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Copper's Resilience Won't Last

The faltering Chinese real estate market hit iron ore first. Copper is next.

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While the price of iron ore has fallen to multiyear lows, copper has held up remarkably well. The performance gap has been particularly striking given the mounting weakness in China's real estate market, a key demand driver for both materials. Copper's tighter supply conditions explain much of the divergent price performance, as well as the consensus enthusiasm for copper prices and the stocks of copper companies. 

We think this optimism is misplaced, as it overlooks a demand-side quirk that portends trouble for copper in 2015. Although the consumption of both copper and iron ore is tied to Chinese real estate demand, copper is used much later in the construction process. As China's real estate starts have fallen this year, iron ore was first to feel the pain. Copper will be next. No copper mining stocks under our coverage trade at a material discount to our fair value estimates, and most appear overvalued.

The latest batch of Chinese real estate data, released Nov. 18, brought more bad news for commodities, especially those leveraged to the country's construction boom. Home prices declined in 69 of China's 70 largest cities in October, dashing hopes for a recovery and marking the sixth consecutive month in which decliners outnumbered advancers.

Rapid Reversal in Sentiment

Iron ore set a new multiyear low in the wake of the news. Spot prices for benchmark iron ore (62% fines, delivered China basis) fell to $70 by Nov. 19 from $75 to begin the week and have dipped below the $70 in subsequent weeks. Year to date, prices have plunged 50%, reflecting the real-estate-led slowdown in Chinese steel production growth (2.1% this year through October versus a 10-year compound annual growth rate of 12.3%) and a bumper crop of low-cost supply from Australia (exports to China have risen 33% this year).

Iron ore's price trajectory contrasts sharply with that of copper. Copper prices barely budged with the gloomy real estate data. The metal now trades at $2.94 per pound in the spot market, down a modest 13% from $3.36 to begin the year. Whereas iron ore is now plumbing lows last seen in the summer of 2009, copper is trading at more than twice summer 2009 levels.

Copper Has Strongly Outperformed Iron Ore This Year

The most obvious explanation for the price divergence is copper's less buoyant supply situation. Supply growth from the world's copper mines has been modest this year. According to the International Copper Study Group, global mined copper production this year is up 3.0% through August, as faltering output from existing mines largely mitigates the impact of new mine production.

Supply conditions are likely to remain looser for iron ore than for copper. The spigot of cheap iron ore supply from Australia and Brazil is likely to remain open for the next several years. By contrast, while copper supply should grow, the gains should be more modest. The ICSG's most recent forecast sees supply rising 3% in 2014 and, after adjusting for historical disruption factors, 7% in 2015.

This supply-focused narrative seems to be driving consensus enthusiasm for copper over iron ore. According to median price targets on Thomson Reuters, the biggest pure-play copper stocks ( Freeport-McMoRan (FCX),  Southern Copper (SCCO), and  First Quantum Minerals (FM)) are, on average, 26% undervalued. Consensus also sees compelling value in copper-oriented diversified miners like  Glencore (GLEN) and  Teck Resources (TCK).

Although we acknowledge copper's more favorable supply outlook, we think consensus bullishness overlooks impending trouble on the demand side of the equation. As a result, our fair value estimates for the copper pure plays are, on average, 25% lower than consensus price targets. We're similarly concerned about the prospects of diversified miners with significant copper exposure.

Why? It all comes down to timing.

Iron ore and copper have a similar demand mix. China is the world's top user of both metals, consuming roughly two thirds of seaborne iron ore and about 40%-45% of copper. Within China, real estate is the leading demand driver for both. About 50% of China's iron ore consumption is tied to construction. Copper usage statistics are more open to interpretation. We estimate that real estate drives 40% of Chinese copper demand, including electrical, plumbing, and air conditioning applications, although the actual share might be anywhere between 30% and 50%.

China Is Top Consumer of Iron Ore and Copper; Real Estate Is Top End Market

While both metals are heavily tied to Chinese real estate, their exposures come at different stages of the construction process. Iron ore is used early, in the steel I-beams and rebar that define a building's structure. Copper is used later, in the pipes and wires that make a building livable.

When real estate activity falters, iron ore is among the first commodities to suffer, along with other early-stage construction materials like cement. That's exactly what we've seen so far this year. Through October, floor space started has fallen 5.5%, with clear consequences for domestic steel production (up 2.1% year to date versus a 12.3% average growth rate over the past 10 years) and cement production (up 2.5% from a 13.1% annual pace in the past decade).

Copper will suffer, too, but the impact will be lagged. For the moment, Chinese copper demand is enjoying the tailwind of a 13.5% increase in floor space started in 2013. China's apparent copper demand is on track to rise 7% this year, buoyed by real estate. That's lower than copper's 12.0% average annual growth rate over the past decade, but not nearly the sort of slowdown of iron ore or cement.

Copper's construction tailwind should abate in 2015, since demand will depend increasingly on the weaker 2014 vintage of real estate starts. Weaker demand growth from China will weigh heavily on a market that has seen precious little non-China growth in the past decade. Outside China, refined copper demand has fallen 7% since 2003.

Copper Will Have Lagged Leverage to Falling Starts

In the context of what is likely to be a relatively big year for copper supply growth, we expect copper prices to fall 15% in 2015. The drop is unlikely to be as dramatic as the iron ore plunge of 2014 thanks to copper's more favorable supply profile, arguably better cost curve support, and relatively lower (albeit still high) exposure to Chinese real estate.

Copper miner stocks are likely to underperform once copper's apparent resilience amid Chinese real estate weakness is revealed as lagged leverage. We believe that shares of Southern Copper, which has the most leverage to copper of the three pure plays we cover, has the most downside risk. 

Daniel Rohr does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.