Copper: Between Substitution And Supply Deficit

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By Chris Shaw

Copper is starting 2011 at a near record high of more than US$9,500 per tonne, which RBS notes is an increase of 245% from the lows of December 2008. More gains can be expected in coming years in the broker's view, driven by growing supply deficits and a tight physical market.

RBS is forecasting a peak copper price of US$11,000 per ounce in 1H14, with risk prices reach these levels earlier if there is strong uptake from new physically backed copper ETFs or exchange traded funds.

Short-term there are some risks to copper prices in the view of Standard Bank, which argues the physical market is likely to weigh on prices in the shorter-term. The bank notes the underlying physical market is looking weaker, while physical premiums in Asia have come under constant pressure over the last few weeks.

This suggests either the Asian market is well stocked, demand has dropped off significantly or there has been a combination of both factors. This shorter-term trend is unlikely to impact on what Standard Bank sees as a bullish longer-term outlook, based on forecasts of a refined deficit this year of around 385,000 tonnes, increasing to a deficit of as much as 562,000 tonnes in 2012.

But as RBS notes, one issue with stronger copper prices is demand destruction, as substitution increases given relative cost differences. Aluminium is the likely beneficiary of substitution in such an environment.

RBS points out copper is 3.8 times more expensive than aluminium at present, compared to a historical average of 1.5 times over the last 30 years. This leads RBS to suggest there is greater price upside for aluminium than for copper in 2011.

Citi expects both copper and aluminium will be among the better performing commodities on a six-month view, reflecting its view of strong emerging market and US demand, loose monetary policy in G3 nations and demand from physically-backed ETFs.

With respect to China, which is a major player in terms of global copper demand, Citi expects copper could suffer from slower growth in generating capacity, though continued growth of electricity growth should be supportive, as should urban infrastructure demand. In contrast to RBS, Citi sees few easily identifiable substitution threats for copper at present.

In terms of forecasts, Citi expects spot copper prices of US$8,712 per tonne on a 0-3 month view and US$9,369 per tonne on a 6-12 month view. In terms of average annual forecasts, Citi expects prices of US$9,124 per tonne in 2011, US$8,809 per tonne in 2012 and US$7,935 per tonne in 2013.

Among the Australian plays operating in the global copper market, Citi rates BHP Billiton ((BHP)) as a key Buy given volume growth, stronger buyback and dividend potential and exposure to higher oil prices. In contrast, the broker rates Oz Minerals ((OZL)) as a key Sell, based on negative merger and acquisition risk and the fact the current share price is discounting a long-term copper price of US$5.40 per pound.

This implies good margins for copper producers. Credit Suisse notes as of the third quarter of 2010 the average cash cost of producing copper was about US$0.93 per pound or US$2030 per tonne, while the highest 10% of supplies are produced at US$1.55 per pound or US$3,390 per tonne or higher.

Macquarie earlier this week revised its copper price forecast to US$5.00 per pound or US$10,935 per tonne for both 2011 and 2012, which flows through to changes to the broker's earnings forecasts in the sector. This accounts for the issue of substitution, which Macquarie sees as some sort of threat at prices above US$4.50 per pound or US$9,840 per tonne, but one that will be over-weighed by what is expected to be an inadequate supply response.

Factoring in the changes, Macquarie continues to rate BHP and Rio Tinto ((RIO)) as Outperform among the diversified miners, both of whom are among the world's top ten copper producers. For copper specific plays, Macquarie also rates both Equinox Minerals ((EQN)) and Oz Minerals as Outperform. The broker's price target for Oz Minerals has increased to $1.95 from $1.65.

Elsewhere in the sector Macquarie rates Discovery Metals ((DML)) and Straits Resources ((SRL)) as Outperforms, while PanAust ((PNA)) is rated as Neutral.

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