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Will Base Metal Demand Fall Off a Cliff?

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December 02, 2007 – Comments (7)

A year ago I was highly uncertain about where I thought base metal demand might go.  As an investor I examined both the bull and the bear arguments.  

As technology improves costs generally decline and there has been an overall downward trend in base metal price over the past century and probably longer if one was to research it.  In recent years the evidence suggests that the cost for mining base metals has gone up and the ability for prices to further decline through technology gains or cheaper labour no longer exceeds the rate of cost increases.  There do seem to be price supports based on costs.

However, metals can end up being sold for a loss should supply end up ahead of demand.  World demand has been increasing and in the past few years the increase in supply has not kept up with the increase in demand, resulting in an enormous boom in base metals at unsustainable high prices.  

But how and where did all that demand come from?  The bulls suggest that we are at the beginning of a boom in a long term cycle for base metals due to the emerging economies.  The bears suggest that over investment will result in massive supply that will slaughter metal prices.  The question doesn't have an easy answer, nor is it one that I can accurately answer, but I can look at where some of the demand came from and consider it in my investment decisions.

The US has had a housing boom.  Last April housing starts were 2.1 million.  At about 400 pounds of copper per home, that's an enormous source of demand for copper.  Indeed, spending some time searching the internet I found that home construction accounts for about 40% of US demand for copper.  It seems to me that homes that were only starting to be built last April would have been using copper that has been sold in recent months.  Fast forward to now and housing starts in the US have declined to about 700,000, roughly 1/3rd.

A simple extrapolation suggests that the US demand for copper could decline by 25% in the coming months from the decline in housing alone.  With US consumption around 15% of world supply, well that would result in almost a 4% decline in world copper consumption from the US alone.

This very simple look at copper got my attention.  The enormity of the decline in the US housing starts will not easily be off set by increases elsewhere, if there are indeed increases elsewhere.  I did a search on housing starts in other countries.  In Japan housing starts fell 35% in October from a year earlier.  

India is supposed to be an emerging economy and one of the places that demand for metals is supposed to be increasing, at least that's the impression I get with all the hype.  Imagine my surprise when I wasn't even doing research on India, but steel, and an article about the stock piling of steel rods due to a slump in apartment construction came up.  Copper goes into apartments as well.

Australia seems flat, which is better than down.

I also looked at news about copper demand and I found an article about projections of copper usage.  The article has nothing in it to satisfy me that the projections are reasonable.  It points out that demand from China drove the growth in 2007, but go back a year to 2006 and that was when copper peaked at over $4/lb and China was not replenishing its warehouse stores of copper.  After the price of copper dropped in early 2007 China was a buyer so it is no surprise that the market was in a deficit in the first 8 months of this year.  I have seen no evidence that China has grossly diminished storage levels of copper now.  It seems to me that replenishing storage levels would have resulted in more demand for copper in 2007 then what is actually being used, which isn't good for outlook for demand for 2008.

If I look further at industry growth, the news suggest the mining industry is going full steam in their efforts to increase supply.

Copper demand seems highly dependent on home construction and the evidence that I see is that the level of housing starts are declining beyond what most people would have guessed, and this has enormous negative implications for copper.  Supply is still being ramped up and demand is falling, and it seems probable to me that supply will exceed demand, and by more than what many people expect.  I personally will sit out and watch copper rather than be vested in it.

I remain uncertain about where I think demand with other metals will go.  They are not as dependent on housing.  Pipelines, for example, do need replacing.  There was one that failed just this past week in Eastern Canada.  But the question is will the money be there to replace pipelines?  With the high level of uncertainty and the nature of price leverage due to supply, for me it is time to exercise caution for investments and watch the market rather than participate.

Happy investing.

7 Comments – Post Your Own

#1) On December 02, 2007 at 10:39 PM, camistocks (< 20) wrote:

As you know I'm a bull, so I have to fight back! China will rebuy after the New Year, they did so last year too. I think your steel article is not about India, but Bangladesh. It seems the construction downturn there is related to a new anti corruption initiative. This should end soon, hey it's Bangladesh, not Sweden! Look here, your  article from another source.

Never forget, 2-3 billion people want to become wealthy and have the opportunity to do so today. Every major economy has accepted capitalism as the best way to create wealth for as many people as possible, well except Hugo Chavez...

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#2) On December 02, 2007 at 11:01 PM, dwot (42.49) wrote:

(K)

Fight away camistocks.  But for the sake of your capital, be ready to run...  Also keep in mind that when copper levels were increasing last year, like they are now, copper retreated to $2.50/lb before it recovered.

Also, last year there were lots of stories about how China wasn't buying much copper yet this year copper demand from China has made the news.  I strongly suspect there isn't much to stock up on.

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#3) On December 02, 2007 at 11:31 PM, dwot (42.49) wrote:

One other thing, copper warehouse levels are higher right now than they were one year ago, by about 20%.

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#4) On December 03, 2007 at 12:12 PM, floridabuilder2 (99.33) wrote:

i don't see metals going up or down yet.... but i do see oil going down, so i am out of oil stocks... your analysis on copper was good....  unfortunately the only short bet i can place on base metals is a basket of base metals ETF.... not one specific for copper

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#5) On December 03, 2007 at 2:33 PM, dwot (42.49) wrote:

But the earnings on all the base metal producers have got to decline...

 

Here is an article today pointing out that for the first 10 months of the year China's imports were up 38.8%.  A big chunk of that was re-stocking.  There was tons of news how they had been de-stocking in the months prior and there is no news to that effect this year.  I think we had an unsustainable spike in demand for 2007 that has possibly hidden some declines.  With China using something like 25%, we are talking about 6 or 7% of the world supply last year, an amount to change the supply/demand equation beyond recognition from this year.

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#6) On December 03, 2007 at 9:00 PM, dude59 (28.97) wrote:

Everything is getting more expensive to get out of the ground. Oil, gold, silver,copper, lead, even iron. over the long term, and I mean ten or so years or more, the prices will go up, but in the short term we have to deal with the credit and housing mess. I fell that the metals will go sideways or down short-term (two to five years).

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#7) On December 04, 2007 at 9:00 AM, dwot (42.49) wrote:

dude59, the cost of mining metals had been declining until recently due to new technology.  If you look back 100 years and adjust for inflation, well it cost about $4-5 pound to mine copper.  Some places can produce copper for under $1/lb.

I think technology has reach its limit in a sense.  They are limited in making bigger trucks due to the physical constraints of the materials to make trucks.  Technology hid a lot of "inflation" by reducing costs.  

I agree with you that the cost of production are now going up and I don't see how the forces that kept them down in the past can do so anymore.  However, prices are still quite high compared to historical values and at current metal prices there are many, many projects that look like a license to print money. 

All things go to zero profitability and you have to ask yourself at what price is that now.  Copper is at $3 and I think copper is overall still profitable at $2.  Analysts still have about $1.25 or $1.50 for long term price for copper, but I think that is low.  But I also think we will see copper in that price range again, but just as the price is unsustainably high right now, I think that price would be unsustainably low.

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