Copper: Economic Risks Ahead And Options’ Downside Skew

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Copper prices are often said to reflect the health of the global economy, hence the moniker “Dr. Copper.” Between January 15, 2016, and December 28, 2017, copper prices rose by 72% as China’s pace of growth picked up and emerging-market nations such as Brazil and Russia began to recover from recession, while the rest of the global economy boomed. This year, however, copper prices are about 5% off last year’s highs, and copper options appear more concerned with downside risks than higher prices. Here’s a look at copper’s demand and supply, and possible trajectory.

China: Copper’s Most Important Source Of Demand

Some may wonder why copper responded so dramatically to such a mild improvement in Chinese growth? After all, China’s growth improved by a seemingly negligible 0.2% from 6.7% to 6.9% (Figure 1).

There are several answers to this question. For starters, China consumes 40-50% of the world’s copper ore each year, making it the key determinant of the red metal’s global price. Secondly, Chinese growth decelerated from 11% growth in 2011 to 6.7% growth by 2016, leading to fears of a broader and deeper slowdown that failed to materialize, sparking a relief rally in industrial metals, such as copper. Another answer which we think is more meaningful and credible is that China’s official GDP understated both the degree of the 2011-16 slowdown and the subsequent rebound.

Figure 1: Did Copper Overreact to the Improvement in Chinese Growth?

An alternative and narrower measure of China’s GDP growth, the Li Keqiang Index, which measures changes in the volume of rail freight, electricity consumption and bank loans, shows that China’s growth slowed from 20% growth in 2011 to around 2.5% by 2015 and then rebounded to around 12% last year. Even if the Li Keqiang Index, named for the country’s prime minister, fails to capture the performance of China’s service industry, it may be reflecting quite accurately periods of acceleration and deceleration in China’s industrial sector, which are relevant to the price of copper and other raw materials (Figure 2).

Not surprisingly, copper exhibits a much stronger correlation to the Li Keqiang index than it does to China’s official GDP (Figure 3). As such, the overriding question for copper investors is: what will be China’s growth rate going forward? The answer might not be comforting. Not only is China facing the prospect of a possible trade war with the U.S., it has plenty of internal problems as well, including a flattening yield curve – often an indicator of economic deceleration – and massive debt.

Figure 2: Copper Prices Often Follow the Li Keqiang Index With a 3-6 Quarter Lag

Figure 3: Li Keqiang Index Has Been a Better Indicator of Copper Prices Than Official GDP

China’s yield curve correlates highly with future changes in the Li Keqiang Index by as much as 0.7-0.8, 2-4 quarters in advance (Figure 4). Currently, that yield curve is signaling a further slowdown in both the official GDP and the Li Keqiang alternative measure of economic performance (Figure 5). Moreover, China’s colossal debts could also sap growth. Back in 2009, when China began to lever up, additional debt boosted growth, offsetting the drag from the financial crisis in Western nations. As China achieves higher and higher levels of growth, additional leverage is no longer boosting economic output as new loans are mainly being used to finance the existing debt rather than generate new investment activity.

Figure 4: China’s Yield Curve Tends to Lead Growth By 2-5 Quarters in Advance

Figure 5: China’s Relatively Flat Yield Curve May be Signaling Further Slowing

Overall, China’s debt levels are similar to those of the United States and the nations of the European Union – not a club that nations should aspire to join if strong economic growth is the goal (Figure 6). If China does slow down due to high debt levels, tight credit conditions (as evidenced by a relatively flat curve), a change in focus away from industrialization and towards higher quality growth, or a trade dispute with the U.S., that’s likely to be bad news for copper.

Figure 6: China’s Debt Ratio Has Reached Western Levels

Upside Risks: U.S. Growth, Deficits And Dollars

While China poses mainly downside risks for copper, in our view, there are numerous upside risks too, and the main one is the USA, but not for reasons that many might expect. The combination of tax cuts and spending increases could boost U.S. growth this year and next. The Congressional Budget Office (CBO) estimates 3.0% U.S. growth for 2018, a significant improvement from the last few years. If U.S. growth does meet or exceed the target, it could play a role in supporting copper prices, but the main reason why events in the U.S. could spark a copper rally lies elsewhere.

