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The Copper Conundrum

Declining prices make commodity producers look cheap, but Morningstar analysts believe there is more downside.

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The outlook for copper prices is worse than most investors think. Prices have marched steadily downward from their $4.50 peak at the start of 2011. At the end of 2015, they sat around $2.10 per pound. Battered copper-mining stocks may now screen as cheap, but we see further downside.

This 50% collapse has been met with a diverse set of opinions about the future trajectory of prices. Bulls point to declining ore grades, solid if slower demand growth from China, and the need to develop new mines to meet future demand. Bears question China's ability to maintain rapid growth, point out recent deflationary pressures on copper costs, and note the plethora of new and relatively low-cost mines that will soon start production. Long-term copper price estimates range from $2.25 to $3 per pound.

We aren't as optimistic. We forecast a long-term price of $2 per pound and expect ebbing Chinese demand, which accounts for roughly half of the global total, to push prices below $2 in 2016 and 2017. We expect China's copper needs to fall as real estate activity fades to a level more commensurate with underlying urbanization trends and as power spending shifts away from copper-heavy distribution to copper-light transmission. On the supply side, cost deflation, a flattening of the cost curve, and rising scrap supplies all threaten prices.

We see significant downside risk in copper-mining stocks, too. High operating and financial leverage threatens to erase equity values for  Freeport-McMoRan (FCX) and  First Quantum (FM). At slightly lower copper prices than we expect, these companies would be owned by their creditors.

We prefer low-cost miners that can generate free cash flow amid persistently low prices. Yet quality doesn't come cheap.  Southern Copper (SCCO), one of the lowest-cost producers we cover, looks highly overvalued. And even this low-cost miner does not earn our narrow economic moat rating in a world of $2 copper.

In this report, we give our long-term outlook for copper. Although some market participants focus on near-term pricing fluctuations caused by fleeting copper surpluses and deficits, inventory stocking cycles, seasonal demand, and weather impacts, a long-term view of supply, demand, and marginal cost is the best way for long-term-oriented investors to gauge value and assess the relative competitive advantages of copper miners.

We begin our analysis with our outlook for Chinese copper demand. China consumes nearly half of the world's copper annually, and its copper consumption has grown at a breakneck pace over the past two decades. China's copper consumption growth in the coming decade will be a major determinant of long-term prices. We then shift to a discussion of demand outside China and formalize our global copper demand forecast. Finally, we discuss the implications of our price forecast for the copper miners in Morningstar's equity coverage universe, from pure plays like Southern Copper to big diversified miners like  BHP Billiton (BBL).

Our 2020 Forecast
We project refined copper consumption will reach 23.9 million metric tons by 2020 compared to 22.8 million metric tons in 2014. That equates to a compounded annual growth rate, or CAGR, of 0.7% versus 3.2% from 2004 to 2014. From 1970 to 2014, global copper consumption grew at an annual compound rate of 2.6%.

On the supply side, we forecast secondary supply of 4.4 million metric tons in 2020 for a CAGR of 2.1%, compared to 6.6% from 2004 to 2014. Our demand and secondary supply forecasts imply mine production of 20.3 million metric tons will be needed in 2020 for a CAGR of 1.3%.

Our methodology assumes supply and demand balance annually, eliminating annual surpluses or deficits. We think this approach helps us best approximate long-term prices. However, by forcing a balanced market each year, we implicitly assume loss-making mines close when prices fall below costs. In reality, if these mines do not close, prices would fall more than what is predicted by our model. This is one of the reasons we expect prices to fall below our long-term marginal cost estimate in 2016 and 2017.

Copper at $2 per Pound
We arrive at our price forecast by finding the point where demand intersects our 2020 nominal total cost curve. This cost curve was formed by adjusting the 2014 curve for inflationary and deflationary pressures on costs and then adding expansion projects expected by the end of the decade.

Our 2020 nominal copper price forecast is $2.24 per pound, or $4,930 per metric ton. That is $2 per pound in 2015 real dollars ($4,410 per metric ton), assuming annual inflation of 2.25%. At the end of 2015, the copper price was roughly $2.10 per pound, so we predict a real price decline of 5%.

This represents a 17% cut from our previous long-term forecast of $2.46 per pound in 2015 real dollars. The reduction to our long-term price outlook is primarily a function of two factors: a lower Chinese demand outlook--although we had been bearish before, we're more bearish now--and cost deflation. As a result of currency depreciation and mine cost deflation, we expect the long-term supply curve to be lower than we once did.

Expect Further Pressure on Copper Prices
A number of factors are likely to push copper prices below our long-term forecast of $2 per pound in the medium term. Our year-by-year demand forecast can be seen in Exhibit 1.

Some high-cost mines will need to close to balance the market. If these mines do not close as soon as prices sink below their costs, then an oversupplied copper market would develop.

Particularly Weak Chinese Demand in 2016–17
We expect Chinese copper demand will fall roughly 3% in both 2016 and 2017 as a result of slowing construction and power activity.

Fewer Chinese Copper Financing Deals
Financing deals have probably inflated Chinese copper demand. Demand increases with these deals because physical copper must be purchased and stored in a warehouse as collateral. We think copper financing deals will become less profitable, leading to lower demand for physical copper, due to lower interest rates in China, higher interest rates outside China, and a depreciating yuan.

Continued Cost Deflation
We think mining costs will continue to deflate in response to lower copper prices.

