Dr Copper’s Negative Prognosis
The best cure for low prices is — lower prices. A strong Dollar, declining demand growth rates in China amidst a demographic deceleration in the Western world have kept Copper and most commodities in a long term tailspin. It’s rare that commodities experience such protracted Bear market while the world economy is in an expansion cycle. To some degree growth deceleration is the same as contraction form a valuation trend viewpoint. As witnessed with the Oil market collapse of 2014 and Natural Gas market of 2008, higher commodity production and decelerating consumption can occur along with long term price destruction. Oil prices fell 74% since the 2014 peak, yet production has remained near record levels, defying conventional wisdom.
There are similarities here with Copper as fears of accelerating production collided with greater fears of decelerating demand, yet a 58% price contraction since 2011 has yet to either remove sufficient supply or encourage accelerated consumption.
Copper content of world mine production has been dominated by Chile since the 1980’s peaking at 36% of global production. China has been the rising star in recent years doubling its market share from 5% in 2000 to over 10% today. While debt levels and a secular decline in manufacturing growth have triggered a price collapse to just $2/pound, operating cost reductions and rapidly deflating fuel prices have allowed the profitability threshold to contract commensurately from the low $2’s to less than $1.60 in places like Chile.
Glencore announced the removal of 400,000 metric tons of copper production on October 9th in an ongoing effort to eliminate $10 to $12 Billion in corporate debt by the end of 2016. Such a move was expected to stabilize supply and demand, yet copper prices immediately fell another 18% over the ensuing 3 months toward its 2009 crash lows. Our ideal long term lows targeted in 2013 were expected to be in the $1.91 – $2.03 area. We have arrived and at least a short term rally is due. Typically copper rises during the early months of the year, but thus far Bullish news has fallen upon deaf ears.
In 2013 we had not envisioned how much the global commodity glut would grow and leave even more pent up deleveraging needed to end the secular deflation wave. Asset sales, bankruptcies and supply contractions are the welcome news events that will eventually discover the painful price required to begin building the next Bull market.
An inventory spike such as oil experienced in 2015 has not manifested in London Copper warehouses, which is a positive near term. Chinese copper premiums have spiked this week hinting near term supply constriction. While metal inventories could rise later in 2016 induced by a harder than expected landing in China’s industrial sector, markets continue to anticipate a long term deceleration in demand that could outpace the expected slowing from the production side.
Consensus 2016 copper production and usage forecasts a 130,000 ton shortfall that is expected to bring equilibrium to prices above $2/lb. Such a perspective may in fact support prices as 2016 matures, yet our view is that there are trends in place that may eventually confound this outlook.
1) Supply from previous copper investments in Chile and globally may rise more than expected with economies of scale built on the back of cheaper costs of production.
Similar to the US Shale industry, as prices have come down, so have costs for labor and power (Oil). Major producers have to follow through with long term capital investments and seek market share and economies of scale or risk massive defaults. Exploration will curtail longer term growth rates, but supply restrictions will be limited for now. Initially, investment costs can be ignored in favor of a cash flow and marginal cost strategy. With bulge producers in Chile claiming break-even costs near $1.60/pound (likely under $1.50 in the nine months since that report) there is room to run lower should China continue to decelerate in the first half of 2016.
2) Demand Destruction: Chinese consumption may prove weaker than consensus if the 13th 5 Year policy stimulus in March prevents capital from supporting construction and industrial metal usage.
A general industrial sector contraction throughout Asia has been underway for much of the past 6 years since the dead cat bounce after the 2008 Great Recession. In recent years the construction, transportation, autos and consumer product segments have also spiraled lower.
Half of China’s economy is tied to manufacturing vs less than 12% in the US. In March China will announce their 5 year plan to gradually redirect capital away from debt laden manufacturing in favor of the faster growing service sector. Such a policy change merely acknowledges reality as their export growth shrinks and manufacturing sector remains mired in a 4+ year recession. Bad debts will continue to rise here until capacity is reduced and bankruptcies are allowed to peak.
Without Chinese stimulus in manufacturing and steel, iron ore and most copper proxies had to deflate or risk an even greater systemic debt bubble implosion.
It’s a good sign that copper usage trends are rising in recent months. However, they are still subdued compared to past upturns and how much of this is just stockpiling collateral for debt service? The secular PMI contraction, the rapidly rising debt burden and indications by Government to shrink support for the industrial portion of the economy leads us to restrain our medium to longer term optimism for copper and related sectors.
3) Rising Dollar will depress copper.
There is no doubt that a further Dollar uptrend would bring copper to new lows. The exchange traded dollar actually peaked in March 2015 despite the clamor over the strong Dollar throughout 2015 dominating the currency news. The consolidation over the past 10 months has been a tug of war as growing US economic weakness has been countered by European quantitative weakening of the Euro as comparative interest rates remain weaker than the Yanks. The Euro – US battle may stay in the current trading range for most of 2016 until more decisive GDP growth rate changes become evident in either direction. For now the Dollar remains a burden for the moribund copper market.
If we feel the Dollar is strong from a conventional perspective, then its positively boiling over from a broad based comparison of US trading partners. Perhaps the Dollar Index can remain in a 92 to 102 range in coming months, but the ballistic rise versus the weighted average of US trading partners this past year reflects the heavy undercurrent of a competitive devaluation theme among the commodity based emerging markets. Until a firm up cycle emerges we should expect more capital flight to the Dollar from emerging markets. Capital is also fleeing China at alarming rates that must be addressed in March to reassure domestic and foreign investors that a soft landing can address the debt bubble and accelerate service sector consumption safely. China has allowed an 8% Yuan depreciation over the past 2 years, but they are unlikely to follow the rapid currency repricing of its emerging market children as they seek to become a global reserve currency over the next couple of years. Support for the Dollar will remain an impediment for a copper Bull market. Accurately forecasting the Dollar will bring clarity to copper’s outlook. Additionally copper will stay mostly in sync with the Oil market until equilibrium in the energy markets is achieved. There are hints this week that a February meeting will encourage the Saudis to attempt to manage Oil prices at a higher price range, implying that the lows are in for Oil. Such news would be well timed with seasonal strength in energy and copper markets that usually materializes by March. An upward adjustment to Oil would likely help stabilize emerging markets and reverse the upward pressure on the Dollar should the Saudi/Russian alliance be confirmed.
Good News: Sentiment Sucks
When everyone is on one side of the room there is nowhere to go except to the opposite side. Sentiment has reached record levels of negativity with the commitment of traders. Historically, when Money Managers and non-Commercial Specs reach their current levels of Bearish net short commitments, prices tend to rebound. In a Bear market that usually means a 1 to 3 month rally. Should US and European GDP’s accelerate, then this rally phase could continue. For now the $1.90’s is short term support and our comfort zone extends only into March/April for a rally phase.
China’s 13th 5 Year Plan to be announced in March should verify what many expect, that China will support its service economy while attempting to deftly shrink its industrial sector. While copper should continue a modest rally near term from the $1.90’s to perhaps the $2.20’s, there is no reason yet to expect a secular Bull market. News from the Saudis and Chinese in February and March respectively could provide significant potential trend reversals for investors. Plenty of risk remains to the downside towards $1.50 copper in 2016 while capital stays away from industrials and the global deleveraging in manufacturing comes to a climax. By 2017 there is potential for a real copper bottom.