Copper: Invest In The Physical Metal

Strong long-term fundamentals

I am a long-term copper bull. Assuming that the world does not plunge into the dark ages, copper is setting up for an explosive supply-demand imbalance over the next decade. World demand is expected to double by 2035 at an unprecedented rate, driven by the electrification trend in developing countries and the energy transition in developed countries. To meet demand, primary supply would have to rise by an estimated 9.7 million tonnes per year, from the current 25 million tonnes over the next 10 years. In other terms, and to put this into historical perspective, humanity is projected to mine over the next 28 years the same 700 million tons that it has previously mined over the last 5,000 years. About $23 billion in investments in both mine expansions and new greenfield projects would be necessary.

Of course, one should not confuse the long-term picture, which is reasonably clear and predictable, with the short-term picture, which is much more subject to noise and uncertainty. The copper price has declined significantly over the June-July period. It has since rebounded to the $3.8 per pound region, but it still remains challenged by macro headwinds, including recessionary fears, monetary tightening and its effects on the housing market, and a deflating Chinese property bubble.

My reading is that the precipitous decline over the summer was overdone and that it was more driven by speculation in the paper market than by actual supply/demand dynamics. However, it is difficult to be bullish on copper over the next few months.

The main reason is that, like for every commodity, the copper price is moved by incremental demand. Over the last 20 years, incremental demand has mostly come from China. Today, China accounts for roughly 50% of world copper demand, and its property sector alone is about 20% of total Chinese demand. The property sector is currently in a massive financial bubble, which the CCP seems intent on slowly deflating. So, despite the recent lifting of damaging zero-covid restrictions, Chinese demand remains uncertain. Add to this the fact that the effects of monetary tightening still have to trickle through the real economy, the possibility of a recession, and a significant slowdown in new home construction in the US: it is unclear where the extra demand is going to come from in order to push prices higher. So, barring surprises from the supply side, I don’t think copper is ready to resume its rise towards the $5 per pound level just yet.

An argument often repeated by copper bulls is that the physical market is very tight at the moment. For instance, Trafigura is warning that copper inventories have fallen to dangerously low levels.

However, visible inventories are only a small part of global inventories and they are not strongly correlated with the copper price.

Another argument that I do not find very convincing is that the world is running out of copper, as evidenced by declining ore grades from mines around the globe.

The same phenomenon can be observed with most other metals and even energy sources. As richer mines are exhausted, prices rise and mining profitability increases, which makes developers explore for new sources of the element and develop new ways to extract it. Arguments about “peak copper”, just like about “peak oil”, have a long history of turning out to be wrong. Besides, at the moment, there are an estimated 700 million tonnes of known reserves worldwide, which are already economical to extract at current prices. This would be sufficient to cover projected demand until 2050. Therefore, the problem is not a scarcity of primary sources, but rather years of low capital expenditures in the industry, motivated in turn by low prices and hostile political environments.

In contrast to short-term headwinds, the fundamentals for a long-term bull market remain intact. From the middle of the decade on, the copper market should clearly turn into a deficit and the supply-demand imbalance become obvious. By then, it will probably be too late to avoid a spike in copper prices, because of the long development times and massive investments needed to bring online new assets. It is worth remarking that any short-term weakness in the copper price is only going to exacerbate the problem, if projects get delayed or cancelled.

Another reason why the supply side is going to disappoint is that supply growth is currently being challenged by a number of external forces. These forces include: stricter environmental regulations, more complex permitting, higher taxes, higher inflation, increased political risk, supply chain disruptions and strained labor relations. Unfortunately, copper projects can hardly afford the extra burden. Today, building a copper mine, from permitting to production, is estimated to take an average of 16 years. In developing countries, one has to add to the technical challenges the political risk of higher taxes and expropriation; in developed countries, one has to add the difficulties of the permitting process, which is often subject to political whims, rather than driven by a clear legal framework. For proof, one only has to remember the following cases: the Twin Metals project in Minnesota, the Pebble project in Alaska, and the Arctic project, also in Alaska. It is no surprise that mining giants are forced to invest in less developed countries, despite their own peculiar political risks. I interpret in this light the decisions of Barrick (GOLD) to expand into Pakistan with Reko Diq, and of Rio Tinto (RIO) into Mongolia with Oyu Tolgoi.

