The significance of copper lies in its vital role in the ever-evolving energy landscape.
A Few Words About Copper
The significance of copper lies in its vital role in the ever-evolving energy landscape. As we transition to renewable sources, such as wind and solar power, and embrace battery technologies, the demand for various minerals, both niche and base metals, escalates. Among these metals, copper stands out as a key player, connecting and facilitating the delivery of clean energy worldwide. This metal possesses exceptional properties that make it indispensable in various clean energy applications. In fact, the generation of clean energy from solar and wind heavily relies on copper, with its usage typically being 4-6 times higher compared to traditional fossil fuel sources, according to Copper Development Association. A few facts that highlight copper's importance, based on the same source:
A 3 megawatt [MW] wind turbine contains up to 4.7 tons of copper [cabling, wiring, turbine/power transformers, and generation equipment];
There're 5.5 tons per MW of copper in solar power systems [heat exchangers, wiring, cabling];
A Hybrid Electric Vehicle [HEV] and a Battery Electric Vehicle [BEV] requires 83.3% and 281.3% more copper, than an ICE vehicle.
The global adoption of BEVs and EVs is surpassing all previous forecasts, with even the impact of COVID-19 failing to impede their penetration. In addition, the declining costs of installing and storing renewable energy technologies over the past decade have contributed to the demand side. As a result, copper usage has remained relatively stable in recent years. And despite concerns about deteriorating macroeconomic conditions in the US and globally, we are not witnessing significant price declines in copper as seen in the past.
The copper market is currently experiencing a significant deficit, with inventory drawdowns at the highest level since 2004. This increases the risk of a shortage this year, Goldman Sachs analysts write in their recent note.
Despite headwinds from China's services-led growth recovery, onshore China's copper demand has met positive expectations, supported by property stabilization and emphasis on the green economy. Overall the demand of the region surged ~4% YoY in Q1 FY2023.
The correlation between copper demand and China's steel industry has significantly weakened due to the rapid growth in the green economy and different dynamics in the property cycle.
Currently, global visible copper stocks stand at around 400kt, while the estimated deficit for the rest of the year is nearly 500kt, indicating a potential scarcity episode somewhere in 2H FY2023. On the inventory front, global refined inventories have declined by 28% (157kt) from late February to the end of April, the highest drawdown since 2004.
Even in a modest recession scenario [in developed markets], modest deficits of 42kt would persist, while a more severe recession could result in modest surpluses of 338kt.
Demand is almost always easier to forecast than supply. But in this case, the supply side is a bit clearer - it's likely to be rather weak this year. In Q1 of 2023, mine disruptions totaled 400kt, or about 1.7% of the global supply. These disruptions have been reflected in production data, with some softening projected in Q2. Destocking of any accumulated volumes is currently underway but will take several months to impact consumption centers. Reduced mine production guidance for 2023 has resulted in a downward adjustment in the global production forecast to 22.3 million tons, an increase of 2.3% year-on-year. This reduction is mainly due to lower production guidance and operation delays in Latin America and South Asia. As a result, no "wave" of copper mine bids is expected this year.
So based on the whole supply/demand story for copper, Goldman Sachs maintains a forecast for a 25% price increase in copper over the next 12 months.
Such fundamentally based upside potential is also supported by technicals. Fundstrat Global Advisors recently shared their new forecast - the copper price should start to rise by the end of May. This thesis was accompanied by a weekly cyclical composite chart developed by Fundstrat analysts. Their model shows a bottom forming in late May, followed by a return to 2022 highs, which could occur between June and early 2024.
In my opinion, such a combination of a long-term perspective, a favorable medium-term supply-demand imbalance environment, and a technical setup that favors a rise in the copper price in the short term offer an excellent risk-reward trade-off for investors who decide to add to their existing allocation in the sector or are just starting to build first positions in copper stocks.
Why Do I Favor Zijin Mining Over Southern Copper?
