20140120-BMO-Copper_Industry_Strategy_The_Math_of_Quantity_vs._Quality_Trade-off_47页_1mb

Copper Industry Strategy Summary - January 20, 2014

Core Content

Copper remains BMO Research's preferred metal in the base metals complex, not due to price expectations (which are expected to decline modestly) but because of its superior returns on capital compared to most other metals. The analysis highlights the structural challenges and opportunities within the copper industry, focusing on supply-side risks, capital intensity, and investment strategies.

Main Points

1. Supply Elasticity and Capital Commitment

• Supply elasticity has been diminishing despite rapid demand increases.
• Miners and investors are increasingly reluctant to commit capital in uncertain price environments.
• Project deferrals, cancellations, and divestments have been common, indicating a more conservative approach to capital allocation.
• The industry's reliance on lower-grade porphyry deposits to meet incremental demand from China has contributed to declining grades.

2. The Role of Scale and Cost

• Larger mine scale is necessary to maintain or increase output, but this comes at a higher capital cost.
• The marginal cost of production has increased due to lower grades, necessitating more ore processing.
• Capital intensity has risen significantly over the past decade, with annual investment quadrupling from $2B to $8B.
• The average cost per project has increased, with greenfield projects costing up to $669M and brownfield expansions up to $337M.

3. Copper Price Dynamics

• Copper prices have appreciated by 15.1% annually over the last 10 years, despite only a 3% increase in demand.
• Supply-side pressures are a key factor in supporting higher copper prices.
• The distribution of price gains will depend on the cost curve of existing operations and the quality of new projects.

4. Investment Strategy

• BMO Research recommends selective investment rather than sector-wide buying.
• Preferred stocks include CS, LUN, III, and KGH, which can deliver growth without excessive dilution.
• Lower-cost producers like SCCO, LUN, and FM are highlighted for their potential to outperform in a rising market.
• Companies such as Antofagasta, Freeport McMoRan, and Southern Copper are rated Market Perform, while Copper Mountain is rated Underperform.

Key Information

Supply Risks

• Two Steps Forward, One Step Back: Despite near-term increases, production is expected to decline after 2020, leading to a growing supply deficit.
• Political and Regulatory Risks: Increasing project scale brings greater political and regulatory challenges.
• Infrastructure and Resource Constraints: Chile, the leading copper producer, faces water and power shortages, impacting its capacity to expand.

Copper Grades and Projects

• Over the last 30 years, copper grades have declined by ~30% from ~1.60% to ~1.10%.
• Most new and expanding projects have copper grades below 1%, with an average of ~0.51%.
• The "low hanging fruit" of volume growth is the porphyry deposits, which contain 50% of global known reserves.
• Key Greenfield Projects include Oyu Tolgoi, Las Bambas, and Kamoa, with varying grades and commissioning dates.

Capital Expenditure Trends

• Base Case Capex: Estimated at $94B over the next seven years to expand production to 21.6Mt.
• Probable Projects: Require $43B to add ~1.6Mt by 2020 and ~2Mt by 2025.
• Possible Projects: Require $180B to add ~5Mt by 2020 and ~9Mt by 2025.
• The question of whether quantity can compensate for lack of quality is framed as a $350B question.

Company Highlights

• Capstone Mining: Expected re-rating in H1/14 after Pinto Valley acquisition and feasibility study.
• Imperial Metals: Low political risk with a large shareholder, expected re-rating in H2/14 after Red Chris commissioning.
• KGHM: Under-priced compared to peers, with significant production from Poland and international operations.
• Lundin Mining: Best capitalized copper stock with a disciplined growth strategy, expected re-rating in Q4/14 after Eagle mine commissioning.

Conclusion

The copper industry faces significant supply-side challenges due to declining grades and increasing capital intensity. While supply constraints support higher prices, the ability of companies to deliver on growth commitments without excessive dilution is crucial. Selective investment in high-quality, low-risk projects is recommended, with a focus on companies like CS, LUN, III, and KGH. The potential for new supply is limited, and the cost of new projects is high, making confidence in copper prices a key determinant of investment success.