We recently did some work on copper stocks to determine whether we believe an investment opportunity exists. People have written a lot about the “green transition” to more climate-friendly energy sources and the resulting demand growth for various metals. Many doubt that copper supply can keep up with demand.
Secular change can lead to potential investment opportunities, but also significant risks (remember gene editing and plant-based meat?). To determine whether an investment opportunity exists, we always seek to compare fundamentals to market expectations.
After some work, we believe the pragmatically-efficient market appears to have discounted increasing copper prices, and conclude copper equities don’t currently represent an attractive risk-reward.
Copper’s chemical structure makes it relatively advantaged to decarbonization trends and well insulated from potential changes to technological innovation in batteries. The lack of an adequate supply response, however, is the key element that makes copper potentially more attractive than other metals. The market has taken notice. Copper equities have risen +44% over the last year, outpacing the broader market by nearly 3,300bps. At first glance, it might be easy to conclude a looming supply shortage is creating an investment opportunity. We think copper equities already price in materially higher copper prices. If those fail to emerge, there could be significant downside risk.
Base case calls for significant deficits to emerge in second half of the decade. The green demand pull on copper is expected to have a significant tightening effect on the global copper balance over the next decade. Industry experts expect an acceleration in demand to +4% through 2030, double the +2% growth rate achieved in the prior decade. After all, copper intensity to the next generation of clean technologies is significant, ranging between 3x-15x for batter electric vehicles (“BEVs”) and renewables compared to traditional internal combustion engine (“ICE”) vehicles and conventional power generation. Magnifying incremental consumption is a limited supply response, reflecting a substantial flattening of the trend of discoveries and few material projects coming online. Baseline mine supply is heading for a peak in 2025, opening the door to large-scale deficits moving into the back half of the decade.
Risks to a more balanced market. The future is unknowable, though history can provide some guideposts around how market expectations compare to reality. As it pertains to copper, estimates for supply have been quite reliable. WoodMac supply estimates in 2013 for 2023 forecasted 23.7mt, about in-line with this year’s total mine production. The demand side has been less reliable, coming in 15% below the expected annual growth rate, a key risk moving forward, especially considering a weakening China drives >50% of global consumption and 40% of expected growth. Technological innovation also needs to be considered. Success in Course Particle Recovery and Primary Sulphide Leaching could add ~2mt to incremental supply by 2030. If demand growth fails to accelerate from the past decade and technological innovation occurs, however, the market would remain in surplus through 2028. No shortages mean copper prices won’t increase and the equities are overvalued.
Copper equities priced for scarcity. At 25x earnings with minimal free cash flow generation expected, copper equities look to be pricing in the rosy base case scenario outlined above. Not all that enticing in our view for capital intensive businesses with historically poor returns on invested capital and geopolitical risk. Price action off the 52-week lows shows just how much optimism is priced in with copper equities +35%, over 2.3x the +15% move in copper.
Our work on Freeport (FCX $42.43) suggests the stock is currently discounting $9,000/t copper while consensus estimates for next year imply $9,500/t, +14% and +27% above current spot prices, respectively. Meaning, you have to believe copper prices move higher from here to not lose money and materially higher for it to be significantly mispriced. We believe current copper prices at $7,700/t justify a per share value in the low-$30s, -22% below current levels. Risks to a more balanced market warrant serious consideration, in our view, a scenario that implies -32% downside for Freeport on just a -7% drop in copper prices to $7,000/t. Not exactly a favorable risk/reward when a similar amount of upside would require a copper price +35% above where it is today.
As always, we will continue to monitor and look for a more attractive risk-reward.
Source: Bloomberg, Berstein, Citigroup, and Patient Capital Mangement
FCX price as of close on 8/17/23
The views expressed in this commentary reflect those of Patient Capital Management analyst(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Patient Capital Management disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.
©2023 Patient Capital Management, LLC
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