China's Impact on Copper
Copper demand growth had been decelerating since the 1960s, a reflection of not only slower economic growth globally, but also the world economy becoming less copper-intensive. This trend reversed in the 1990s as Chinese growth began to accelerate after languishing for decades. The rise in China's share of global commodity consumption in the past 15 years has been remarkable. China's share of steel demand has ballooned to 45% from 9% since 1990 and coal to 49% from 23%. Although consumption share growth has not been as pronounced in copper, the trend is still the same.

China consumed 4.7% of global copper in 1970. By 2014, that number had swelled to nearly 50%. Since 1990, China's copper consumption has grown at a compound annual rate of 13.8% compared with 0.4% for the rest of the world. Exhibit 2 shows the country's demand by end-use.

China's incredible growth has underwritten a higher price level over the past 15 years. China's rapid demand growth more than made up for meager copper consumption growth in the rest of the world and was the primary driver of copper prices. The real price of copper more than tripled from 2000 to 2011 and, despite recent declines, is still more than double the 2000 price today.

However, our bottom-up analysis suggests a dramatic slowdown in China's copper demand growth from the 11% annual rate notched from 2005 through 2014. We expect little growth in copper consumption through the end of the decade as falling demand in the building construction and power sectors, collectively 60% of total consumption, offsets healthy albeit decelerating growth in consumer-related applications such as automobiles and appliances.

We forecast Chinese copper demand declining a cumulative 5.5% in 2017 from a cyclical peak in 2015, as real estate activity fades to a level more commensurate with underlying urbanization trends and power spending shifts away from copper-heavy distribution to copper-light transmission.

Copper Demand in the Rest of the World
Large copper consumers other than China include the European Union (12.7% of global demand), the United States (8.1%), and Japan (5.1%). Together with China, these countries account for three fourths of global demand. Outside China, copper demand growth dropped at an annual rate of 1% in the 2000s, after posting demand CAGRs of between 1% and 3% in the 1970s, 1980s, and 1990s. Much of the ex-China decline over the past decade was attributable to a combination of manufacturing offshoring (to China) and a real estate downturn in rich countries. But with offshoring having largely run its course and the outlook for U.S. housing significantly brighter, those headwinds are unlikely to persist.

Unlike China, mature economies such as the European Union, United States, and Japan significantly cut copper consumption during the last economic downturn. But it's important to note that copper consumption in these countries was falling even before the last recession, continuing the trend of falling copper intensity of GDP that had been apparent for decades.

We think it's also likely that at least a portion of the prerecession decline in copper consumption by rich countries is related to manufacturing moving from developed countries to China and other emerging nations. As manufacturing output moved offshore, a portion of copper demand simply shifted from rich countries to China. During the global recession, falling copper demand was probably related to a big slowdown in building construction and investment.

In general, we expect copper intensity of GDP to decline in developed countries, with the United States a notable exception. We expect a turnaround in U.S. copper demand related to significant growth in housing starts. Building construction accounts for nearly half of U.S. copper demand. We forecast a U.S. copper demand CAGR of 4.1% from 2014 to 2020, compared with an average decline of 2.7% from 2004 to 2014.

We believe the outlook for housing is better than most think. Consensus has housing starts rising to 1.4 million to 1.5 million over the next several years, up from 1 million in 2014. We see starts rising to 1.9 million by 2019, before settling down to about 1.5 million 10 years from now.

Our bullishness is informed by two factors: favorable demographics and diminished financial constraints. We believe demographics alone are sufficient to attain consensus-level starts. Millennials are likely to drive significant household formation as they transition from their 20s to their 30s. While the baby boomers are no longer the prime mover for housing, they're unlikely to detract from demand until the 2030s. Concurrently, we expect a tighter job market and looser mortgage availability will trigger the formation of millions of "deferred" households.

It's natural to also look to India to plug the hole China will leave in global demand growth. But China-size Indian copper demand doesn't appear to be right around the corner. India still consumes a paltry amount of copper per capita and is reasonably far away from GDP levels where copper consumption per capita starts to tick higher. Using IMF forecasts, we think India's GDP per capita will reach about $8,000 by 2020. We forecast an Indian copper demand CAGR of 10.9% from 2014 to 2020, compared to the 2.5% annual growth rate the country posted from 2004 to 2014.

But even with this impressive growth (2014 GDP per capita is only $5,445), we wouldn't expect copper consumption per capita in the country to be greater than 1 kg per person; compare that with the 8.3 kg per capita China consumed in 2014. That said, because India's population is so large, a greater gain than we're expecting in copper consumption per capita could have a material effect on our long-term demand forecast.

Avoid Copper Pure Plays
Equity market valuations appear to assume a sustained recovery in copper prices from recent sub-$2.20 levels. We believe low prices are here to stay and profits are unlikely to recover to levels necessary to justify prevailing valuations.

We recommend avoiding copper pure plays entirely. Despite precipitous share price declines in the past year, copper-focused miners are significantly overvalued, implying free cash flow prospects that won't be attainable in a world of $2 copper. Consensus target prices for copper pure plays are too aggressive, in our view. For example, the median price target for Southern Copper is $29. Assuming $2 copper, we think the shares are worth only $11. Freeport's median consensus price target is $9 versus our fair value estimate of $2.30.

Diversified miners are not immune to lower copper prices. While they have less exposure to copper, much of their remaining businesses (including iron ore and met coal) are still subject to a secular slowdown in China's fixed-asset investment. Pockets of growth include  Anglo American's (AAL) diamond segment and well as BHP and  Teck Resources's (TCK) energy businesses.

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