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It becomes hard to remember the days when copper prices were below 2 dollars, let alone below 1 dollar, but those days are back. There were many saying that copper, zinc and other base metals would simply keep moving up in the euphoric rally of 2005-07. With that in the recent memory bank, it is now time to start thinking about what will happen with base metals. Are they an investment of the past? Will we see 25 cent zinc and 60 cent copper? Or will we charge ahead on another bull run? The answers to those questions are fairly simple, especially if you believe in a normal business cycle of free markets.
What this normal cycle would suggest is that there is a fundamental long term equilibrium that everything has, be it the metals market or your body temperature. What happens when there is a fever in your body? Well, lots, the internal defense systems kick into high gear to produce more antibodies as the body did not have enough in stock to fight the invasion of the infection. So the body will produce a massive amount of antibodies, far more than needed. After that, the body is in very good shape for some time after until the antibody count gets too low again.
This can be applied to any market, including the metals market. When there is “normal” demand, there is a rate of supply to the market, and prices settle at a fair level. This level is said to be where businesses make no economic profit, that is, enough to pay the bills and have a small amount left over, no real reason for anyone else to enter the business. If demand starts to increase, then the price goes up, because meeting supply is a long term goal. There are inventories to draw down on, but that doesn’t typically last long. To bring in more supply to the system is a multi-year commitment of finding new ore bodies, or re-commissioning old ones, as well as building new processing facilities for the extra capacity, which could take years. Due to the increase in demand and tight supply, prices start to run up. In the mean time, opportunistic people see the better than economic gains in the sector and start up their own businesses. As it is a slow process to bring on new supply, the price stays up for quite some time. Even as many new entrants to the market come in, few of those add to the supply. After several years, some deposits start to produce and this increases the supply. Also, the particular economic event that used more base metals than usual may have ended. So now what we have is several supply sources coming on stream and a lower demand. At that point stock piles go up and the price of the metals come down. As these metals prices come down, so does the amount of participants in this market because economic profits are reduced to or near zero.
This is the point of the business cycle we are in. It is nothing that is out of the norm, it is just not pleasant. Going forward, what is going to happen is the price of these metals will keep coming down as more supply hits the market and more buyers leave the market. At that point prices will return to their long term average price or go below that if there is a prolonged economic downturn.
As we have had a build up in inventories, in the case of copper as much as 8 fold from the bottom, there are a lot of inventories to use up before prices start to move again. Even with an 8 fold increase of inventories, that number is still only half of the one million tons of inventories that were stock piled in the late 90’s and turn of the millennium. That would explain why the price of base metals where at half of where they are now.
With the new economic stimulus package introduced by the US government we could see some of the current inventories be consumed and prices stabilize at or above long term prices. For copper, that could be anywhere between $1.60 and the 2 dollar range. There is over 3 trillion dollars of infrastructure spending needed if the infrastructure is to be restored to proper shape. It is not likely that the full amount will be entertained at the present time, but even 25% of that budget will have a positive impact on base metals prices for several years.
If infrastructure spending in the US does not pick up, then we could see copper at closer to 1 dollar a pound. That being said, even at 1 dollar a pound there are several very robust projects on the market that are trading at a significant discount.
Once the world economy sorts itself out and the BRIC nations start growing again, we should see base metals enter into another rally, which like all rallies, will be reasonably short.
Victor Goncalves
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All pricing information was taken from www.kitco.com, the LME, www.infomine.com. Moly inventories have been taken from a research piece form Sprott Asset Management.
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