A few home truths about copper

Doing that last post, I ran across the Resource Investor website. Now I don't know if they're right or wrong, good or bad, but they at least have more data at their command than does Guambat, and apparently years more experience in dealing with metals resource issues.

Take this article, for instance:
Once upon a time long ago (more than five years ago; a very long time in American financial strategic thinking) a steep increase in the cost of copper caused home builders to switch to aluminum wire, when in those far off days, as now, was cheaper than copper and (when pure) has about the same capacity to carry current in an equivalent volume. But, alas, it turned out that aluminium alloy wire had a lower melting point and a much more destructive corrosion cycle than copper wire.

After a while, the aluminium wiring all broke down and had to be replaced at many times the cost of what it would have required to use copper in the first place. [See Copper in Your Home.] Fortunately for the myopic homebuilders their warranties to the original owners of the homes had mostly expired, and it was the homeowners, the little guys, who bore the brunt of the ‘repair’ costs. It turned out for the homeowners that the market ‘price’ of the copper was not the problem. It was copper’s overall long-term lower cost due to its unique properties that had been ignored in a costly ignorance driven mistake. Copper, it turned out, was indispensable regardless of its price.

Copper prices are once again through the roof supposedly due to the ‘unforeseen’ insatiable demand of the rising economies of Asia. Those who would be small investors should pay attention to what large ‘end users’ of a commodity do to protect themselves against price volatility.

Carmakers

What, for example, do carmakers do to avoid being held hostage to rising commodity prices? First of all, they divide commodities into two categories, necessary and not necessary.

On the one hand, for example, carmakers do not care at all about the price of a commodity such as gold. The vanishingly small use of gold as a durable coating for electrical contacts, particularly, in the manufacture of cars and trucks is today vastly exceeded by the amount of gold used to plate exterior ornamentation offered as an option, and the cost of such ornamentation is completely borne by the customer. A few cents worth, never as much as a dollar, of gold plating on a wheel cover, for example, can allow the supplier and the seller(s) at wholesale (the car maker) and at retail (the dealer or the aftermarket) to raise the price of the plated item by multiples of the price for the (actually more expensive to make-chrome plating has costs of technology and pollution management that far exceed those for gold) chrome plated item.

Copper, on the other hand, is indispensable. It is absolutely necessary to the production of motor vehicles that have longevity and safety. Primarily used in the wiring harness of a vehicle, its nervous system and the windings in its electric motors, principally in the starter motor, there is as much as 45 pounds of copper in an average vehicle. You cannot make a safe reliable motor vehicle without copper.

A hybrid powered vehicle with its electric drive motors on each wheel and the high current capacity bus bars to carry the current from its batteries or fuel cell uses much more copper than an average car. It is the availability of copper not its price that concerns carmakers or any users of copper for economical and efficient carrying of electric current.

The North American and western European production of cars and trucks varies between 35 and 40 million units a year. For historical reasons the vehicle makers prefer and often specify that ‘new’ copper be used to make the wire, rod and plate material used in the production of ‘new’ vehicles. The total annual requirement for copper in the western OEM automotive industry is thus a maximum of one million ‘short’ tonnes per year.

At first glance this seems like a large number, and historically the purchasing departments of the automakers assumed that they were major customers and could affect the pricing to them through volume. However even the largest carmaker, General Motors [NYSE:GM], uses less than 1% of the total global production of new copper per year, and the global OEM automotive industry uses less than 10%.

Burn the following sentence into your memory: The housing industry is by far the largest end user of copper, around 40%, with electrical and electronic together adding another 35% of the total.

I believe that GM was the first carmaker to institute a group in its purchasing department specifically to manage the risk of maintaining a supply of strategic (i.e., absolutely necessary) raw materials. Even though GM did this around 10 years ago, the global OEM automotive industry is still woefully deficient in strategic planning and risk management of this type as Wilbur Ross discovered when he began analyzing OEM automotive suppliers in bankruptcy.

I believe that it will be news to almost all of the world’s car makers other than GM that copper wiring harness production is one of the most profitable businesses in the automotive supply world, because the cost structure of manufacturing wiring harness is between 60% and 85% labour, so that even when copper prices ramp up the effect is to reduce margin not eliminate it.

Yazaki, the Japanese company, that didn’t even make wiring harness just 20 years ago, realized this feature of the product line and went into the business and expanded it by opening plants in low labour cost countries around the world, Romania, Morocco and China, for example. Then they instituted a program of ‘hedging’ the cost of the copper they needed by becoming heavily involved in the futures market. Japanese industry pioneered this approach, and the Japanese government maintains a strategic stockpile of metals as a national hedge against unavailability, not price volatility! [The same concept that the US uses for its strategic petroleum reserves, though the pollies are often urged to manipulate the reserves in reaction to market prices.]