The highly beneficial setup that I described above doesn't mean that it's worth buying all producers to profit from exposure to copper. The copper market has an interesting structure in terms of the distribution of resources. More than 21% of all global reserves are located in Chile, according to the latest USGS data - logically, the main production of the raw ore takes place there [~23.6% of global production].
However, if we look at China, with copper reserves of only 3% of the global, more than 42% of the world's refinery production takes place in this country - the Chinese economy is the main driver of demand in the entire market.
In terms of reserves, Southern Copper has the highest reserves of any publicly traded company in the world, according to its IR materials. Currently, the company has approximately 44.8 MT of copper reserves, and resources are estimated at about 71.9 MT. By March 31, 2023, about 2/3 of EBITDA comes from the Mexican operations, while the other 1/3 comes from southern Peru. Therefore, I think it's important to point out some risks related to SCCO from the perspective of these regions. In recent months, protests in Peru have stood out from those in most other Latin American countries, fueling concerns about a blockade of SCCO's mining operations.
The Mexican region also raises some questions. The new legislation AMLO [the President] implemented gives the government unprecedented control over the country's mining and water resources, creating a more complex and risky environment for private investors, according to a recently published study by the legal counsel firm ArrentFox Schiff [May 17, 2023]. The legislation includes reductions in mining concession terms, the requirement for public bidding processes, limits on concession types, increased reporting obligations, and social contributions from mining profits. These changes have a significant impact on long-term investment decisions and have led to ~$9 billion in lost investments and up to 420,000 job losses, ArrentFox estimated.
Even though SCCO has the largest resources among publicly traded companies, it has been slow to develop them. At the same time, its operating cash costs per pound of copper produced continue to rise, indicating higher expenses for mining and processing the metal.
From the fourth quarter data, we know that SCCO planned to spend ~$15 billion in capital expenditures on several projects in Mexico and Peru, including Buenavista Zinc, Pilares, El Pilar, and El Arco in Mexico, and Tia Maria, Los Chancas, and Michiquillay in Peru. From what I can see, while these projects look interesting and some of them will begin development relatively soon, the main CAPEX has yet to be spent. Los Chancas and Michiquillay, for example, will require a combined ~$5.1 billion, and both are expected to come online shortly before or after 2030. So in the medium term, the high CAPEX is likely to reduce SCCO investors' cash flow, while production growth will start much later.
On the positive side, I see relatively low leverage ratios and very good coverage of interest payments - these metrics look very attractive compared to other industry giants like Rio Tinto (RIO) or BHP Group (BHP), as does the level of EBITDA margins. But that is exactly why the company is valued quite expensively.
I guess that SCCO could get a tailwind in copper prices if the fundamental medium-term forecasts of Goldman Sachs and other analysts come true. That's why I can't issue a Sell rating - it is a "Hold" this time around.
So what attracted me to Zijin Mining Group and why it looks better than SCCO?
As we saw in the Goldman Sachs note, the Chinese economy has made relatively stronger progress in supporting copper demand this year - in my view, this should continue in the future. However, as I wrote in the article on Vale (VALE), this future will most likely be multipolar and not as globalized as before.
China is now trying, by all means, to become a self-sufficient country when it comes to owning and disposing of the resources it so desperately needs. Through Zijin Mining - one of the country's leading mining companies - China is increasing its self-sufficiency in the metal used in electric vehicles and solar panels.
Zijin Mining is a $40-billion multinational mining company operating various mining projects in several countries, including China, Russia, Papua New Guinea, Serbia, Australia, and the Democratic Republic of Congo. The company covers the entire mining value chain, from exploration and development to production and sales. In addition to mining, Zijin Mining is also engaged in smelting, refining, and production of other non-ferrous metals such as silver, lead, and tungsten.
The company has recently developed large greenfield copper projects:
Kamoa-Kakula in Congo [45.04% ownership] - contained copper of 43.69Mt with a grade of 2.53% [fourth-largest undeveloped in the world];
Cukaru Peki in Serbia [100% ownership] - contained copper of 1.28Mt with a grade of 3% and gold of 81t with a grade of 1.9 g/t;
Despite all the macroeconomic challenges in recent years, the development of these projects has allowed Zijin to continue to actively expand its operations, and after increasing production by 41% in 2022, it has become one of the top 6 largest copper mining companies in the world.
