Copper vs Oil: The Great Disconnect

Copper is a constant on Capital 10X and remains the key transitional metal in our view for the ongoing renewable revolution.

Historically, copper also has an almost unbeaten record for sniffing out economic strength and weakness before many other commodities. Fondly called Dr. Copper for this very reason, the copper industry is an essential part of the global economy and demand is closely tied to overall economic growth.

According to the Copper Alliance (a leading advocate for the copper industry), one tonne of copper is enough to build 40 cars, power 100,000 mobile phones, drive operations in 400 computers and bring electricity to 30 homes.

Historically, there has been a strong correlation between copper and oil, as both are affected by the same economic factors and market conditions.  Energy costs make up a significant portion of the costs of copper extraction, smelting and refining, so there is a material basis for copper and oil prices to fluctuate in unison.

Oil is also a critical power source for economic activity, and quickly reflects falling or rising economic output. Oil accounts for about 3% of GDP and is one of the world’s most important commodities.  Petroleum is essential to the manufacture of innumerable products from plastics and chemicals to clothing, and constitutes billions of dollars of transactions, even before considering its use as a fuel for transportation.

A decline or expansion of the world economy almost always results in an increase or decline of oil and copper prices.  Forecasts of the respective prices and consumption of these two commodities, are generally set and revised with projections of global economic growth.  Case in point, economists will often perceive a rise in oil prices as news of inflationary or recessionary tailwinds.

However, we’ve noticed something strange happening lately. We are seeing a decoupling of copper and oil prices, with copper prices rising dramatically year to date while oil prices are struggling amid global inflationary concerns and a worldwide banking crisis.

Oil vs Copper Price (Year to Date %)

So why is copper holding up so much better than oil, when forecasters expect slowing economic growth, tightening lending standards and a potential recession within the next 12 months?

We think the answer all comes down to inventories…

Oil: A Story of Geopolitics & Supply

The International Energy Agency (IEA) states that in Q4 2022, supply outpaced demand by over 1 mb/d, despite a cut in OPEC+ production targets and disruptions to US supplies (due to winter storms).

Also, gains in energy efficiencies and soaring sales of electrical vehicles, will curb global 2023 demand growth by close to 900 kb/d in 2023.  The market participation of Russia and China remains unpredictable, as sanctions have prompted Russia to seek new customers (at arguably reduced prices) for their oil, and the nature and speed of China’s reopening is still uncertain.

US Central bank policy has overshadowed China’s reopening, with the two week old banking crisis taking crude oil futures down by about $11/bbl, or 13% since March 3rd.

The US oil benchmark, Western Texas Intermediate (WTI) continues to slump as well as US crude stockpiles build.  Overall, optimism is fading from the market.

Copper: The Uncrowned King of Commodities

Like Rodin’s the Thinker, copper sits above the rest in contemplation of the current tepid macroeconomic backdrop.

Copper is the best performer this year out of the industrial metals, rising more than 7% year-to-date, while other comparable metals have fallen in an environment of slowing economic growth expectations.

There is evidence that current prices aren’t reflecting expected supply deficits, which we’ll discuss below.

Very Low Inventory Driving Current Price Strength

We think the most likely explanation for Copper’s strength vs oil comes down to copper’s very low global inventory levels. As we’ve covered in previous articles, global inventories for copper and other industrial metals held at exchange monitored warehouses (i.e. LME & SHFE) are at record lows.

The situation looks like its gotten worse amidst all the economic worries not better, with investment Bank Goldman Sachs forecasting that the world could run out of visible copper inventories by Q3 this year, if current demand trends continue.

The re-opening of China, a major consumer of copper is a major contributor to rising copper demand expectations this year. Chinese demand rose strongly in February, the latest month of data.  Currently, copper inventories are at the lowest seasonal level since 2008.

According to GS, Chinese copper demand rose 13% in February year-over-year; and they believe that the price could hit $10,500 a tonne as the Asian nation increases their post lunar new year industrial activity.

Copper Global Visible Inventories

One of the major factors affecting the strong copper price is the increasing demand for green technologies, more specifically batteries.  McKinsey & Co. has identified that electrification is projected to increase annual copper demand to 36.6 million metric tons by 2031, and only rapid new mine development and the adoption of copper mitigating technologies, could potentially fill the looming copper supply gap.

Shortfalls, Slowdowns & Supply Gaps driving an Uncertain Future

A 2022 S&P Global study found that significant copper shortfalls will begin in 2025, as a result of increased demand from the energy transition and limited new copper supply. Their rocky road scenario assumes that if current conditions continue, there will be a 10 million metric ton shortfall by 2035. Even in their high ambition scenario, which assumes significant strides in technologies for extraction and recycling techniques, a shortfall will continue until 2035.

Forecast Copper Supply & Demand Balance

Source: S&P Global

Unfortunately, the mining industry will not be able to meet this supply gap from new production without a frankly unrealistic increase in drilling capital expenditures.

