The copper bubble looks set to burst - here's how to profit - Outside View by MoneyWeek

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The copper bubble looks set to burst - here's how to profit
Jun 18, 2011

Copper is hardly a glamorous metal. But over the past decade, it has become the pin-up of the commodity bull market.

Demand from emerging markets, and China in particular, has pushed the price up by more than 450% since 2001. That sort of gain rivals even gold.

Most analysts expect this to continue. Further demand from China, which currently accounts for 38% of the total global copper trade, is set to push the price up another 25% this year, we're told.

But not everyone agrees. And if they're right, recent wobbles in the price of the base metal could be just the start. In fact, the bottom could be about to fall right out of the copper market. Here's why.

Not all of China's copper is being used for building

Michael Pettis, formerly of Bear Stearns and now a professor at Peking University, has cast doubt on the copper bulls' main argument - China's apparently insatiable demand for the stuff. He thinks the real reason Chinese companies are buying so much is to get around Beijing's recent borrowing restrictions.

Why? Pettis notes that domestic companies are importing foreign copper even although it is available for lower prices in Shanghai. "Credit-starved companies were importing copper because they could obtain trade finance or some other sort of foreign financing, and then used the physical copper... as collateral for domestic borrowing." In other words, companies borrowed money from abroad to buy copper they didn't need, so they could use it as security for local loans.

Another source of 'fake' demand is the popularity of exchange traded funds (ETFs). You can now buy ETFs backed by physical copper, rather than futures, which has of course increased demand for physical supplies as retail investors pile in.

Of course, it's no big secret that not everyone who buys copper wants to use it to make a pipe or a washing machine component. But copper sceptics say this 'fake' demand is having far more of an impact than analysts realise or care to admit.

The 'real' copper price should be closer to $5,000

Veteran copper analyst Simon Hunt told the BBC recently that rampant financial buying has led to massive amounts of copper - two million tonnes, around 10% of annual global consumption - being stored in unregistered warehouses.

Hunt thinks that if you stripped out financial buyers, copper would cost around $5,000 a tonne, not today's $9,000. Indeed the average cost of processing and delivering copper is only around $3,000.

The trouble is that it's very difficult to gauge the market. The leading copper marketplace is the London Metals Exchange. But its registered inventories only account for a fraction of world supplies. The rest is hidden in unregistered warehouses around the world and "practically invisible", says Stephen Spencer of independent copper analyst Traderight.

Why does this distinction between 'financial' and industrial demand matter? Well, because if it's true, it would mean that a change in financial sentiment - perhaps like the one we're seeing right now - could cause prices to dive as financial buyers tried to offload their stocks en masse.

Indeed, says Hunt, the recent "correction was part of the game being played out... At between $9,000 and $10,000 there was difficulty in finding new investment buyers; lower prices are needed for the game to continue."

What a plunging copper price would mean for your portfolio

A sudden glut of copper would hit the markets hard. The obvious casualties would be those directly invested in copper, say, through ETFs. Likewise, the price of copper mining stocks would also take a hit. Investors in other commodities or extractive industries would likely suffer too.

After all, the investment thesis underpinning the commodity boom of the last decade has been insatiable Chinese demand. If investors started to question that, a whole basket of commodities could fall pretty quickly.

The least affected commodity would probably be gold, which is more of a currency than a physical commodity. If anything the uncertainty caused by a massive commodity correction may well encourage investors to seek 'safe havens' like gold.

But if you want to do more than merely protect yourself you might consider investing in a firm that should benefit from lower copper prices. The cable and wire manufacturing sector for example, is heavily exposed to copper prices. Copper accounts for roughly 70% of the cost of a generic cable. The sector has been depressed recently as a high copper costs have driven down profit margins. Lower copper prices would allow manufacturers to re-inflate these margins.

Fierce competition in China would make it difficult for Chinese manufacturers to profit from a lower copper price. But US manufacturers don't have the same problem. They don't have to compete with China either - the cost of shipping outweighs the benefit gained from cheap Asian wages (labour only accounts for 3% of the cable cost). Our favoured play is Coleman Cable (Nasdaq: CCIX), which looks cheap on a forward p/e of 7.2.

Another option is to short copper. You can do this through spread betting or by buying a short copper ETF. Spread betting is risky at the best of times and when you use it to take a punt on a volatile commodity like copper you could end up losing a lot of money. That's not to say you should rule it out. But make sure you know what you're doing first (you can visit our spread betting section to find out more).

The short ETF is a slightly less risky option, although again it is not as straightforward as a traditional ETF tracking the FTSE 100, for example. These sorts of funds are only suitable for fairly short-term bets, and if the copper price goes against you, you can rack up losses quite quickly, though unlike with spread betting, you can't lose more than your initial stake. The ETFS Short Copper (SCOP) tracks the Dow Jones-UBS Copper Sub-Index, and rises as the copper price falls and vice versa. It is 100% invested in copper and has a management fee of 0.98%.

This article is authored by MoneyWeek, the UKs best selling financial magazine. MoneyWeek offers intelligent, easy-to-read analysis of the financial news, with practical investment advice.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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