Copper & Stockpile that Isn’t?

By Peter Pham - May 14, 2012 | Tickers: BHP, VALE, FCX, CHIM | 0 Comments

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There’s been a lot of talk about the imbalances in China’s growth: whole cities being erected laying empty like some Faustian version of Shangri-La, the price paid for illusory growth from speculative excesses, currency manipulation and shoddy workmanship.  Most of these words are typed on some form of iGadget produced in China, by Chinese people. I hope the irony isn’t lost on you.

The latest attack on China is their effect on the copper market.  Those bearish on China point to this as yet another example of how unsophisticated they are, as if stocking up on things you need during times of financial stress is somehow silly.  The problem, of course, is that no one knows what the numbers are.  The FT Alphaville article that brought this issue up in late April has more ominous pictures of piles of copper than it has numbers describing them.  The last report about China’s copper stockpile from the China Non-Ferrous Metals Industry Association had it at approximately 1.9 million metric tons.  This was as of the end of 2010.  I’ve seen other reports that put the stockpile at 3 million tons.  Let’s go with that one.

What’s the Problem?

I ask this question seriously.  No one questions the idea of a Strategic Petroleum Reserve in the U.S or the U.K.  China has been building one as well as one in iron ore.  So, what’s wrong with Copper?  If the reports of a 3 million ton stockpile are correct than that represents a 4 month supply for China’s more than 8 million ton annual consumption.  Is that indicative of compulsive behavior or prudent arbitrage management and forward thinking given the state of monetary excess that will be needed to paper over the U.S. and European sovereign debt issues?

You know that pesky 800 lb. gorilla in the room? 

With China’s banking system being squeezed by tight monetary policy and business still needing credit to expand, they have turned to using their stockpiled copper as collateral for loans.  I’m not sure that this collateral is Basel-3 compliant, but I am sure that these banks and businesses don’t care.  These loans were originated at around 80% of the market value of copper from what I’ve seen and $3.00 per lb. is a pretty strong long-term floor with the exception of another Lehman event, which is not out of the question.  Then again, a Lehman-like event, say J.P. Morgan’s CIO account disappearing overnight (sic), would likely result this time in both supply chain disruption and a hyper-inflationary move by the Fed and ECB. 

More likely, though, as the PBoC moves to loosen the monetary reins, these copper-backed loans will lose their luster and the copper will be added to the market supply over time, putting a cap on prices in the medium term. 

The Shadow of the Hunt Brothers

If one looks at the copper inventories of the LME, the COMEX and in Shanghai one should note the changes, especially the LME and Shanghai.  Copper is being withdrawn from the warehouses in London at an astonishing rate.  I keep saying that capital is flowing from West to East, well, here is proof of that.  The price of the three major strategic metals has been either capped, in Copper’s case, or brutally sold in the case of Gold and Silver.  It only makes sense that those who have the greatest need for these things along with an enormous pile of money to buy them with would not do so.  Futures markets can be dominated in the short-term by momentum traders and prices can get distorted, but fundamentals always win out in the end. 

If policy makers in China believe the price of copper to be undervalued in a structural sense then they would turn a blind eye at this accumulation for securitization because the long-term risk is easily managed.  Moreover, if they take steps to liberalize the Yuan, which they have recently, and allow it to appreciate then they are just being good traders, buying depressed Copper with over-valued dollars for future use or sold into the market for appreciated Yuan. 

Buy low, sell high, anyone?

Global Tail Risk?

The copper market will likely run a 250,000 ton deficit this year, how much of that is from China building this relatively enormous stockpile is anyone’s guess.  What is also unclear is just how bad the slowdown in China will be, though their equity markets are currently handicapping that the worst is past. 

The price of 62% iron ore delivered to Qingdao has been in free fall since the U.S. Non-Farm Payroll number and European elections roiled the equity markets causing commodities, especially oil, to tumble.  Iron ore prices have slid 8% in the past month.  Copper has traded down to the bottom of its 6 month trading range.  Oil and gold have pulled back and Silver has been beaten with the ultimate ugly stick.  It sure does look bad right now.  But, that would be the signal for another round of QE/LTRO putting a bid under equities which will also push commodity prices higher.

Copper is known by futures traders as a leading indicator across the metals complex; effectively a derivative of equity prices.  Global copper demand is projected to climb to more than 25 million tons by 2016 along with supply, a CAGR of ~5%.  The Global X China Materials ETF (NYSEMKT: CHIM) is invested all across China’s mining sector from gold to copper to rare earths, of which China holds a near market monopoly.  Major mining concerns like BHP Billiton (NYSE: BHP) and Freeport McMoRan (NYSE: FCX) are trading at a P/E of less than 9 while paying a 3+% yield.  Brazil’s Vale (NYSE: VALE) is an even better buy at a 6.1 multiple and 5.6% yield.  China’s long term growth path is slower than these stocks’ effective yields, so to me they represent good value in a U.S. equity market still selling at a traditionally very high multiple.

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