Sunday, August 30, 2009

Copper and BHP

I have a vivid memory of pitching a commodity linked currency contract to a large Australian mining company during the Asian crisis in late 1997. They were already bleeding from their swollen AUDUSD hedge book. The deadpan response of the company’s cardigan wearing Treasurer was: “I’m not going to be the one to sell copper at the bottom of the market”…Copper proceeded to plunge and the company was ultimately taken over.

The crux of our pitch was that with World GDP growth expected to fall towards 2%, metals prices were going to take a hit. Following is a chart of GDP and copper prices since 1990 (source: IMF):

See the Asian crisis? It’s easy to miss given the more recent gyrations. It begs the question – how can copper prices (and commodity prices generally) continue to levitate at current levels in the face of such widespread demand destruction?

Now clearly the world has changed a great deal since the Asian crisis. The desperately low copper prices of the late 90’s and early noughties were the catalyst for consolidation and restructuring on the production side of the ledger. Producers now have greater pricing power. On the consumer side, the emergence of China into full throttle industrialisation logically puts a flaw under medium term demand. BHP sees China doubling its annual demand from current levels by 2025.

To get a sense of the demand and supply equation consider the following table:

There are a couple of things that jump out from this breakdown. The first being the absolute dominance of China, the second being that ‘high income’ countries (to use IMF vernacular) in aggregate remain significant to world demand.

Which leads to the obvious question – if there was a surplus in 2008, then what happens in 2009 when world GDP really falls off the edge (annualised Q1 GDP in US down 6.4%, Germany down 6.7%, Japan down 14.2%). Even if GDP has stabilised and (just maybe) begun to recover in the second half, it is now coming from a low base. Think we can reasonably expect the copper surplus to persist this year.

And going forward into 2010, even if China’s physical demand were to level out at a higher level (say 2 million tonnes per annum) if world GDP grows by 1% YOY after dropping 2.5% the year before, then there’s a reasonable chance that there will be a surplus for that calendar year as well.

So it’s a fair probability that for at least the short to medium term, physical demand for copper will be outstripped by supply.

How then can commodity prices be trading at their current levels? It’s not because the cost of production demands it (witness BHP’s current EBIT margins at around 40%, nearly double that of the dark days of the Asia crisis). Or put another way, who has been the marginal buyer pushing up prices beyond the physical demand for the metal. The answer not unexpectedly is China. The following chart of refined copper imports in China illustrates the point. (Source: China Customs Office)

Impressive isn’t it. The fact is China has been sucking in copper above and beyond its current needs. Macquarie estimates as much as 400,000 tonnes have been stockpiled in the first half. While there have been reports that China has bought 235,000 tonnes for its strategic reserves.

So will stockpiling continue?

As with all things China it is hard to get definitive, but a couple of arguments would suggest not.

Firstly, logic would suggest China does not need to chase the price higher. The whole point about building strategic reserves in a very weak market is to facilitate management of supply when demand picks up. With around 40% of their annual import requirements covered by stockpiles, China’s consumers can afford to be a little less hasty in bidding for supplies even if they are for additional reserves.

Secondly, indications are that liquidity is being reined in. Statements about the reclassification of sub-debt in relation to bank reserves and about how the proceeds of loans should be applied suggest anecdotally (if not in substance) that the Party is concerned about liquidity-fuelled speculation. The fall in new lending in July mirrors the decline in copper imports. Early indications are that liquidity and its handmaidens, greed and lust, are on the wane.

To BHP then – what is its valuation looking like with the share price over $37? Consensus forecasts look something like:

The commodity assumptions underlying these earnings are many and varied depending upon the broker. But as a generalisation on a straw poll, they are pretty much extrapolations of current prices continuing to strengthen from here (UBS for example has forecasts for copper of 223 cents per pound for FY2010 and 255 cents in FY011 - compared to a realised price of 224 cents in FY2009).

In short, I’d class the current valuation as pretty rich. While the long term Chindia industrialisation story remains favourable, as with all things, this fundamental outlook should be risk weighted to reflect the many uncertainties in our world. At 15x to 20x earnings, and on the basis that these earnings are calculated using favourable commodity prices, there is not much room for error (or upside).

On the other hand, maybe we are living on the verge of an inflationary world where the USD will plummet, commodity prices will soar, and China will lead us into another era of excess and fine dining. Maybe…

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