In addition to temporarily stoking growth, the combination of tax cuts and spending increases is going to explode the U.S. budget deficit (Figure 7). Already it has risen from 2.2% of GDP in 2016 to 3.8% today, and those numbers don’t reflect the latest tax cut and spending increases. The combination of a larger budget deficit in the U.S. with generally contained or shrinking fiscal deficits in most other countries could put the U.S. dollar under downward pressure. Note the correlation between the size of the “twin deficits” (trade + budget) and the level of the dollar index in Figure 8. The only time when the relationship didn’t work was 2009 through 2013. During that period, the U.S. fiscal situation deteriorated, but the dollar didn’t collapse because just about every other country’s situation worsened in tandem. Normally, with the Fed raising rates, one might have expected a strong dollar, but the relative fiscal deterioration in the U.S. compared to Europe, China, and other regions and countries is putting the dollar at a disadvantage. A weaker dollar is bullish for commodity prices.

Figure 7: U.S. Deficits Could Reach 5.5-6.0% of GDP by 2019 From 2.2% in 2016 and 3.8% Today

Figure 8: Except for the 2009 Crisis, Larger “Twin Deficits” Usually Mean a Weaker Dollar

That said, investors in copper should be careful not to expect too much support from either U.S. growth or a weaker dollar over the long term. For starters, the CBO suggests that U.S. growth will slow to only 1.8% by 2020, and if the Fed keeps hiking rates at anywhere near its current pace, tighter monetary policy will offset much of the fiscal boost. What the fiscal hand giveth, the monetary hand taketh away. Moreover, Chinese growth will probably prove to be a more important story for copper than growth in the U.S. or value of the dollar.

Outside of the U.S., global growth remains robust. European and Japanese growth remains fueled by easy monetary policy. India continues to boom. Brazil and Russia are recovering. Overall, the picture isn’t bad for copper. That said, Brazil and Russia depend to a remarkable extent on the health of the Chinese economy, as do most other commodity exporters from Australia and Canada to Chile and South Africa.

Supply: 21,000 Tons Of Supply Is Hard To Absorb

Copper supplies will likely grow by 4% in 2018 to a new record high of nearly 21,000 tons (Figure 9). This means that copper supplies will have more than doubled over the past quarter century. That supply is increasing should come as little surprise, given the profitability of copper mining. Copper costs, on average, about $1.90/lb to mine, and with the price currently above $3, that implies 50%+ operating margins, on average. As such, there is every reason to think that copper supplies will continue to grow well beyond 2018 to the probable detriment of copper prices.

Figure 9: Copper Mining Supply Continues to Rise

Copper Options Market Pricing

Perhaps reflecting the risk that Chinese and global growth will prove inadequate to absorb copper’s massive supply, the skew on options volatility is to the downside – especially on longer-dated options (Figure 10).

The overall cost of copper options isn’t particularly high by historical standards. At-the-money (ATM) options have been trading at around 17% in recent weeks, which is much closer to historic lows than to historic highs (Figure 11). If copper options follow the same volatility pattern that we have observed in equities and bonds, then tighter Fed policy and a flatter yield curve might eventually translate into a major uptrend in copper volatility (both realized and implied) as we move into the early 2020s. Back in 2011 and 2012, copper options implied volatility traded around 25-40%. If the Fed tightening results in another economic crisis, those levels of volatility could one day become the latest new normal.

Figure 10: Options Traders Think That Downside Risks Outweigh Upside Risks

Figure 11: Option Implied Volatility

Bottom Line:

  • Chinese growth appears set to slow to the detriment of copper.
  • U.S. fiscal expansion is weakening the dollar and supporting copper.
  • Global growth remains robust to copper’s benefit, but many nations depend on China.
  • Copper supply continues to grow, to the detriment of copper’s rebound.
  • Options markets are calm overall but appear more concerned with downside than upside.

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