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Wed Jul 27 12:11:52 PDT 2005

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Heavy metal

Jul 26th 2005
>From The Economist Global Agenda

Copper hit an all-time high this week, after China announced plans to
revalue the yuan. Why?

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DESPERATE for light relief on deadline day last week, Buttonwood was
clicking through new company results and came across a blast from her past.
Freeport-McMoRan, a complicated Louisiana company, operates one of the
world¹s biggest copper mines, in a remote corner of Indonesia¹s West Papua
province. The vast open-cut mine, which measures a mile across, was created
by slicing the top off a mountain, Grasberg‹sacred to some locals‹and
dumping waste in the adjacent waterways. The construction of this enormous
mining complex, deep in inaccessible territory, amazes engineers and
outrages environmentalists in equal measure. On a visit some years ago, your
correspondent was suitably impressed by both.

Freeport (led by James ³Jim Bob² Moffett, a pal of former president Suharto
and a star Elvis impersonator) is very profitable, as it produces gold along
with its copper. And its second-quarter results were particularly flattered
by the comparison with the same period a year earlier, when production was
still affected by the collapse of a pit wall in late 2003, causing several
deaths. Profits for April through June of 2005 were $175m on revenues of
$903m, compared with a net loss of $53m on sales of just $486m.

Other copper-mining firms have also been reporting good profits, for the
metal has stayed the course better than almost anything except oil in the
on-again, off-again commodities bull market since 2002. China¹s dash for
industrial growth exceeded the capacity of its domestic base-metals
industry, setting off a general surge in world prices. But the rising tide
that lifted all commodities has ebbed of late, Barclays Capital points out
in a new report, leaving different materials to fend for themselves
according to their different market fundamentals. Copper, despite a few
blips this year, is fending particularly well: its price has doubled since
2003 (see chart below), touching a new dollar high on the London Metal
Exchange on Monday July 25th.

One reason, says Michael Lewis, a commodities pundit at Deutsche Bank, is
that the price of copper is particularly closely correlated with Chinese
industrial output, and that seems to have stayed stronger than many
expected. Last week¹s official statistics showed output growing by 16.8%
year-on-year in June, up from 16.6% in May. China consumes one-fifth of the
world¹s copper, and was the only big consumer to increase use of the metal
in the four months from January through April, on figures from the
International Copper Study Group (ICSG).

Dr Copper

Why should we care particularly about copper? First of all, because it
provides a fascinating keyhole through which to view the big economic shifts
that influence our life and times. We don¹t know for sure what shapes our
economy and we certainly don¹t know what shapes China¹s. But copper, because
it is used in such a wide array of applications‹plumbing, telephony, cars
and many other things‹can sometimes take the temperature of the economy and
diagnose its condition.

Another, more mundane, reason is that commodities have become popular
financial investments over the past couple of years. Tired of uninspiring
returns on equities and bonds and keen to diversify into assets whose
returns are often negatively correlated with those on securities,
individuals and institutions have piled into things like mutual funds that
track commodity indices.

Returns on the Goldman Sachs Commodities Index rose in the first quarter by
22% but fell in the second by 4.5%. Are investors going to make a killing or
get caught out, and maybe our pensions with them? And is the current high
price of copper a sign that there is genuine durable economic demand out
there‹or is there some specific problem with the balance of supply and
demand?

Like most other base metals, copper is in short supply. Stocks held
officially by exchanges around the world amount to only 75,000 tonnes or so,
after a year of de-stocking. That¹s not much of a buffer in a world that
consumes 17m tonnes a year.

There are rumours of huge unofficial stockpiles but the structure of copper
prices suggests that these are exaggerated. When supplies are tight, the
metals market becomes ³backwardated²: it costs more to buy a contract for
delivery soon than it does to buy a contract for more delayed delivery,
rather like an inverted yield curve in the bond market. Copper has been in
backwardation almost constantly since 2003. Just as telling, the premium for
spot copper over the nearest forward contract jumps up when buyers worry
about being able to get their hands on the stuff. At the beginning of 2004,
there was virtually no spot premium, says Mr Lewis. By July 25th it almost
touched $300 a tonne.

Why are supplies so low? Normally, ³High prices are the best cure for high
prices,² as Andrew Brady, of CreditSights, a research firm, puts it. Copper
production is increasing in response to high prices. But it seems to have
hit a number of speed bumps. Mining companies spent little on research and
development, or on exploration, in the 1990s and were slow to get going
again. Disasters such as Grasberg¹s mudslides also took their toll on
production. So did strikes‹most recently in Chile, Zambia and America. And a
few mines, some say, have given priority to producing associated metals such
as molybdenum, which is mined in tandem with copper and whose price has
increased even faster than the bigger metal¹s. There are plenty of new
projects under consideration, but they will take a while to make a
difference.

Does the rising price of copper then reflect strengthening global growth?
Yes, to a large extent. But it also reveals a stickiness in the market to
which uncertainty over the direction of two currencies‹the dollar and the
yuan‹may also have contributed. So China¹s announcement last week of its new
³baby-steps² foreign-exchange regime (the yuan up 2.1% against the dollar,
with permitted daily fluctuation of up to 0.3% and based on an unspecified
basket of currencies) has had everyone in a lather trying to figure out what
effect it will have on economic growth and demand for commodities.

The bullish argument has it that the Chinese will find materials cheaper,
even if only marginally, and will hence buy more of them: no more
substituting plastic tubes for copper ones. The bulls get added traction
from the fact that China is hosting the Olympics in 2008 and still has a lot
of infrastructure to build. The bears, on the other hand, maintain that a
dearer yuan will reduce demand for higher-priced Chinese exports and shrink
employment in China, as well as separately raise interest rates and cool
economic growth in America.

Realistically, China¹s new currency regime is unlikely to matter a hoot in
the short term

Realistically, the new currency regime is unlikely to matter a hoot in the
short term. China has moved the bare minimum it needed to in order to defuse
a protectionist backlash among its trading partners. It can now do virtually
anything it likes with its currency. However much the government might wish
to keep easing the descent of its helium-filled economy by letting the yuan
move upward, it is unlikely to undertake anything that encourages
speculation or increases unemployment. Any serious revaluation of the yuan
will therefore take years rather than months.

And that raises the possibility that while copper prices probably have a
little more upside in them now, a stronger yuan, slowing world growth and
increased copper supply might all coincide a couple of years from now,
forcing copper prices to slump. Dr Copper, to the sick bay.

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