unleash its trillions (instead, some enhanced funding for the EMS, due to be introduced in mid-2013, has been agreed). Had the eurozone agreed on full fiscal union it would have meant that Germany would use its balance sheet to bail out the weak members. Germany only achieved its current economic power by working through many years of austerity to make its manufacturing sector one of the great competitive industries in the world. There would be only a small chance that Germany’s electorate would agree to such a scheme if it were on offer. At the moment, it looks not to be.
But the self-policing agreement looks distinctly like a new attempt to introduce the Maastricht Treaty conditions that were supposed to have been agreed 20 years ago, only this time they are stricter and supposedly more automatically enforced. We doubt that will be the case. Fiscal rules will always be broken.
The limited agreement reached at last Friday’s summit has been greeted positively by markets, for now. But it remains a halfway house that is unlikely to stick or be rigorously enforced (especially when the current crop of Euroland politicians are replaced by others). We know that further money printing or quantitative easing tools won’t work because Europe’s problems are not about liquidity but insolvency. Fudge will be in the air; equity markets will want to believe, but bond markets may take a different view. We remain sceptical that the solution proposed at last week’s summit meeting will be workable.
China is at the start of its long march to achieve balanced and sustainable growth, a march that is bound to cause hiccups if not busts along the way. Years of growth dependency on fixed asset investment and exports has left behind a package of problems. They range from pricing money too cheaply resulting in bank deposit rates being negative in real terms; to a large amount of ‘hot’ money sloshing around the system; to bubbles in real estate and in the manufacturing sector; to many infrastructure and other projects which will never be able to produce a real rate of return; to a debt load that is greater than generally assumed (no one in Beijing knows what the real level of debt is of local governments); to a pending water shortage; to the overuse of nitrogenous fertilizers, such that large acres in the south cannot now be used to grow foodstuffs etc. and so on.
Now the economy is clearly weak as the PMIs are showing. Weakness is evident in construction and any of its supply chain components, in exports, in appliances and in car sales.
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According to some authoritative sources, China’s car sales should grow by only 3% this year even though car inventories are growing rapidly. This photo was recently taken by Nicholas Zhu of ANZ Bank during a recent visit to Ford’s second largest production centre in the world at Chongqing: its stock yard is full. And what about the others?
The mid-October Canton Fair is always a good barometer of future business. This year both the number of visitors and orders plunged. The total value of new business for electrical products, electronics and appliances, fell by 21.3% for those destined for Europe and 33.1% for those going to the USA.
The aircon sector is also a reliable proxy for the whole appliance sector since China accounts for 80% of world aircon production. Exports, which account for about half of China’s domestic production, fell by 17% in August and 23% in September, the last reported month. From our discussions exports have continued to collapse since.
Despite this weakness, which policy makers had long anticipated, monetary easing is and will remain very selective unless the world economy outside China physically goes into recession. The cut in the Reserve Requirement Ratio (RRR) was primarily aimed at helping companies, mostly SMEs, repay their loans by year-end as without this liquidity injection some would have been in serious trouble. Normally, loans get renewed early in the following year.
It is perhaps only when the new leadership is firmly in control in 2013 that China will experience a generational change. Too much power has gone from Beijing to the provinces and local governments; there are too many problems arising from a decade or so of unsustainable growth. The influence of the PLA seems to be growing, in fact some say it is restless. We suspect that we will experience a year or two of “clamp down” as the new leadership attempts to regain greater control. This period should also coincide with a global recession as part of our rolling recession thesis. China’s officially reported GDP growth should be in the 4-6% range, if not in actual recession, in 2013 and 2014.
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The US recovery is fragile. Growth will remain minimal and the economy is likely to revert to recession late next year or in 2013. However, some foreign holders of US Treasuries have become frustrated by the antics of Washington. These governments may well force the issue by creating the foundations of a full blown run on the US dollar sometime over the next six months. This should force the Fed to defend the dollar and bring the politicians to finally agree a deficit reduction programme which would be credible to markets. In turn, this would be the start of a strong dollar recovery and if government rolled back the red tape and health care costs etc. which have been foisted on the private sector, the USA would be on the threshold of a period of sustainable growth.
