Heavy metal

Buttonwood

Jul 26th 2005
From The Economist Global Agenda

Copper hit an all-time high this week, after China announced plans to revalue the yuan. Why?

DESPERATE for light relief on deadline day last week, Buttonwood was clicking through new company results and came across a blast from her past. Freeport-McMoRan, a complicated Louisiana company, operates one of the world’s biggest copper mines, in a remote corner of Indonesia’s West Papua province. The vast open-cut mine, which measures a mile across, was created by slicing the top off a mountain, Grasberg—sacred to some locals—and dumping waste in the adjacent waterways. The construction of this enormous mining complex, deep in inaccessible territory, amazes engineers and outrages environmentalists in equal measure. On a visit some years ago, your correspondent was suitably impressed by both.

Freeport (led by James “Jim Bob” Moffett, a pal of former president Suharto and a star Elvis impersonator) is very profitable, as it produces gold along with its copper. And its second-quarter results were particularly flattered by the comparison with the same period a year earlier, when production was still affected by the collapse of a pit wall in late 2003, causing several deaths. Profits for April through June of 2005 were $175m on revenues of $903m, compared with a net loss of $53m on sales of just $486m.

Other copper-mining firms have also been reporting good profits, for the metal has stayed the course better than almost anything except oil in the on-again, off-again commodities bull market since 2002. China’s dash for industrial growth exceeded the capacity of its domestic base-metals industry, setting off a general surge in world prices. But the rising tide that lifted all commodities has ebbed of late, Barclays Capital points out in a new report, leaving different materials to fend for themselves according to their different market fundamentals. Copper, despite a few blips this year, is fending particularly well: its price has doubled since 2003, touching a new dollar high on the London Metal Exchange on Monday July 25th.

One reason, says Michael Lewis, a commodities pundit at Deutsche Bank, is that the price of copper is particularly closely correlated with Chinese industrial output, and that seems to have stayed stronger than many expected. Last week’s official statistics showed output growing by 16.8% year-on-year in June, up from 16.6% in May. China consumes one-fifth of the world’s copper, and was the only big consumer to increase use of the metal in the four months from January through April, on figures from the International Copper Study Group (ICSG).

Dr Copper

Why should we care particularly about copper? First of all, because it provides a fascinating keyhole through which to view the big economic shifts that influence our life and times. We don’t know for sure what shapes our economy and we certainly don’t know what shapes China’s. But copper, because it is used in such a wide array of applications—plumbing, telephony, cars and many other things—can sometimes take the temperature of the economy and diagnose its condition.

Another, more mundane, reason is that commodities have become popular financial investments over the past couple of years. Tired of uninspiring returns on equities and bonds and keen to diversify into assets whose returns are often negatively correlated with those on securities, individuals and institutions have piled into things like mutual funds that track commodity indices.

Returns on the Goldman Sachs Commodities Index rose in the first quarter by 22% but fell in the second by 4.5%. Are investors going to make a killing or get caught out, and maybe our pensions with them? And is the current high price of copper a sign that there is genuine durable economic demand out there—or is there some specific problem with the balance of supply and demand?

Like most other base metals, copper is in short supply. Stocks held officially by exchanges around the world amount to only 75,000 tonnes or so, after a year of de-stocking. That’s not much of a buffer in a world that consumes 17m tonnes a year.

There are rumours of huge unofficial stockpiles but the structure of copper prices suggests that these are exaggerated. When supplies are tight, the metals market becomes “backwardated”: it costs more to buy a contract for delivery soon than it does to buy a contract for more delayed delivery, rather like an inverted yield curve in the bond market. Copper has been in backwardation almost constantly since 2003. Just as telling, the premium for spot copper over the nearest forward contract jumps up when buyers worry about being able to get their hands on the stuff. At the beginning of 2004, there was virtually no spot premium, says Mr Lewis. By July 25th it almost touched $300 a tonne.

Why are supplies so low? Normally, “High prices are the best cure for high prices,” as Andrew Brady, of CreditSights, a research firm, puts it. Copper production is increasing in response to high prices. But it seems to have hit a number of speed bumps. Mining companies spent little on research and development, or on exploration, in the 1990s and were slow to get going again. Disasters such as Grasberg’s mudslides also took their toll on production. So did strikes—most recently in Chile, Zambia and America. And a few mines, some say, have given priority to producing associated metals such as molybdenum, which is mined in tandem with copper and whose price has increased even faster than the bigger metal’s. There are plenty of new projects under consideration, but they will take a while to make a difference.

Does the rising price of copper then reflect strengthening global growth? Yes, to a large extent. But it also reveals a stickiness in the market to which uncertainty over the direction of two currencies—the dollar and the yuan—may also have contributed. So China’s announcement last week of its new “baby-steps” foreign-exchange regime (the yuan up 2.1% against the dollar, with permitted daily fluctuation of up to 0.3% and based on an unspecified basket of currencies) has had everyone in a lather trying to figure out what effect it will have on economic growth and demand for commodities.

The bullish argument has it that the Chinese will find materials cheaper, even if only marginally, and will hence buy more of them: no more substituting plastic tubes for copper ones. The bulls get added traction from the fact that China is hosting the Olympics in 2008 and still has a lot of infrastructure to build. The bears, on the other hand, maintain that a dearer yuan will reduce demand for higher-priced Chinese exports and shrink employment in China, as well as separately raise interest rates and cool economic growth in America.

Realistically, the new currency regime is unlikely to matter a hoot in the short term. China has moved the bare minimum it needed to in order to defuse a protectionist backlash among its trading partners. It can now do virtually anything it likes with its currency. However much the government might wish to keep easing the descent of its helium-filled economy by letting the yuan move upward, it is unlikely to undertake anything that encourages speculation or increases unemployment. Any serious revaluation of the yuan will therefore take years rather than months.

And that raises the possibility that while copper prices probably have a little more upside in them now, a stronger yuan, slowing world growth and increased copper supply might all coincide a couple of years from now, forcing copper prices to slump. Dr Copper, to the sick bay.

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