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 Page 2 of 15 No. 29/2011 ● 12 December 2011 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 Page 3 of 15 No. 29/2011 ● 12 December 2011 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 Page 4 of 15 No. 29/2011 ● 12 December 2011 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.