Yazaki, even though it manages its costs by hedging, still indexes its prices for copper to its customers to the market price. Thus Yazaki’s margins are maintained. Just a very few car makers do their own risk management, and if Yazaki is a supplier of wiring harness to these particular companies it is on a value added basis; the copper is supplied by Yazaki’s customer. I believe that Toyota [NYSE:TM] and, possibly, GM are the best examples of companies that hedge their bets on strategic metals.

Market Fundamentals

Why is the price of copper going up at such a rapid rate? It is not due to fundamentals of supply and demand. It is due to the fact that the speculators can manipulate the copper market for a tiny fraction of what it would cost to manipulate the oil market or the housing market. Very nice returns can be made while risking relatively small amounts of capital compared to what it would take to squeeze a market such as that for oil. Well-managed end users saw this coming and instituted their own risk management programs.

Speculators have now figured out that availability, not price is the key issue for end users of ‘indispensable’ commodities such as copper and that American OEM end users have simply not prepared themselves for strategic long-term planning and risk management. The speculators are therefore putting on a classic squeeze. They only need to buy the surplus to be able to throw the market into deficit. In 2005, it was confidently predicted that copper would be in surplus for 2006 by around 500,000 tonnes. Even at $7,000 per tonne, that is only 3.5 billion dollars - a trifling amount for a hedge fund.

To insure deficits the large speculators simply can buy the necessary material in the London Metals Exchange warehouses at the market price. Then as unsold stocks are reported gone the speculators watch the price rise. The speculators also benefit from labour unrest at copper mines as “the word” spreads that mining company margins are the highest in history. It also didn’t hurt that a landslide last year interrupted the supply of natural gas from Bolivia to Northern Chile where 40% of Chilean copper is produced.

Since Chile alone accounts for 38% of the world’s new production of copper annually, this meant that 15% of the world’s copper supply was cut off. Speculators now salivate at the Bolivian political scene. The nationalization of Bolivian natural gas production may well, if Venezuela is an example, reduce the gas supply to Chile on a long-term basis thus reducing supply dramatically, so that an even smaller manipulation of the total production can control the price.

The problem for the hedge funds is an exit strategy. They need to unwind their positions without causing the market to drop. The latest strategy is to promote investment in copper by mutual funds looking for large profits. For the last three years copper has increased an “average” of 51% per year. Only zinc has done better. The problem is that mutual funds are not investing for wealthy individuals like hedge funds; they are typically using the leverage of pension funds and large groups of small investors and risking the capital of the little guy.

[Investment advisers at CalPERS could firm up by August a plan for America's biggest pension fund to allocate its first $1 billion in commodities, a fund official said.]

Housing Market

Large New York banks are predicting a major drop in housing sales in the U.S. this fall. One of them has told its newsletter subscribers that it predicts that the market will drop at least 15% and perhaps as much as 30% this fall. [Existing home sales slowed to a 6.92 million annual rate as of March from a record 7.27 million rate in June last year, the National Association of Realtors said.]

The U.S. new housing market takes the largest share of copper of any industry. This is true all over the world. [Check out this neat educational pictorial of uses of copper in the home.]

It is estimated that the total global production of new copper will [be] 15 million metric tonnes for 2006. It has been possible this year to keep the price of copper rising by holding 3% of that total off the market thus throwing the market into deficit. When and if the U.S. housing market goes into recession the reduced demand will be more than 3% of the global total. Will the speculators keep buying and holding at the beginning of a recession of indeterminate length. The copper miners, the mutual funds and you better hope so.

By the way, a man I know well, who has been the copper buyer for a very large international end user, told me that based on the fundamentals of supply and demand he would price copper between 1.25 and 1.50 today. All of the rest, he says, is speculative.

The good news is for the global OEM automotive industry. If the housing market tanks it will free up the supply of copper and drop the price. Oh, I forgot, without the cash from refinancing their homes to withdraw the increased equity Americans won’t be buying any cars, air conditioners, golf carts, lawn mowers, home electronics or any of the other things that use copper. And, also, American purchases of many of the above items from China will slow down or vanish, so the Chinese will see a reduction in demand for copper also.

Conclusion

If the housing recession occurs, and the above cascade happens, what will then be the price of copper? Mining companies such as Phelps Dodge [NYSE:PD] are betting on a price two years out of no less than $2.50 per pound in order to satisfy bankability requirements from their long-term lenders.

I hope they’re right, but I wonder why financial analysts are still betting on huge price increases for copper when New York banks and well managed copper companies are saying otherwise? Are hedge funds panicking?

See this Guambat boast post.