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Copper & Gold – The Long Ride from Lehman Brothers (Part II)

Monday October 28, 2013 15:50

“The [copper] demand in China during this year has been stronger than many people had expected…”

“And we’re seeing some initial signs of improvement in Europe through demand activities… Globally, premiums for downstream copper uses are strong. Consumer inventories remain low, and the demand side is positive.”

“In the longer run, the delay in projects with companies cutting back capital [spending] points to a supportive copper supply situation.”

Richard C. Adkerson, CEO Freeport-McMoRan Copper & Gold Inc. (NYSE:FCX Third-Quarter Earnings Webcast, Kitco News, Oct. 22)

Oct. 28, 2013

Although gold production is an economic powerhouse of Northern Nevada, copper mining is becoming increasingly important in basin and range country. Gold giant Newmont Mining bringing the Phoenix project in Battle Mountain on line for copper production this year is a good example.

It was reassuring then to hear Freeport McMoRan CEO Richard Adkerson’s optimistic red metal forecast for the remainder of this year and 2014. Internationally, Freeport also produces prodigious quantities of gold as a byproduct of copper mining and thankfully the yellow metal has regained some shine too.

Gold surprised almost everyone last week keeping pace with the S&P 500 that made new highs and gaining significant value compared to global commodities oil and copper. This is welcome news for a fallen angel that has experienced bearish value destruction since last November not only in U.S. dollar terms but also relative to equities and key commodities. Comex gold closed Friday at a respectable $1,352.5 per ounce.

This cannot be fully explained by a falling U.S. dollar which revisited the lows of January. The weak dollar certainly didn't help oil and the red metal which experienced wicked reversals to the downside – West Texas Intermediate Crude tumbled from its $100 per barrel perch on building inventories and copper dropped to $3.266 per pound as a developing credit crunch in China and a strengthening yen in Japan put a damper on Asian markets.

The question then is how to rationalize CEO Adkerson’s optimism for copper’s future with seemingly contradictory signals coming from the present marketplace. The answer may lie in the expectation for extended monetary accommodation in the U.S. – it is safer to be upbeat about supply and demand fundamentals when there is a solid backstop of easy money.

This is more a comment about market environment than the quality of Mr. Adkerson’s forecast; he remains one of the most nimble and adaptive CEOs in the mining industry. To his credit, FCX share price was on the rebound from its December 2008 depths long before the S&P 500 found its mineshaft in March 2009.

Volatility – One, Two, Three…

My Oct. 8 Kitco commentary began a retrospective analysis of copper and gold prices since the fateful Lehman Brothers bankruptcy filing Sept. 15, 2008. This period has witnessed two significant copper crashes as well as all-time records for both copper and gold. It was also a period of unprecedented monetary policy to mitigate the 2008-2009 financial crises and stimulate recovery. In addition to stimuli of other developed economies, the U.S. Federal Reserve’s quantitative easing, or QE, programs have had a significant influence on commodity prices.

The October column showed that the first QE cycle initiated shortly after Lehman Brothers collapse was quite effective at reflating fallen copper prices and boosting gold prices. The second cycle tended to inflate these prices against a backdrop of overzealous recovery expectations pushing copper to record $4.5+ per pound levels in early-2011. This was followed by a second crash in copper prices after the U.S. debt downgrade Aug. 5, 2011 and an all-time Comex record gold price of $1,923.7 per ounce Sept. 6, 2011. The third QE cycle started in September of last year is now expected to continue at full strength before tapering begins sometime next year. So far, QE3 has not experienced the extreme gyrations of the previous cycles and may very well be remembered as a time of commodity price “stabilization.”

To illustrate that point, it is instructive to plot the 3-month price volatility of copper and gold from the Lehman event to Friday’s close as shown in Figure 1:

*For this analysis, volatility is defined as the price standard deviation (SD) divided by its mean expressed as a percent over a three-month period

Figure 1 – Comex Copper & Gold Price Volatility (Lehman Brothers to present)

Shortly after the Lehman Brothers bankruptcy filing, copper prices crashed from mid-$3 to sub-$2 per pound levels. This resulted in an extreme price volatility spike (red trace) of 25% at the beginning of QE1; gold price volatility (gold trace) jumped to a high but a less severe 7%. To put these levels in context the average volatility over the entire period (dashed lines) is 5.8% for copper and 3.7% for gold so the QE1 peaks scored 4.3X and 1.9X their long-term averages respectively.

As QE1 eventually helped reflate prices, volatility subsided. Although copper had a few skirmishes above the $3 per pound level it took 11 months before the red metal could reliably sustain prices above that watermark. Importantly, Comex copper has been above $3 per pound ($6,610 per metric ton) 99.8% of the time since Oct. 14, 2009 – a period of just over four years.

