By Jim Williams
This week's article on copper is a little different. Instead of talking about current prices, we are going a little deeper. Okay, a lot deeper. In fact, we are going to take a look at the industry from a leading expert with vast knowledge of copper mining.
tED magazine had the privilege of talking copper with Rick Rule, President and CEO of Sprott U.S. Holdings.
Rule has dedicated his entire adult life to natural resource securities investing. In addition to the knowledge and experience gained in a long and focused career, he has a worldwide network of contacts in the natural resource and finance worlds. As Director, President, and CEO of Sprott US Holdings, Inc., Rule leads a highly skilled team of earth science and finance professionals who enjoy a worldwide reputation for resource investment management.
During our interview, Rule was candid, honest and completely transparent about the industry, politics and his look at the future price of copper. Read on to see where he sees copper going, from his perspective.
tED magazine: What are your thoughts on copper in the current market?
Rick Rule: It is fairly apparent to me that in a three- to five-year time frame, the copper price needs to go higher. My suspicion is that the only thing that has kept the copper price from going higher in the last two or three years really has to do with the surprisingly weak global economy.
At Sprott, we believe that the incentive price for bringing new, conventional copper into production is in the sort of $3.25 to $3.40 per pound range. When the industry reports its production costs, even when they report all-in sustaining costs, they generally neglect in the context of the costs to include the cost of prior-year write-downs. And the copper mining industry over the last 15 years has had some periods where they've had some severely substantial write-downs. If you look at the incentive price that's needed to bring new mines in production and you consider the fact that an awful lot of the existing production is coming from mines that are fairly long in the tooth – I'm thinking of Escondida (Chile), Toquepala (Peru), Grasberg (Indonesia), mines like that.
The truth about any very large capital-intensive business is the periods. If you have a period of time, like you have now, where the industry is producing copper for certainly less than the incentive price and in many minds, less than the total cost of production, you balance supply and demand in a different way. You balance it with supply destruction, which I believe is the process that we will be going through in the next two or three years if the copper price doesn't go up.
Generally, in resource-based businesses, markets balance themselves because the very low commodity price generates enough utility to customers that demand increases. But, you have situations like we are having now where weak global demand doesn't seem to want to rebalance copper supply and demand.
tED: What you mean by “supply destruction”?
Rule: Supply destruction simply replies to the fact that if you are producing copper at a very low, or negative total margin – that is, if your fully-loaded cost to produce copper is $3 a pound and you are selling it for $2.40 a pound – you're losing 60 cents/pound on millions of pounds. Pretty soon, it gets tiring.
If you're losing 60 cents/pound, just as an example, your incentive to go find new copper mines, build new copper mines – or even make sustaining capital investments in your existing mine – is very low. The consequence of that is that when you have mined the best rock out of this mine, you've rendered the rest of it uneconomic. That's what supply destruction is. The low prices eventually lead to deferral of sustaining capital investments and eliminate new capital investments, which means the mine – hence the company's ability to produce, or supply copper – becomes impaired. And, it becomes impaired for a long time. As an example, in a sort of Chilean porphyry strip mine, if you begin to defer sustaining capital investments – by, as an example, not authorizing the pre-strip to push back the pit walls – what happens after a period of time is, the pit walls get too steep and you lose your ability to mine in the pit. In order to rectify this, you have to do in one or two years (the stripping, or pushing back) that you should have been doing for five years. That constrains your ability to be able to produce, but it's also very capital intensive and time consuming.
That circumstance is very messy but what's interesting about it is, if you rebalance supply and demand through supply destruction, the industry can't respond to the pricing signals from tighter supplies because they have impaired their ability to produce. What happens in those circumstances is that you can – I'm not saying we will – but you can have fairly explosive upside in copper prices because, as I say, the industry isn't able to respond in the near term to pricing signals by increasing production because of the capital-intensive nature of that supply response and the time lag involved in things like permitting, financing and building.
tED: What influences do you see playing the biggest role in the price of copper?
Rule: Right now, demand. If we had an uptick in the global economy, that would be very, very helpful. It appears that we are still in the grips of a global period of economic weakness – the demand just does not seem to be there in a range of industrial products. I think that's gripping copper. Looking further out, I think the challenges that the copper mining industry faces will have to do with cost of capital. We are in a period right now of record low interest rates and in a capital-intensive business. If your cost of capital goes up, your production costs go up.
The most interesting part of the copper mining equation that I see right now are the absolutely new incredible copper discoveries that have been made in Congo by Ivanhoe. The Kamoa and Kakula mines are, by my reckoning, the most important new copper discoveries that we've seen in probably 100 years!
