Copper conundrums: Prices could fall by as much as US$400 by year-end

Feature | 21 June 2017
Copper_Pipes

The price of copper could fall by as much as US$400 per tonne by the end of the year, despite a similar rate of growth in demand as was experienced
in 2016, says Caroline Bain

The price of copper remained in the doldrums for much of 2016, while the prices of other metals, notably zinc and tin, rebounded. That said, copper joined in the rally in the final quarter of the year.

Prices surged again in early 2017 on the back of disruptions at the world's two largest mines, Escondida in Chile and Grasberg in Indonesia. More recently, prices have eased back amid a general downturn in investor sentiment.

Optimism fuelled the price gains

Indeed, it was investor optimism about demand that was a key driver of the revival in copper prices. It is no coincidence that the price rallied in the wake of Donald Trump's victory in the US presidential election. Trump's promises of fiscal stimulus and a huge infrastructure spending package pointed to both stronger US economic growth and higher metals demand. At the same time, China's economy was showing clear signs of a stimulus-driven pick-up in the final quarter of 2016. Not surprisingly (given that China consumes around half the world's copper) there is a close relationship between economic activity in China and the price of copper (see Figure 1).

Figure 1: China manufacturing PMI and copper price

Source: Thomson Reuters, Markit, Capital Economics

In fact, such was the scale of positive sentiment at the end of last year that the traditional inverse relationship between the US dollar and the price of copper broke down. Both the dollar and copper rallied. This was perhaps not so remarkable as the same factor was underpinning the rallies - namely the prospect of stronger, and potentially more inflationary, US growth.

More specifically to copper, the final quarter also saw more constrained supply. Mine supply of copper is notoriously susceptible to disruption, whether by adverse weather, strike activity or regulatory issues. However, for the first nine months of 2016, operations ran unusually smoothly. Mine disruption then escalated in the first quarter of this year. The six-week long strike at Escondida is estimated to have resulted in 3.6m-4m tonnes in lost output.

Assessing the state of demand

Commentary on the copper market usually focuses on production, with debate on the trajectory for prices often revolving around mine disruptions. This is hardly surprising given that, unlike production, the state of copper demand is not directly observable - you can record the metal at its source, but not at its end-use. As a result, estimates of copper consumption are inferred, and described as 'apparent' consumption. While there are various ways of calculating demand, roughly speaking it is implied from the residual of production, stock change, and net imports. So, out of what is produced globally, the copper which does not find its way into exchange warehouses is taken to be consumed.

Not only does this fail to capture stocks of metals not held on an exchange, both trade and stocks need not necessarily reflect underlying physical demand. For example, sometimes opportunistic buying or an arbitrage opportunity can inflate imports. Indeed, China's copper imports in 2013-15 were highly distorted by financing deals that involved the use of imported metal as collateral for loans. Similarly, moves in exchange stocks can be driven more by 'warehouse' economics (the cost of warehousing) than end-user demand.

In an effort to demystify the demand picture, we created an in-house proxy for global copper demand (see box below).

Figure 2: Proxy for world copper demand and price

Source: Thomson Reuters, Capital Economics

So, what is the proxy telling us?

The proxy for global copper demand shows that demand picked up in the fourth quarter of last year and it remained strong in early 2017. However, plotting the copper price against the demand proxy suggests that prices had got ahead of trends in physical consumption (see Figure 2). This bears out our view that it was optimism about demand rather than actual demand that sparked the price rally.

What is more, adding in the supply picture makes the story even more compelling (see Figure 3). Refined copper production has been growing strongly, again particularly in China, encouraged by the recent revival in prices. The latest data show China's refined copper production growing by 7.4% year-on-year in the first quarter.

Figure 3: Global net demand for copper and price

Source: Thomson Reuters, Capital Economics

Looking forward

We think the outlook for the global economy has improved since the start of 2017. In particular, we have revised up our forecasts for the eurozone and China. That said, the upward revision to our forecast for China's growth reflects the strong start to the year. Indeed, we expect China's economic growth to slow over the course of this year, in the absence of additional stimulus.

The government appears committed to reining in credit growth, particularly in the property sector. This has negative implications for copper demand given that more than half of China's copper consumption is in the construction and infrastructure sectors. Admittedly, ongoing investment in the power grid and in renewable energy will support demand and, in a nod to the strong start to the year, we have pencilled in growth of 2.5% in China's copper demand in 2017.

At the same time, we anticipate stronger growth in the US economy of around 2.3%, up from 1.6% in 2016. However, we also expect the Federal Reserve to hike interest rates three more times this year, which underpins our forecast of
a further appreciation of the dollar.

The upshot is that we think copper demand will grow by 2.2% this year, a similar rate to last year. We also believe that it is unlikely the mine disruptions this year will be sufficient to prevent
a further 1.6% rise in refined copper production (it takes some time for a shortage of concentrate to be reflected in lower refined output). As such, we think the market will be close to balance (see Figure 4).

Figure 4: Copper market balance (thousand tonnes)

Source: ICSG, WBMS, Capital Economics

This relatively benign outlook suggests there will be little to bolster prices over the course of this year. Our forecast is for price of copper to fall to US$5,200 per tonne by end-year, down from around US$5,600 at the time of writing (late May).

Caroline Bain is chief commodities economist
at Capital Economics

Box-out 1

The DP is a monthly index of economic activity which approximates physical demand. It provides us with demand growth rates and an industrial breakdown of demand, as well as estimates of consumed tonnage.

It comprises data from the 10 largest consumers (approximately 85% of total demand). For each country, we look at the five sectors which capture the majority of copper end-usage - the manufacture of transport equipment, of electrical equipment and electronic components, machinery and metal products, as well as construction. Where possible, industrial production indices are used for the bulk of the manufacturing data. Where unavailable, indices are constructed by deflating relevant series of industry gross output.

Following the construction of the individual country demand proxies, they are then amalgamated into a global proxy. This is achieved by weighting the country series together by their respective shares of the global gross value added (GVA) associated with the sectors concerned. We have created a "World Ex. China" variation of the proxy too.

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