Metal vs. miners

Given the preceding discussion, the question now is how investors can gain long-term exposure to copper prices. The most straightforward way is via the stocks of major copper producers, or via COMEX futures for exposure to the commodity itself.

It is an often repeated mantra that producers tend to outperform the commodity in a bull market, and underperform in a bear market. However, considering the fact that producers are facing increasing political and operational risks, including corrupt jurisdictions, environmental activism, supply chain disruptions, higher taxes, and structural inflation, I believe there is a reasonable probability that this cycle might be different, ie the commodities might outperform the producers.

This is particularly true in the case of copper, because of the high costs and long times necessary to bring online new assets. This in turn increases the likelihood of a “copper squeeze”. If prices are going to spike significantly at some point during the next decade, investors in the underlying commodity will realize significant returns. However, investors in the shares of miners may not be that lucky. First of all, as shown in the case of oil, there is always the risk of increased taxation. If copper is declared a strategic metal, it is not so far-fetched that we could see excess profit taxes imposed on copper producers in case of a shortage. Besides, commodity prices tend to mean revert and producers need sustained periods of higher prices to reap a benefit. So, in case of a sudden spike in copper prices, I see an advantage in holding the physical metal itself. The same argument could also be applied to uranium and precious metals.

CPER

Copper futures are probably the better option but, for investors who lack access to them, the United States Copper Index Fund (NYSEARCA:CPER) represents an alternative. The Copper Index Fund is an ETF that seeks to replicate the daily changes in percentage terms of the SummerHaven Copper Index Total Return, net of management expenses. The benchmark index is based on a number (either one or three) of eligible copper futures contracts, selected to maximize backwardation and minimize contango, while remaining in the liquid portion of the futures curve (for instance, at the moment it is based only on the March 2023 contract). The index is rule-based; details about the methodology can be found here. It is rebalanced monthly, so CPER is also rebalanced each month. CPER has decent liquidity (it trades on average around 125 thousand units on the NYSE) and an acceptable expense ratio (0.88%).

Under the hood, CPER holds a portfolio of copper futures contracts and other copper-related instruments, such as forwards and swap contracts. Contracts are collateralized by cash, cash equivalents and short-term US government debt. The current list of holdings can be found here.

It is important to emphasize that the investment objective is not for the NAV or the market price to track, in dollar terms, the spot price of copper. On the other hand, the objective is only to replicate the percentage change of the benchmark index over a period of one day. Because of rebalancing and contango/backwardation, CPER might underperform or outperform the spot price. The following plot shows the performance of CPER, its benchmark index and copper spot prices over the last 10 years.

It is also important to understand that, since CPER is an exchange-traded security, its shares can trade at either a discount or a premium to NAV. Typically, however, they trade within 200 basis points from NAV. The following plot shows a distribution of its deviations from NAV over the last quarter. Currently, they are trading at a small discount of 0.43%.

Conclusion

The short-term outlook for copper is clouded by recessionary fears, monetary tightening and uncertain Chinese demand. However, the long-term fundamentals remain intact. Given the supply/demand imbalance that is expected to fully develop by the middle of the decade, there is a high likelihood that prices are going to appreciate considerably from the current level, potentially leading to a copper squeeze. This possibility rests on the peculiarities of the copper market, which is subject to high political and operating risks. For these reasons, it is also likely that the copper price will outperform a diversified basket of miners.

The United States Copper Index Fund is an exchange-traded fund that invests in copper-related derivatives contracts. It is a decent alternative to futures for US investors seeking to gain direct exposure to the physical metal.

Given that, unlike shares in producer companies, CPER does not pay a dividend, and actually has a small expense ratio, one should consider the opportunity cost of investing in it. I believe that timing is essential: the holding period for such instruments should be relatively short, eg a few months to a year. Therefore, all the stars should be perfectly aligned. I believe that the time will come, but it is not here yet.