The challenge is going to be the political and social circumstances in Congo. Financing deposits in Congo can be done, but it's not easy. The truth is that all of Congo (including Katanga) in the copper belt is both politically and socially challenged. The industry is going to have sort of a game of chicken watching the development of Kamoa and Kakula because, leaving the politics aside, they will be absolutely extraordinary copper mines. The question is what impact will they have on the price of copper when their copper hits – or doesn't hit – the market? (Look for a future article from tED expanding on this topic.)
tED: Have we seen the last of historic highs ($4.50/lb in 2011) and historic lows ($1.90 in 2016) in copper prices?
Rule: I think the answer to that is – depending on how many years you give me. We may not have seen neither the high, nor the low. If we had another circumstance like we had in 2008 – another liquidity crisis – If we had that, I think we would take out the lows. (I'm not saying we are going to, by the way. I'm not one of these “the sky is falling” guys, but I look at the level of debt through at least all of the political economy, not the private sector, but the public sector, and I don't think it's impossible that we could have a liquidity-driven economic destruction.) Then again, I'm not an economist, I'm a credit analysis, I'm not saying it's going to happen, but it wouldn't surprise me at all if we had a liquidity crisis and I think we could take out those lows if that were to happen because there isn't a lot of demand now.
With regards to the highs – and I realize these are contradictory statements – but if you study the copper price over 30 years, you will see that it is extremely cyclical and extremely volatile. If we have a period where the copper prices stay sub-$2.50 for three or four years, the circumstance of that would be that we set ourselves up for a real supply disruption. And, supply disruptions generate absolutely unbelievable upside in commodity prices. At Sprott, we are fond of saying that the cure for low prices is always low prices, and the cure for high prices is high prices. If you are going to be in the materials business, you learn that if you are not a contrarian, you are going to be a victim. If we have a circumstance where the industry isn't allowed to invest in new productive capacity because of price, and isn't allowed to make sustaining capital investments, you could see a real spike in the copper price in the sort of four, five or six year time frame. It takes a really long time to resolve that because of the length of time that it takes to put the capital to play to increase supply.
tED: There are so many potential “what ifs” that impact the price of copper (President Trump's infrastructure plan, China, mine strikes). Out of all the factors out there, what do you believe has the biggest short-term impact on copper prices?
Rule: I don't know the answer to that. I really don't. I think it would be a U.S. economic recovery. I'm not saying we are going to have one, but one of the things that we note in our relationships at Sprott with our Chinese customers, is that they are aware that the financing for the One Belt, One Road still comes, increasingly, from selling stuff to us. If stuff is moving out of Wal-Mart, money is moving to China and they have the ability to continue to invest in infrastructure.
(Another factor is) our own softness, despite their very large currency reserves, is a bit of a constraint for them. So I would say the most important, near-term impact would be the beginnings of a recovery in the United States.
In terms of Trump: Although, I think the narrative is interesting, my suspicion is that he won't have very much of an impact at all. He might have an impact for U.S. copper producers, in terms of creating a friendlier regulatory environment, but my suspicion is that his ability to fashion an over-arching political agenda in the United States is fairly limited. Again, I'm not a political analyst, but it would appear to me that the Democratic establishment party is implacable in their hatred towards him. I don't think he has an awful lot of support from the Republican establishment – although, he does have support from the Republican rank and file – and the bureaucracy absolutely loathes him. The consequence of having the apparatus of the state opposed to him, and the fact that he's tried to pick 40 or 50 fights, as opposed to winning one or two, suggests to me that he's going to be, in terms of the broad economy, a non-entity for four years. Now, for myself politically, I have decidedly Libertarian leanings, and my own suspicion that a government divided gets nothing done, is probably a good thing. I realize that's a pretty cynical point of view, but I don't think that he will make much of a difference in the economy or the copper price.
tED: What would make a big difference?
Rule: I think if we had an improving U.S. economy. That would make an enormous difference. The Chinese have been very public about their outbound investments in One Belt, One Road and their continuing infrastructure investments. I do need to say, and this is relevant, that two, two and a half years ago, maybe a little bit longer, our own mainland Chinese clients told us they were less interested in making copper investments. I should have understood that as a passive acknowledgement by the Chinese state that their economy was slowing down. Very recently, those same Chinese clients, have expressed a renewed interest in copper, which would suggest that confidence in the Chinese domestic economy is improving. It may be that my outlook toward the world economy is wrong. I might be being a little too cautious.
tED: If China's economy does not show recovery in 2017, what does that mean for copper prices?
