Bearish Fundamentals Should Continue to Weigh on Copper Prices

How the mighty have fallen. Copper, one of the most prolific commodity fund darlings of the great 2006 bull market has fallen on hard times.

There was a time in early 2006 when it looked like there was no limit as to how high copper prices could rise. The housing market in the U.S. had not turned all the way down yet and demand from China looked insatiable.

Copper has many industrial uses, not the least of which is as a component in wiring used for construction of commercial and residential buildings. Thus, when the construction business is healthy, demand for copper and thus prices will tend to be firm. Caught up in a wave of bullish hysteria affecting many raw materials, copper prices climbed to their highest levels of all time, topping out at $4.44 per pound in April of 2006.

However, as in any bull market, high prices will eventually cure high prices. Prices had attained levels that started to curb Chinese demand. The Chinese government began to take steps to keep the economy from ”overheating.” In response, Chinese copper imports fell 19% over the course of 2006.

Probably more crucial, however, was the abrupt and severe slowdown in U.S. housing starts. Builders account for 46% of U.S. copper use with the average new U.S. home containing about 400 pounds of the metal. Thus, a slowdown in new housing will have a substantial effect on copper demand.

To add to the bearish mix, $75 crude oil had many believing the U.S. and world economies were headed for a slowdown, or worse. Slowing economies mean slower demand for industrial materials.

Copper prices responded by declining for the remainder of 2006 and continued to slump as we began 2007. Indeed, at the time of this writing, copper prices have receded more than 40% from their 2006 highs. Is this simply a correction in a long term bull market or do prices still need to adjust lower to account for a now hefty build in supplies?

The answer could be ”Yes.” Both could be correct. In the longer term, the outlook for copper and other industrial commodities appears to be a bright one. However, as for the first half of 2007, prices remain high by historical standards and in light of existing fundamentals, probably still too high to mount any kind of substantial recovery rally in the near future.

If the trend is your friend, copper should be friendly to call sellers in 2007.

The primary barrier copper faces in the near future is high stockpiles ”“ a ”hangover” if you will, from last year’s unprecedented price explosion. As demand rose and prices soared, mining operations ramped up production at a torrid pace. When global demand began to wane, producers continued to extract the metal at the same rate. Thus, as we began 2007, copper stocks in London, Shanghai and New York were at the highest levels since mid 2004. In addition to high warehouse stocks, it is estimated that global mine reserves are adequate to meet 16 years of world demand.

Producers, however, are still quite content with current prices. Copper’s climb to over $4.00 per pound last year was unprecedented. Until 2005, copper prices had never traded above $1.61 per pound. It is estimated that most copper miners break even at about $1.10 per pound. That means today’s price of $2.45 per pound still allows copper companies to enjoy an historically high profit margin and thus, creates no incentive to scale back production.

Quite the contrary, miners are still increasing production. World refined copper output is seen rising 5% in 2007 over 2006 figures. In addition, global supply of copper concentrate is expected to increase by 5% as well, to 13.2 million tonnes in 2007.

Bulls will argue that Chinese demand is set to resume in 2007 which will help buoy prices. Indeed Chinese copper demand is expected to increase by 7% over 2006. We believe that if this figure is truly realized, it may serve to curb the selling in copper and may even help bump prices off of current levels by late in the year. However, the promise of increased Chinese demand will not be enough to start another bull market in the metal.

China is only part of the equation when it comes to copper demand. As the fastest growing economy in the world, China currently accounts for about 20% of the worlds copper production. Respectable yes. But not the whole story. The U.S. and Europe account for over 50% of global copper consumption. Yet, projections for demand growth in these nations are not quite as rosy.

Phelps Dodge [NYSE:PD] estimates that U.S. refined copper consumption will grow by only 1% in 2007 with European demand expected to grow at the same pace. Meanwhile, Japan, another top copper consumer whose demand rose by 5% in 2006, is only expected to see 0-1% growth in consumption this year.

With 2007 production expected to increase by 5%, we find it difficult to envision copper prices mounting anything more than limited rallies in 2007, especially in the first half of the year. In fact, unless there is a sudden and substantial turnaround in demand for U.S. housing or U.S. automobiles, we think the market will need increased demand from China just to sustain current levels.

I’ve often been asked the question that if we feel a market is going to move lower, why don’t we just short the futures in our portfolios? The answer is, we don’t know the market is going to move lower. Nobody knows. We see the fundamentals as being bearish but that does not mean that futures prices cannot make price moves to the upside in the meantime. Our contention is that based on the current supply/demand fundamentals, we simply feel the market will have a hard time mounting a rally to substantially higher levels. For selling calls, this is all the analysis we need. An investor can sell call options, collect the premiums, and as long as prices remain anywhere below his strike price, the options expire worthless and the investor keeps the premiums as profit.

We feel this is an excellent strategy in the copper market right now for the following reasons:

1. Fundamentals for the copper market remain bearish for the immediate term; 2. Volatility left over from last years wild price moves has left overpriced call options available to astute option sellers; 3.

Long term charts for copper remain in a bearish set up, helping confirm our fundamental views.

We would view any strength in copper prices in the coming 2-4 weeks as opportunities for selling call premium at far out of the money strikes. One note about copper options: Open interest is not as liquid as in markets such as soybeans or crude oil. A bit of patience and homework is necessary if you are selling these on your own.

Copyright © Liberty Trading Group 2007
Source: www.resourceinvestor.com