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By Jeremy Glaser | 07-14-2010 04:17 PM

Time to Look at Copper Plated Bonds?

Southern Copper's solid balance sheet and low-cost structure will help protect bondholders no matter where copper prices go says Morningstar's Dan Rohr.

Jeremy Glaser: Is it time for investors to look for copper-plated bonds? I'm Jeremy Glaser with Morningstar.com. I'm here today with analyst, Dan Rohr, to look at Southern Copper and their financial position.

Dan, thanks for talking with me today.

Daniel Rohr: Thanks, Jeremy.

Glaser: So I guess the overarching question first is, what's been happening with commodity prices in particular, copper and what kind of impacts that can have on Southern?

Rohr: The market for copper, like that of a lot of base metals like nickel and zinc, has really been behaving like a man with a broken leg. He's leaning very heavily on this crutch of Chinese demand while he's waiting for the broken leg, the European, U.S., Japanese demand to recover to pre-crisis levels. The risk here is that some jerk comes along before the leg has healed and kicks the crutch out from under him.

Prices for copper are right around $3, give or take a few cents depending on which day you look. If Chinese demand remains strong, continues on its growth trajectory, and European, U.S. Japanese demand recovers to pre-crisis levels, we could be looking at copper prices quite a bit higher.

Now on the flip side, if Chinese demand growth falters and drops before we see a recovery in OECD demand, we can be looking at a significantly lower copper price potentially.

We like Southern Copper from a credit perspective because of its cost position, which insulates creditors to a certain extent from the volatility that you're naturally going to see in copper prices. I think a few numbers really put that into perspective. Over the past few years, we've seen copper range in price significantly from high above $4 a pound in early 2008 to below a $1.50 a pound in early 2009.

Southern Copper's cost structure is such that over the past three years, their average cost per pound has been $0.19, so regardless of copper is above $3 where it is today or goes back to the bottom, the lowest that we saw in the depths of the financial crisis, this is a company that's going to be cash flow positive.

Glaser: So big decline in prices might hurt profitability, but certainly they'd be able to survive it from a…?

Rohr: So you would naturally see the equities take a beating and that certainly what happened with Southern Copper shares as copper prices went south, but we think creditors would have a pretty good cost cushion in Southern Copper's operations to mitigate the downside risk and protect the principal of their investment in the bonds.

Glaser: Often times, commodities become heavily politicized issue. We've seen even recently in Australia, which I think people think of as a very stable market and there was a lot of hoopla around potential mining tax. Southern only operates, I believe, in two countries, Mexico and Peru, how do you account for that kind of potential uncertainty that you think you might…?

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