In short, the period ahead will be characterised by rolling world recessions and deflation post 2013. Figure 4 shows our projections for world industrial production over the next four years.
Figure 4: World Industrial Production - % Growth Per Annum – 1990- 2016
Source: Asianomics Limited, Haver
Copper Industry: A shadow of its former self
There is a world of difference between the physical consumption of copper – material which actually goes into furnaces – and demand (see Figure 5). Virtually everyone, from producers to analysts, talks about demand. But demand is also what the financial sector purchases either directly from producers or via merchants. The sums involved are huge, maybe as much as 5-6 million tonnes by the end of this year.
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Figure 5: World Refined Copper Balances
Source: Various
For instance, whilst China’s actual copper consumption has been quite weak all year but since September virtually collapsing, many analysts and producers keep talking about robust demand. What has been happening is that fabricators take out a ‘usance’ letter of credit to import cathode hoping in the process to defer some of the costs through RMB appreciation. Through the letter of credit they actually import more copper than they need. They sell this surplus to traders who in turn sell the cathode to wealthy SMEs and private individuals, or speculators as our friends in China say. These speculators then warehouse the cathode in private unreported warehouses. Based on our work some 4 million tonnes may be so held in China.
It is this fiction that is being promoted by producers, banks, analysts and consultants to show that demand is strong, that the global market is tight and that prices must move higher. Growth rates of 4% a year for world copper consumption as far as the eye can see is the order of the day, implying continued shortages and rising cash costs is their mantra.
Nothing, in our view, could be further from the truth. First, such growth rates must assume a solid increase in world GDP. Such an outcome is highly unlikely as we have set out above, a view which is fully in tune with the warning given by the Bank for International Settlements in its September report, The real effects of debt, BIS Working Paper No 352. The report illustrated the constraints on growth as being due to debt and demographics and concluded that the only way out was for the world to save more.
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Second, global consumption is being attacked by manufacturers and fabricators by using their skills to either limit the amount of copper used in their products or to design copper out of their systems by using an alternative material or new technology.
The tonnages so far lost are large. We estimate that since 2005 they amount to 2.5 million tonnes broken down by year as shown in Figure 6.
Figure 6: Copper Lost to Substitution 2006-2010
Year Kt 2006 450 2007 550 2008 500 2009 600 2010 400 Total 2,500 Source: SHSS
Substitution is not just the replacement of one material by another. There are five elements to substitution, which are:
Replacement of Copper with another material Tightening specifications and better designs Where copper has been penetrating a market, the pace slows or is reversed Where high copper alloys are replaced by low copper alloys Where new technologies largely design copper out of their systems
Aluminium is replacing copper in many parts of the wires and cables industries. Globally, in LV cables around 175kt of copper was replaced by aluminium in the period 2006 to 2010; in MV and HV cables around 260kt; in speciality cables around 360kt; and in telecom cables around 225kt.
China is not immune to these developments. Around 200kt of copper has been lost to aluminium in the wire and cable sector this year alone, mainly in magnet wires, power cables, telecom and data cables. Magnet wires used in aircon compressors, in micro-wave ovens and in other appliances are switching to aluminium. In the power cable sector, the growth of aluminium is faster than that of copper.
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Globally, copper is being substituted by aluminium and other materials in a wide range of products. One notable recent feature is the growing use of aluminium tubes replacing copper ACR tubes in the aircon sector. We hear that many aircons makers are switching as fast as they can. This is a global market of around 1.6 million tonnes a year.
New technology will soon start making inroads into key markets for copper. High Temperature Super Conductors (HTS) are already starting to be employed in the electrical grid system in some countries, a global market of over 3 million tonnes. We hear that China is also very quietly introducing HTS into their grid network.