Many of the world’s largest copper mines are facing dwindling reserves, depleted ore-grades and are slowing production due to capital-intensive major projects being moved underground in a bid to increase access to more ore.

Looking for new deposits (called greenfield exploration), is very costly and imposes inherit risks and difficulties. Not to mention, finding copper and putting it on production takes a long time.

The past decade has seen greenfield exploration slow dramatically, as the excess supply from 2006-2012 was worked down.

S&P Global estimates that new discoveries averaged 50Mt annually from 1990 to 2010. Moving to the present, discoveries have fallen by 80% to only 8Mt / year.

Current estimates expect a cumulative supply gap of 50Mt or over two years of global demand, between 2022 and 2030.

Mining project approval rates have stalled. During the first half of 2022, the volume of committed projects totaled just 260,000 tonnes of production per year.

Mining Project Approvals by Year (kt copper)

Source: S&P Global

Three Ways to Invest in a Copper Shortage

Given the significant inventory shortages we have identified above, copper prices are poised to hold up better than other commodities if we are going into a period of economic weakness.

A resumption of quantitative easing by Central Banks or falling interest rates, could easily push copper prices to new highs under the current supply shortages.

We prefer three different ways to invest in these trends, bucketed by diversification and risk.

On the lower risk end of the spectrum is the Global X Copper Miners ETF (Ticker: COPX). The ETF is well diversified with 51 positions, and the top 10 stocks taking up a little over half of portfolio.

The diversification of COPX helps you avoid taking on company risk, the risk that one company does something stupid. COPX provides exposure to the price of copper with the potential for better returns than physical copper given the operating leverage copper miners have to the underlying commodity.

Top 25 Holdings of the COPX Copper ETF

Source: Ycharts

Year-to-date copper prices are outperforming the copper miners 3.4%, though in early February the copper miners were up 18%, 10% more than physical copper.

YTD Performance of Copper vs COPX ETF

Source: Ycharts.com

Our second preferred way to invest in copper upside is to own a high-quality large miner like Southern Copper (Ticker: SCCO). Southern Copper has a market value of $55bn and generates almost 80% of revenue from copper.

Southern Copper Footprint

Source: Southern Copper Investor Website

Yes, Southern Copper is more expensive than large mining peers like BHP or Freeport-McMoRan, but it has outperformed them significantly this year due to its heavy copper weighting.  Exactly the exposure and outcome an investor would want.

Forecast EV/EBITDA in 2023

Source: YCharts

YTD Performance

Our final investment pick to take advantage of the positive copper outlook is a small cap miner, with a unique value proposition. Investing in small caps does come with higher operational risks, but this is balanced by far higher return potential as smaller miners are often mispriced, especially at the beginning of a sustained period of stable to rising commodity prices, like we may be in today.

The company we’ve chosen has a truly unique operational footprint as it produces copper but does not need a mine to do so. The company Amerigo Resources (Ticker: ARG, ARREF), which we’ve written about before on Capital10x, provides significant leverage to copper prices without exposing investors to uncertainties that come from operating a complex copper mine.

Amerigo receives waste fluid (tailings) from El Teniente, one of the largest copper mines in the world. The company extracts the remaining Copper and Molybdenum from the waste stream, selling it back to the mine at the current global copper price.

Another risk mitigator with Amerigo is the company’s very low leverage. Cash exceeds debt which gives the company flexibility should copper prices decline for a period, if the world does go into a shallow recession.

Amerigo is trading on a trailing EV/EBITDA of 5.3x with Copper at $4.11/lb. The last time the stock traded at 5.3x EV/EBITDA copper was at $3.00/lb.

Amerigo EV/EBITDA multiple vs Copper Price

This tells us there is significant upside at current copper prices, especially seeing as EBITDA is expected to be $36 million at $3.60/lb copper which is in line with EBITDA in 2018, when the stock was at a similar multiple.

Bottom Line: Amerigo is pricing in $3.60/lb copper when prices are trading at $4.00/lb or 10% higher.  

Commodity Prices Rarely Lie

Whenever we notice two economically sensitive commodities like oil and copper diverging in price, we take notice.

After looking at the fundamentals of each, it became clear there are huge differences that likely explain the divergence.

Oil investment may be low historically, but we can see demand weakening in real time through rising inventory levels in the US and elsewhere.

Copper in contrast has an acute supply shortage. The supply situation is so critical that even as global growth and demand are weakening, prices have been rising, telling us supply just isn’t there.

Copper has the superior short term and long term demand trends and continues to be our preferred commodity investment this decade, regardless of the chances we see of a global recession in the near future.

The opinions provided in this article are those of the author and do not constitute investment advice. Readers should assume that the author and/or employees of Capital 10X hold positions in the company or companies mentioned in the article. For more information, please see our Content Disclaimer.

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