Whatever Happened To Doctor Copper?

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Three or four years ago, as the global economy began the long haul out of a major recession, it seemed that those who follow financial news couldn’t escape articles waxing lyrical about the predictive powers of copper. The price of the metal was rising and that, we were told, showed that those in the know saw rising industrial demand and therefore an end to the dark days. Doctor Copper was hailed as the ultimate diagnostician.

So, as the recovery has continued, albeit slowly, it would be logical to expect the copper price to have continued rising, right?

 

Wrong. Those heady days at the end of 2010 marked the highs in copper prices.

There are two main reasons for this. Firstly, it is easy for those who concentrate on the stock market, where supply of each stock remains relatively static to forget that commodity prices are a function of demand and supply. As the price rose above $4/lb, so supply began to increase as previously uneconomic mines began producing. That increased supply took time to come online, but now that it has, there is a worldwide glut of the metal, as detailed in this Bloomberg article from October.

The second factor is that, unsurprisingly, the parabolic growth in China has slowed somewhat. The Chinese economy is still growing, but double digit growth has ceased, at least for now. China accounts for around 40% of global copper demand, so any signs of a slowdown have a huge effect on the price.

Given that both the supply and demand sides of the equation have been depressing prices, then, it is actually quite remarkable that copper has not fallen further. There is a general expectation that the supply side of the story is set to continue to put downward pressure on copper in 2014, even if Chinese and global growth begins to pick back up again. Indeed, according to this story, Goldman Sachs (GS) has included a “long Chinese stocks/short copper” trade in its best ideas for 2014. For this to work the historic correlation between Chinese growth and the copper price has to break down and supply factors must dominate.

Hmmm, there seems to be a little too much agreement here for my liking. I am by nature a contrarian and when it seems that an idea is conventional wisdom there is usually an opportunity for a relatively low risk trade with potential for a decent return. It isn’t hard to find one in copper at current levels.

The technical case for a long copper trade is fairly obvious. You don’t have to have an MIT degree in advanced chart reading to see an obvious support level at $3.00 on the Kitco chart above. The current proximity to that level (Copper is trading at around $3.16/lb as I write) provides a logical place for a stop loss that limits potential losses. Be careful when setting a stop loss based on obvious support at a round number, though. You need to leave room for the possible squeeze should the price drop close to the level. Somewhere around $2.85 would represent a clean break of the support, giving a potential loss of around 10%. A return to $4.00 gives a profit target of around 40%. This is the kind of risk/reward ratio that I like.

Of course, no matter how good the trade looks from a risk/reward perspective, you still have to have a reasonable expectation that it will go your way. Far be it for me to take on the brilliant minds at Goldman, but I can easily see a scenario where copper appreciates in the first quarter of next year. There will undoubtedly be worries about global growth as Washington resumes its absurd dance around the budget and debt ceiling, and predicting growth in China, which is still essentially a command economy, is tricky. The demand side, then, could remain questionable, but it is largely supply that has kept prices down.

On that side of things, simple logic would indicate that things might not pan out as the bears expect. Supply was increased fairly quickly on the expectation of continuing price appreciation and the longer the price hovers just above $3, the more likely it is that supply will be reduced and the expected glut will not materialize. If so, then the improvement in China that Goldman expects and the usual last minute resolution to the budget “crisis” in the US could see a significant spike in copper.

I should stress that, like any trade that is contrarian in nature, you would have to enter this one with the understanding that it could well not work out. As I said, part of the appeal is the proximity of a logical stop loss level, so you must be prepared to cut for a loss if that level is reached. There are plenty of things that could cause that; continued slowing in China and weak demand resulting in a rapid buildup of stockpiles, for example, or the Fed tapering QE earlier or faster than expected.

On balance, though, this looks like a trade with a good risk/reward ratio and a decent chance of success. Who knows, if I am right and the price of copper does rise, we may even see another rash of articles about the ability of “Doctor Copper” to assess the world’s economic health.

 



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Commodities , Economy , Investing Ideas

Referenced Stocks: GS

Martin Tillier


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