A Short Squeeze in Copper?

Over the past six months copper prices have declined considerably, as was predicted in a previous research note on Foresight Investor. At that time copper was trading at $3.10/pound and seemed vulnerable to a downside correction. Copper prices are currently trading at roughly $2.66/pound at the time of writing, after touching a low of $2.42/pound in January.

However, a lot has changed since August 2014 and an analysis of copper’s long-term fundamentals, together with short-term sentiment and technical indicators, gives us reason to believe that copper prices might have some upside potential in the coming weeks. In the following paragraphs I will explain these factors in more detail. 

Everyone is short copper

A glance at the CFTC Commitment of Traders data shows that investors have an exceedingly large net-short position in copper futures (Figure 1). As the chart clearly illustrates, such high levels of net-short positioning have often coincided with near-term upside price reactions in copper.

Figure 1: CFTC Commitment of Traders non-commercial net-positions in copper futures (Source: www.TimingCharts.com)

With investors’ bets against copper at such high levels, one has to ask if this level of bearishness is warranted. To investigate this, we will take a look at copper’s long-term fundamentals.

Global supply/demand balance

An analysis of the current supply/demand dynamics shows that the copper market is surprisingly tight (Figure 2). RBC Capital Markets expects a 139 ton surplus of copper in 2015, which is relatively low compared to previous “surplus years”. Furthermore, the copper market is projected to slide into a deficit between 2016 and 2018. The tight supply/demand balance in the copper market indicates that investors’ current bearish expectations are far from a surefire bet.

Figure 2: Global supply/demand balance (Source: RBC Capital Markets)

In addition to this, there is reason to believe that the copper market might become tighter still in the coming months. 

Miners under pressure

One of the main catalysts for the plunge of copper is the enormous increase in new mine-supply. Global mine supply has increased with nearly 30% between 2005 and 2014. However, all of this new copper supply does not come cheap (Figure 3). Analyzing the current cost-curve of copper supply, we see that this new incremental production comes at significantly higher costs.

Figure 3: Copper cost-curves (Source: Citigroup)

The current low price of copper ($5.860/ton) is putting quite some pressure on mining companies and we are starting to see the effects of this. According to a recent Bloomberg article, large mining companies are expected to cut project spending by as much as $20 billion dollars in 2015. Moreover, mining companies have been reducing their production due to rising costs and the prolonged price slump. All in all, these factors indicate a significant fundamental floor for copper prices around $2.40.

Copper demand: down but not out

Another important catalyst for the decrease in copper prices is the very disappointing economic growth in China (Figure 4). China is by far the most important determinant of copper demand, as the country consumes roughly have of the current global supply and is projected to increase its consumption in the coming decade (Figure 5).

Figure 4: China real GDP-growth. (Source: JP Morgan)

Figure 5: Global copper consumption across major regions (Source: RBC Capital Markets)

Although China’s economy will remain relatively lackluster by historical standards, there are reasons to be positive about the Chinese economy, especially in the near-term. Reasons for this include monetary policy easing by the PBoC and the collapse of global oil prices.

Some high frequency economic indicators are already showing that the Chinese economy might be gaining some momentum. The Citigroup Economic Surprise Index for China has turned strongly positive over the past week, indicating that Chinese economic momentum is starting to surprise to the upside (Figure 6). Furthermore, The HSBC China Manufacturing PMI Index has increased for the past two months and is now above 50 (Figure 7). According to research by JP Morgan, the two-month change in the Chinese manufacturing PMI is a good short-term signal for trading base metals (Figure 8).

Figure 6: Citigroup Economic Surprise Index for major regions (China=light blue line) (Source: Citigroup)

Figure 7: HSBC China Manufacturing PMI Index (Source: Markit, HSBC)

Figure 8: Chinese manufacturing PMI trading signal historical performance (Source: JP Morgan)

Because of the current positive developments in the Chinese economy, base metals (including copper) could experience some support in the coming weeks.

Technical analysis

Although copper is definitely in a longer-term downtrend, there is room for some upside price action (Figure 9). Both the RSI and MACD indicators are above the ticker lines, which indicates that copper could be bottoming out. The upside target for copper is the significant resistance zone at $2.90-$3.00/pound.

Figure 9: Copper technical analysis as per March 17th

Conclusion

At the moment, market participants have an exceedingly large short position in copper. These bearish bets seem unwarranted when analyzing copper’s long-term fundamentals. The current copper market surplus is not very large compared to historical data. The current low price environment has been quite harsh for miners and as a result spending for future projects is being shuttered and current production is being rationalized. This creates somewhat of a floor under current prices, at least in the short-term. Chinese economic growth has been weak over the years and is expected to remain anemic. However, there are signs that the economy could regain some traction in the coming quarter. Historically higher than expected, Chinese economic momentum has boosted base metal prices, including copper.

All in all, this leads me to believe that copper prices have more upside than downside potential in the coming weeks. My short-term target for copper prices is the resistance zone between $2.90-$3.00/pound.

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Simon.waslander

Simon Waslander

Simon is the CEO and Editor-in-Chief of Foresight Investor. He has been following the markets passionately for over 7 years.

This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.

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