Although QE2 was a period of inflation for metal prices, the price volatilities were much less severe falling mostly below their long-term means (i.e. solid traces below the dashed lines of similar color). In contrast to the low prices of QE1, Comex copper breached $4 per pound ($8,820 per metric ton) shortly after the start of the QE2 in Nov. 2010. Copper prices remained above that level for 77.6% of the program until QE2 was phased out in June 2011. From the end of QE2 until the present, copper has revisited $4/pound territory only 7.5% of that 28-month period.

Shortly after QE2, the ensuing U.S. Congressional debt debate and eventual downgrade caused a second round of significant volatility spikes. Copper crashed and gold scored new highs with volatility peaks of 2.0X and 2.1X above their long term-averages. It is noteworthy that the character of the copper volatility response after the U.S. debt downgrade is similar to the response following the Lehman bankruptcy filing: a sharp spike followed by two lesser ones of decreasing magnitude spanning a period of approximately one year. At the very least this emphasizes the lasting impact of price shocks to the metal markets.

Finally, QE3 is a mixed story with a troubling fall in gold prices that began in November 2012 and gained momentum in April amid fairly stable copper prices that have traded within the $3.0 to $3.8 per pound range. Gold volatility spiked to the 6% level after the April 12 downturn or 1.6X the longer average. By contrast, copper volatility has mostly stayed below its mean. As of Friday’s close, copper and gold volatilities are both below 3% - very quiet times for the metallic duo. Significantly, during the latest U.S. debt debacle, neither copper nor gold revisited the volatility levels experienced following the 2011 debt crisis.

Reversion to the mean revisited…

My Oct. 8 Kitco commentary posits copper and gold together with their relative valuation are undergoing a rather dramatic reversion to the mean from the Lehman crisis to the present. Table 1 is an update from the previous analysis:

Table 1 - Reversion to the Mean (Update through Oct. 5 closing prices)

Friday’s closing prices and relative valuation together with the 1-month and 3-month moving averages are all still all very close to the 5-year mean and mean valuation. This strongly suggests that a reversion to the longer term mean remains in progress. The low volatility (<3%) for both metals provides additional evidence that gold and copper are quietly waiting for a new direction.

Putting the pieces together…

In a market unaided by monetary accommodation, the next direction for copper and gold would normally be driven by the venerable laws of supply and demand. Mr. Adkerson addressed both in his third-quarter and the outlook for copper appears fairly bullish going forward. If Mr. Adkerson has underestimated the production coming on line in 2014 or overestimated China demand, copper could conceivably fall into sub-$3 territory in a “normal” market. The extension of QE3 taper into 2014 has made this unlikely for the intermediate term - the $3 per pound floor for copper has held with only a few brief exceptions since October 2009 on the wings of supportive monetary policy.

Alternately, a red metal flight to $4 per pound heights is also not likely. The tepid pace of global growth is a reality that has replaced the heady expectations of the inflationary QE2 cycle. Copper prices have been locked in the $3 to $4 per pound range 81% of the time since the October 2009 recovery and will probably remain in that range until global stimuli is reduced.

All three QE cycles have resulted in a steady value erosion of gold relative to key commodities. Quantitative easing tends to elevate the value of “real things” so that an ounce of gold buys fewer pounds copper and barrels of oil than at the program’s inception. Gold has traded at a premium to the red metal since the 2011 U.S. debt downgrade but that premium is rapidly vanishing - an ounce of gold Friday buys nearly 100 pounds less copper than in early-November. My Oct. 8 Kitco commentary computed a “fair value” of copper relative to gold of roughly 400 pounds per ounce, very near the valuations of  Table 1. Reversion to the mean therefore potentially marks a value transition for gold from premium to discount (i.e. valuations < 400 pounds per ounce).

As explained in my Kitco commentary Gold Trapped in a Value Wedge , gold trading at a discount to commodities limits its upside potential and may presage further downside. If, for example, continued QE3 returns valuations to November 2010 levels of 360 pounds per ounce, a $3 to $4 per pound range for copper would suggest a $1,080 to $1,440 per ounce range for gold.

Absent future price shocks, an extended QE3 will likely be characterized by low volatility with copper and gold prices stabilized within trading ranges. As monetary accommodations fade and inflation expectations return, this trend should reverse again in gold’s favor with the return of sustainable higher prices.

By Richard Baker, CP Value Analytics
Eureka, Nevada

Headline photo: Practice ride for the 2010 Eureka High School Rodeo in the heart of North American gold country.


Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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