Rule: Continues soft. I think there are adequate supplies on the market in the face of weak demand, that if the Chinese economy doesn't improve, the next 12 months will be pretty soft.
tED: Say all things go according to plan: an infrastructure plan begins, China's economy leads to a huge demand, and mining labor problems cut supply, what is the top price you can predict for copper?
Rule: I really have no idea. Copper is so volatile. I get tempted to answer because I am hardwired to make people happy, but I wouldn't have any faith in my answer. If you give a good salesman like me the ability to use the words “could,” “would,” and “should,” I can make any scenario work!
Honestly, it wouldn't surprise me in the next two or three years to see copper take out the old highs. We need to remember the utility associated with copper is pretty astonishing. In the short term, there's a lot of price elasticity, or demand in elasticity. Copper is such an essential component of our way of life that if there is a supply disruption, or if there is strong demand, in the near term the ability to substitute or improve fabrication efficiency doesn't exist. That's why you get these insane moves like 75 cents to three dollars. They don't last. Over time, markets work. When you have periods of very high prices (when I say periods, I mean four or five years) the utility of the material relative to its price is poor for users and they find a way to conserve, they find a way to substitute. At the same time that producers enjoy a low cost of capital because of their high margins (and they have operating capital to put into new supply), then you have a situation where demand falls and supply increases. Anyone from first year Economics knows what happens – that produces a crash. Five or six years out the low copper prices stimulate demand and no one bothers to conserve, no one bothers to substitute, and eventually the supply goes to supply heaven. So demand increases, supply falls and the price goes up and the cycle repeats, and repeats and repeats.
tED: With copper reserves as they are, will there ever be more demand than supply?
Rule: Oh, sure. Reserves is an economic term. Rock that has a certain grade might be a resource at $2.50. It might be a reserve at $3.50. Remember, it takes a tremendous amount of capital to make that reserve into supply. If you have a period where you are, for one of the better phrases, upside down – that is, where you are producing copper at a cost that is above the price that you sell it for – and you don't make the sustaining capital investments we talked about earlier, you can impair for five to ten years the ability to be able to produce. When that supply/shortfall happens, the price goes crazy for a while. If you remember to the early part of last decade, we came off 80- to 90-cent copper in the late 1990's. The consequence of shutting in production and an increase in demand from what was within a small economy (China) gave us something like a four-fold increase in the price of copper in fairly short order.
I'm not saying it's going to happen. The past could easily be prologue – that's the history of the mining business.
tED: If I am a distributor reading this article, can I expect current prices to hold steady? Can I have confidence in no “dramatic” price shifts?
Rule: If you are talking about a 12-month timeframe, depending on your suppliers' economic outlook, I think supplies are very adequate because I see a fairly weak economy. Now again, I am a credit analyst, I'm not an economist, it might be that I am wrong with what the economy will look like in the next 12 to 18 months and what aggregate demand will look like. I don't think I am. I think the softness in electricity prices, the softness in dry bulk freight rates, the softness in the oil price, would suggest that the economy – with a few global exceptions – isn't going to generate a lot of demand in that next 12 to 18 months.
If your suppliers' timeframe is what it is in the mining business, very short term, that is 12 to 18 months, I think supplies will be adequate and prices will be muted. That sets up, of course, a tremendous rally three, four, five years out.
tED: At the time of this interview (Thursday morning, June 29), the headlines were talking about LME stock levels. Can you tell tED readers why should they, as a distributor in the U.S., care about the inventory in London?
Rule: I think the LME quote is an indication. I think your suppliers need to probably pay more attention to warehouse inventories and in particular, maybe Chinese inventories. There was a circumstance you may remember, from around 2002 to 2005, where one of the things that happened was that first, Chinese fabricators and then other Chinese people, began to store their wealth in copper. The consequence of that is the Chinese inventories absolutely ballooned. That in and of itself lead to price weakness. The LME price is one component. It is probably the best benchmark, but I think you probably need to pay attention to finished inventory and commodity warehouses – and finished inventory through the rest of the fabrication chain. Look at LME prices as more of an indicator than anything else. Think of the LME price as the symptom.
About Sprott U.S. Holdings, Inc.
Sprott U.S. Holdings, Inc. is a holding company made up of three separate and distinct companies: Sprott Global Resource Investments, Ltd., Sprott Asset Management USA Inc. and Resource Capital Investment Corporation. These three companies make up the U.S. Subsidiaries of Sprott Inc. and are active in securities brokerage, segregated account money management and investment partnership management involving both equity and debt instruments, across the entire spectrum of the natural resource industry.
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