China’s Zijin Mining ranked sixth [largest copper miner] with 859,000 tonnes of mine-produced copper in 2022 (up 47% over 2021). The company increased its annual copper output following the successful production commencement of key projects such as the Upper Zone of the Cukaru Peki copper and gold mine in Serbia, the Kamoa-Kakula copper mine and the Julong copper mine in Tibet.
The positive momentum continued in the first half of 2023. For example, Zijin's ROE increased 558 basis points year-over-year, while EPS in U.S. dollars increased 83% YoY.
Unlike SCCO, Zijin does not plan to spend multi-billion CAPEX on results in 8-10 years. Most of the major projects are already underway. In addition, the company's revenue stream is set to be replenished by the sale of lithium shortly.
Zijin's IR website, author's notes
Zijin is also not inferior to SCCO in terms of margins if we focus on gross margin from mining.
At the same time, the company is relatively cheap due to its underfollowed and "pink-sheet" status.
Returning to my argument regarding the deglobalization processes in the world, I'd like to emphasize that the significance of Latin America, particularly Chile (the largest copper producer in the world) and Peru (the second largest), will most likely decrease going forward. China is now actively seeking copper from its own overseas deposits or from deposits closer to its borders. Examples include Rio Tinto's Oyu Tolgoi deposit in Mongolia, which was recently expanded, and Russia's Udokan deposit in the Far East, known as one of the largest undeveloped copper deposits in the world. As I stated in my earlier articles, the Udokan Copper Co's processing plant is ready to start production shortly, and the deposit has an estimated life of about 70 years - all the copper from this mine is likely to ship to China as the nearest Russian neighbor.
In light of this paradigm shift, it seems to me that it makes more sense to look within China for a high-quality copper mining company that can serve growing local demand in the event of a "minor isolation" of the country." By the "minor isolation," I don't mean sanctions and cutting off from the rest of the world, as has happened with Russia - this is more about the continuation of the trade war between the West and the East, and the bilateral desire of both sides to be less dependent on each other.
In this case, I think Zijin meets all the criteria for a high-quality, large, and liquid company (ticker 2899 on the Hong Kong Stock Exchange) - its margins continue to grow, major projects have recently been launched, and there are several more in the pipeline that will help support future operational growth and diversification of the business.
Final Words
Of course, my thesis is subject to many risks, especially concerning China. First, changes in legislation and policy can have a significant impact on performance. Sudden regulatory changes or a crackdown on certain sectors can create uncertainty and market volatility - copper mining is no exception here. Second, the Chinese stock market is less transparent, making it difficult for investors to obtain accurate and timely information about companies. This lack of transparency extends to financials, corporate governance, and potential risks. Finally, geopolitical tensions and macroeconomic factors such as trade disputes, political tensions, monetary policy changes, and economic slowdowns can affect stock prices and investor sentiment in China. So if you started out with a risk management rule to avoid Chinese stocks, this article definitely won't do you any good - sorry for wasting your time.
The second point you should pay attention to is the strong sensitivity of copper prices to the business cycle. If you believe in at least a mild recession, you should probably wait for a better entry point in copper miners' stocks. Everything here, of course, depends on your investment horizon - the longer it is, the less relevant the cycle should be to you as an investor. You have to agree, though - one always wants to buy lower and sell higher. No matter how optimistic analysts' forecasts for copper prices are, or how low global stocks of this commodity are, when the recession comes, it'll become possible to buy mining stocks much cheaper than now.
Despite all the risks, I believe that Southern Copper Corp., despite its long-term growth potential, is no less exposed to geographic risks than Zijin Mining Group - the former has relatively similar margins and growth, but longer projects with high investment requirements and also higher valuation multiples. For these reasons, the latter one looks more attractive to me - especially its listing on the Hong Kong stock exchange, where liquidity is much better than for U.S. ADRs.