A President and CEO of a major global wire and cable company has recently stated that
In the telecom sector: by 2020 38% of the global market will be lost to fibre optics, by 2030 65% and by 2040 80%. In auto wire harnesses: in 2010 100% was copper but by 2020 20% will be aluminium and 5% optical wires; and by 2030 30% will be aluminium and 20% optical wires. In power cables: by 2020 15% will be HTS but by 2030 40% will be HTS. Sometime around 2020 carbon nanotubes could start replacing copper in LV cables including building wires. This development is in the R&D stage but looks promising.
In the auto industry, miniaturisation, or downsizing, has become an important development. For instance, in terminal systems in cars the weight of the average copper connector has been reduced by 75% from 0.16g to 0.04g. In the housings, the weight has been reduced from 9.4g to 4.65g; and in wire harnesses, changing the designs and reducing the diameter of wires has taken out between 36% and 40% of the copper weight.
These are just a few examples of what is occurring to limit the amount of copper being used by industry. The impact of these losses is being masked by the activities of the financial sector but once those stop the world will then observe the true balance between supply and consumption. Prices will then be driven by real fundamentals.
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Figure 7 is our analysis of world consumption by end use. Note the importance of building & construction and infrastructure. End uses in these two sectors account for almost half of world consumption. For China, these two sectors account for just over 40% of the country’s consumption with appliances including aircons accounting for nearly 20%. In fact, in China copper contained in the export of finished goods, such as aircons, together with export of semis accounts for between 25% and 35% of the country’s refined consumption depending on the year and composition of exports. A 10% fall in exports in 2012 would infer that domestic consumption would have to rise by around 600kt just to keep demand at the same level as in 2011.
Figure 7: World Copper Consumption: Breakdown by End Use
% of Total
1. Building & Construction 33% Plumbing etc 6% Aircon tubes 1% Roofing, guttering etc 1% Comms wiring in buildings 1% Power distribution, wiring etc 24% 2. Infrastructure 13% Power Transmission, dist. network 11% Telecom Network 2% 3. Industrial 11% Electrical: Industrial transformers, motors 6% Non-Electrical: Valves fittings etc 5% 4. Transport 13% Harness, motors 7% Radiators etc 1% Railroad, shipping, marine 5% 5. Other Equipment 30% Appliances, instruments 9% Aircon, refrigeration 7% Industrial, electronics, PCs 4% Ammunition, clothing, coins etc 10% Source: SHSS, various
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The amount of copper lost to substitution in the 2011-15 period will be huge, around 3.35 million tonnes as set out by year in Figure 8.
Figure 8: Forecast Copper Lost to Substitution 2011-2015 – Kt-cu
Year Kt 2011 550 2012 600 2013 650 2014 750 2015 800 Total 3,350 Source: SHSS
Future copper consumption will be driven by global economic growth and intensity of use. In the period 2011 to 2015, average world IP growth should be no more than 0.4% a year (our rolling recession scenario) but world refined copper consumption should fall by an average of 0.9% a year (Figure 9).
Figure 9: World IP & Refined Copper Consumption Growth (% YoY)
Year IP Consumption 2011 4.0 3.0 2012 1.5 0.9 2013 -2.0 -3.0 2014 -4.0 -7.3 2015 2.5 2.0 Source: SHSS
Stripping out what the financial sector purchased and largely warehoused outside the reporting system means that world refined copper consumption numbers will be as shown in Figure 10.
Figure 10: World Refined Consumption – MT-Cu – 2010 - 2015
2010 2011 2012 2013 2014 2015 17.4 17.9 18.1 17.6 16.3 16.6 Source: SHSS
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Meeting these forecasts of world refined copper consumption will not be a problem for the industry as shown in Figure 11.
