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Copper Conundrum

Declining prices make commodity producers look cheap, but Morningstar analysts believe there is more downside.

Jeffrey Stafford, CFA and Daniel Rohr, CFA, 02/12/2016

The outlook for copper prices is worse than most investors think. Prices have marched steadily downward from their $4.50 peak at the start of 2011. At the end of 2015, they sat around $2.10 per pound. Battered copper-mining stocks may now screen as cheap, but we see further downside.

This 50% collapse has been met with a diverse set of opinions about the future trajectory of prices. Bulls point to declining ore grades, solid if slower demand growth from China, and the need to develop new mines to meet future demand. Bears question China’s ability to maintain rapid growth, point out recent deflationary pressures on copper costs, and note the plethora of new and relatively low-cost mines that will soon start production. Long-term copper price estimates range from $2.25 to $3 per pound.

We aren’t as optimistic. We forecast a long-term price of $2 per pound and expect ebbing Chinese demand, which accounts for roughly half of the global total, to push prices below $2 in 2016 and 2017. We expect China’s copper needs to fall as real estate activity fades to a level more commensurate with underlying urbanization trends and power spending shifts away from copper-heavy distribution to copper-light transmission. On the supply side, cost deflation, a flattening of the cost curve, and rising scrap supplies all threaten prices.

We see significant downside risk in copper-mining stocks, too. High operating and financial leverage threatens to erase equity values for Freeport- McMoRan FCX and First Quantum. At slightly lower copper prices than we expect, these companies would be owned by their creditors.

We prefer low-cost miners that can generate free cash flow amid persistently low prices. Yet quality doesn’t come cheap. Southern Copper SCCO, one of the lowest-cost producers we cover, looks highly overvalued. And even this low-cost miner does not earn our narrow economic moat rating in a world of $2 copper.

In this report, we give our long-term outlook for copper. Although some market participants focus on near-term pricing fluctuations caused by fleeting copper surpluses and deficits, inventory stocking cycles, seasonal demand, and weather impacts, a long-term view of supply, demand, and marginal cost is the best way for long-term-oriented investors to gauge value and assess the relative competitive advantages of copper miners.

We begin our analysis with our outlook for Chinese copper demand. China consumes nearly half of the world’s copper annually, and its copper consumption has grown at a breakneck pace over the past two decades. China’s copper consumption growth in the coming decade will be a major determinant of long-term prices. We then shift to a discussion of demand outside China and formalize our global copper demand forecast. Finally, we discuss the implications of our price forecast for the copper miners in Morningstar’s equity coverage universe, from pure plays like Southern Copper to big diversified miners like BHP Billiton BBL.

Our 2020 Forecast
We project refined copper consumption will reach 23.9 million metric tons by 2020 compared to 22.8 million metric tons in 2014. That equates to a compounded annual growth rate, or CAGR, of 0.7% versus 3.2% from 2004 to 2014. From 1970 to 2014, global copper consumption grew at an annual compound rate of 2.6%.<P. On the supply side, we forecast secondary supply of 4.4 million metric tons in 2020 for a CAGR of 2.1%, compared to 6.6% from 2004 to 2014. Our demand and secondary supply forecasts imply mine production of 20.3 million metric tons will be needed in 2020 for a CAGR of 1.3%.

Jeffrey Stafford, CFA, is an equity analyst for Morningstar, covering agriculture and chemical companies.
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