Oil and Copper – Separate Ways Part 3

Copper outlook remains positive, despite the ramp up in prices

For our latest newsletter, we wanted to conclude the three part series dedicated to oil and copper. In the prior two publications, we analyzed recent OPEC+ decisions and their implications for oil supply, how growing global growth could affect demand for crude and refined oil, and the impact of geopolitical tensions between UAE and Saudi Arabia on oil pricing. We appreciate that oil prices have recently seen an increase, but please note that our outlooks are always more medium term and thematic in nature. We are less concerned about the day-to-day and week-to-week move in asset prices, but more about the structural trends underpinning their movement because for us, those factors could affect the macroeconomic landscape and thereby our assessment of country, sovereign, and political risk. And with that, please enjoy our outlook for copper.

Copper prices have seen tremendous upside over the past year. While the average price of copper was around USD 6,500/MT over the previous four years, in the past year it suddenly increased to above USD 10,000/MT, with an average price closer to USD 8,000/MT.

Copper LME prices over the past 5 years

(Source: Bloomberg)

Looking ahead, the outlook for copper is increasingly predicated on our (and the investor community’s) view on China growth and global electric vehicle demand given the use of copper in electric vehicles themselves, their charging stations, and transmission lines.

As noted above, copper prices reached a multi-year high of over USD 10,000/MT in May 2021, and have since retreated slightly to USD 9,200/MT. The first question to ask is, have copper prices gotten ahead of themselves. ?The answer is somewhat, but not entirely. Afterall, copper has been in this territory before as copper prices reached USD 10,000/MT in February 2011. Furthermore, copper is up around 125% from the lows of last year, which seems like a lot, except when we consider that oil is up over 90%.

In addition, we know that China’s copper demand tangibly surged mid-2020, with the data from China’s Customs General Administration reporting 762,000 tons of unwrought copper was imported in July 2020, compared with around 400,000 just a few months prior. In fact, the July 2020 reading was the highest on record. Even when copper hit USD 10,000/MT in 2011, China’s import demand was much lower at 300,000 tons. And in 2011, the world was not buying Teslas at the scale it is today. Thus, there are factors at play that support the current level of copper prices.

China copper imports over the past 5 years

(Source: Bloomberg)

Speculators bet on copper, while China buys up the world’s supply

There are two interesting takeaways here though. First, the rise in copper prices trailed when China started ramping up its imports. This implies that the spike is driven by speculators, and not just because of wholesale purchases. Granted, open interest for futures has not risen significantly on the LME, so it’s less about new entrants coming in and betting on copper prices, rather than the entire investor community simply believing that copper is and will remain an asset. Second, which is more of a question, why was China ramping up its copper imports in mid-2020, when demand for most commodities was falling? There are two potential answers and takeaways for this as well.

First, in an attempt to arrest COVID-19 related headwinds, China used its fiscal levers to kickstart an infrastructure development plan. In contrast with other countries, China’s infrastructure projects were ready to go on Day 1 and these developments required copper. And it’s because of these investments and capital expenditure, which again required copper, that China managed to generate positive growth in 2020, whereas no other major economy did.

Second, China was also stockpiling copper and other base metals in 2020 and storing them in inventory. As US-China ties deteriorated following the election of President Donald Trump, China likely started to procure various commodities as a hedge and to support its economic needs. Now, it’s not as if worsening ties with US would imperil China’s access to copper since most copper comes out of Chile, Peru and the Copperbelt. But it’s likely that China saw copper, and other base metals, as a way of keeping its economic engine humming giving it the edge it would need should worsening ties with the US were to create economic headwinds. In fact, China just last month announced plans to sell some of its copper held in official reserves. Although geopolitical tensions with the US remain high, the approach in Washington D.C. is markedly different than the previous administration, thus allowing an easing in commodity purchases for inventory purposes.

Supply fell, but not because of any overt decision by supplying nations, but because of limited labor

Beyond the demand side, supply side considerations likely also helped fuel the surge in prices. Copper production is not decided by a cartel, like oil, but instead a free-floating product based on availability.

Chile provides 25% of the world’s copper, with one mine alone (Escondida) responsible for 10% of the world’s supply. Copper makes up 50% of the nation’s export basket, and thus any hurdles in Chile can have dramatic effects on the global copper supply. In 2020, some of Chile’s mines were operating at lower capacity due to labor shortages as COVID-19 provisions went into place, and thus total copper production dipped by just under 1%, from 5.79 million tons to 5.70 million tons. This alone is not a massive decline, until we consider that Peru’s production fell from 2.5 million tons to 2.15 million tons, and when we layer on the market perception of copper shortages, coupled with China’s actual increase in purchases, we can see why copper prices at 10,000/MT make a lot of sense.

Looking ahead where do prices go?

Chile and Peru are forecasting that 2021 output will be similar to 2019, thus a return to normalcy. Beyond 2022, Chile’s production will likely start to increase slowly approaching 6 million tons, whereas Peru’s figures may remain flat and even slightly decline.

Against this, we also anticipate China’s purchases to slow down, but the electric vehicle component will remain a dominant theme as purchases of electric vehicles grows, and new entrants come into the market. In fact, more and more car companies are pledging to go electric, or at least have electric vehicles as a key product in their offering set. Also, markets like the European Union are increasingly requiring electric vehicle adoption. Thus, the global electric vehicle market outlook and demand will no longer be dependent on the availability, and ability of consumers to buy Teslas since numerous car companies are starting to offer electric vehicle at various price points.

Furthermore, and as one investment bank recently noted, copper inventory in the value chain of various products is falling, and then the recent floods in China likely affected the domestic copper output in the region. Based upon supply increasing just marginally, while demand expecting to also grow, we expect copper prices to remain supported. One investment bank is forecasting copper to rice to 11,500/MT in the near term. Again, we are not trying to forecast prices, but we concur that the current range is not excessive and likely where the natural clearing price for copper could be in the near-term. In the medium to longer-term, as supply starts to increase out of Chile and Peru, and the effects of the floods in China subsides, we could see some softening of prices, but that could be a long ways out. Till then, prices will likely find support and the current level of copper is not excessive.

The political and economic implications

For Chile, this is positive as it implies that the already high dollar inflows the nation is receiving may continue. For Peru, the outlook is slightly more mixed due to lack of policy clarity. President Pedro Castillo is the nation’s new president and has a history of making provocative statements regarding the nation’s mining sector; namely a desire to nationalize the industry and raise taxes. In recent weeks, he has walked back these statements and his party does not have a majority in congress, thus it’s not evident he could even carry through on nationalization even if he tried to. But uncertainty could result in higher copper prices if markets begin to worry about supply constraints and/or additive taxes. Although Castillo’s policies would be net negative for the sector, for the actual commodity, they could provide an additional floor. At the moment though, it is not evident that his commentary is filtering through into copper prices themselves, whereas they have caused some consternation among companies operating mines in the nation.

As a final takeaway, longer term, oil and copper could be inversely related products and hence move in “Separate Ways.” Granted, oil is used in multiple products. But if electric vehicles truly take off, then theoretically, the demand for oil could dip while the demand for copper could increase. This inverse relationship, should it materialize, could be interesting from a hedging perspective. But until ?then, as we watch oil, we do not expect demand to spike just yet, thus supply side factors will be key to monitor. Whereas for copper, it will truly be a demand led story given that supply decisions are not done via a consortium, but rather each country in the copper space simply maximizing its potential production.?