Figure 11: World Changes in Mine & SxEw Production (Ref. Cu. Equiv) MT-Cu
2010 2011 2012 2013 2014 2015 Mine & SxEW Products 15.5 New Projects 0.2 0.4 0.6 0.8 0.4 Expansions 0.5 0.8 0.4 0.1 0.0 Closures/Attrition -0.2 -0.2 -0.3 -0.5 -0.5 Net Additions 0.5 1.0 0.7 0.4 -0.1 Add Probable 0.0 0.0 0.1 0.3 0.4 Total Net Additions 0.5 1.0 0.8 0.7 0.3 Forecast Production 15.5 16.1 16.6 17.7 19.0 19.5 Add Secondary 3.5 3.5 3.5 3.0 2.8 2.5 Total Refined 19.0 19.6 20.1 20.7 21.8 22.0 Production Source: SHSS Copper Prices: Dollar repositioning
To repeat our refrain copper prices are not being driven by the users of the metal, but by financial markets. The correlation is marked. When prices fell sharply below US$7000/tonne during the LME week (early October), the banks came in to aggressively support the market. The word going around was that large margin calls were hanging over the market.
It is equity markets and the US dollar that we need to watch to see how copper prices will perform. The more bullish will say that global equity markets will reach new cycle highs next year and then collapse. Others say that these markets will get into trouble far sooner. But one development is almost certain: it is that the world is heading towards its second credit crisis, though some would argue that we are still in the first. The crisis is either going to evolve sometime soon or be delayed until towards the end 2012.
It is when that crisis breaks that it will signal the end of the gaming of copper prices or as we have termed this bust – Game, Set and Match (see Figure 12). It will mean that the holders of the unreported stocks will want to be cashed up, not holding a physical asset like copper. A straw in the wind that we heard recently is that some of those banks and merchant houses who have recently acquired LME warehouses would now like to sell. What seemed a good business model one to two years ago now appears a losing one. It suggests that they see this credit cycle bust coming followed by deflation which would thus make the business of buying copper for
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the financial sector and warehousing those purchases in their own warehouses an unprofitable business opportunity.
Figure 12: World Average Cash Cost of Production Versus Prices, 1980 - 2016
Source: SHSS
When the market breaks it will have to contend with not only weak underlying world consumption, but having to absorb the cathode warehoused outside the reporting system. It could be as much as 6 million tonnes by then.
Despite what many producers and their analysts tell us, it is prices which largely drive costs. During the last period of weak copper prices from 1998 to 2003, average world cash costs of production fell by around 25%. First, as history shows marginal producers get priced out of the market. This is a long process because prices must fall not just below their cash costs but below their closure cost which can amount to up to 10cents/lb. It is a lengthy process because management staves off closure for as long as possible.
Second, the industry goes into tight housekeeping mode. Expenditures will be deferred, stripping ratios will fall and underground ore grades will rise; head counts will be cut; and consumable prices, such as for tyres, diesel etc will decline sharply. In short, the bottlenecks that plague the industry in boom periods disappear. This is how the industry always reacts in periods of weak prices, which many seem to have forgotten. The moral is that production costs are just a snapshot in time; they are variable and are largely driven by prices notwithstanding the long-term fall in average ore grades.
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In summary, prices will have to keep falling, forcing the market to balance itself. History also teaches us that prices always return to the mean although the initial reaction is for them to fall well below the mean after such an excess as has been experienced in the copper industry.
In 2010 US dollars, the average price from 1980 to 2010 was $5100/tonne (231c/lb) and from 1990 to 2010 it was $4100/tonne (186c/lb). Somewhere between the two will be the mean, representing 10-30 year average prices. For our shorter period, LME prices should average $5000/tonne, but by year-end showing very sharp falls, as shown in Figure 13.
Figure 13: LME Average Copper Prices
Year $ 2011 8500 2012 8100 2013 6000 2014 3000 2015 2500 2016 2000 Source: SHSS
History will repeat itself. Just look at what happened in the 1978-1985 period. Worries about the US dollar and inflation prompted institutions, individuals and even companies unconnected with copper to buy physical copper. We were told at least 1 million tonnes was so held though from our knowledge then it was probably higher (we had one client who alone had bought 250kt). When they came to cash in their trades prices had already fallen and most lost money on the trades. This should be a salutary lesson for holders of this material such as pension funds. Time to get out before the end game swallows you.
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