The price of copper has tumbled quite a lot in the last few days and the magnitude of the fall has been greater than even that for iron ore. This does not bode well for companies like Freeport McMoRan Copper (NYSE:FCX) whose business is dependent mainly on copper. Futures contracts for delivery in May are now trading below $3 per pound of copper. 
The price of copper has been falling due to a series of negative news from China, which consumes 40% of the world’s copper production every year. In addition, a large quantity of copper is tied up in financing deals in China so falling prices may trigger the unwinding of these deals and thus exacerbating the extent of price fall.
Freeport is already facing a tough situation in Indonesia from where copper export shipments are on hold pending the resolution of taxation issues. The Indonesian government had imposed a heavy export duty on copper concentrate exports in January which Freeport says violated its original agreement with the government and is therefore invalid.
Factors Behind The Copper Price Fall
1) Disappointing Chinese Trade Data
Trade figures released by the Customs department on Saturday showed that Chinese exports slumped by 18.1% in February, when the market was expecting an increase of around 7.5%. In addition, imports rose more than expected. This resulted in a trade deficit of $23 billion against a surplus of $32 billion in January. The data underlined the market’s doubts that China won’t be able to meet its GDP growth target of 7.5% in 2014. 
Copper is considered to be the barometer of economic activity in any country due to its widespread use in every major sector such as manufacturing, power, infrastructure etc. Owing to China’s status as the world’s leading consumer of copper, any negative news on the macroeconomic front leads to a notable drop in copper prices.
2) First Domestic Corporate Bond Default In China
Last week, the Chinese solar equipment maker company Chaori defaulted on an interest payment on its bond. Even though it is a small company, the default made Chaori the first Chinese company to default on corporate bond payments and triggered panic as the market anticipated a flood of similar defaults by stressed companies in the days ahead. So far, state-owned Chinese banks have been keeping troubled companies afloat through low-cost loans and bailouts. This led investors to assume that even bonds that are not formally guaranteed by the Chinese government are safe investments because the companies wouldn’t be allowed to fail. All of that looks to change now as the markets now rush to identify potentially troubled companies. 
The reason this is rattling copper markets is that copper is used in financing transactions where companies get loans in exchange for the commodity as collateral. These borrowers use the loans obtained at a low interest rate to invest in assets with higher yields and pocket the arbitrage. Falling prices are causing lenders to demand more collateral from borrowers who will now be forced to sell copper in the market for the same. Also, some banks may themselves dump copper in the market to recover their money. This might create a supply glut, leading to a further drop in prices. Analysts estimate that one-third of all the copper imported in China is used for such financing deals and around half of all the copper in bonded warehouses is tied in such deals. 
What This Means For Freeport McMoran
Freeport McMoran acquired two oil and gas companies last year and borrowed money heavily to finance these deals. Its long term debt stood at $20.4 billion at the end of 2013 which it promised to bring down to $12 billion by the end of 2016. In doing so, it assumed an average copper price realization of $3.25 per pound for 2014 and aimed to generate operating cash flows of $9 billion. The company also stated that a reduction in price realization by 10 cents would decrease operating cash flows by $370 million. So if we assume the average realized price of copper for 2014 to be $3 per pound, that alone will erode Freeport’s expected 2014 cash flows by $925 million, bringing it down to $8.075 billion. While this will still exceed its capital spending target of $7.1 billion, it will leave only $975 million to pay down debt. If this scenario plays out along these lines, we doubt that Freeport will be able to meet its debt reduction target at the end of 2016. ((Freeport McMoran Q4 2013 Earnings Presentation, Freeport Website))
In doing the above calculations we have assumed that Freeport’s estimated copper shipment figures will not be affected. However, the situation in Indonesia makes this doubtful. Freeport’s shipments of copper have been halted after mid-January amid a dispute with the Indonesian government over a new export tax on copper concentrates. The company has said that it may be forced to declare force majeure, which is a legal clause invoked to limit liability when circumstances beyond a supplier’s control causes disruptions in shipments. The shipment figures from Indonesia for the year may not meet the stated targets. In such a case, operating cash flows will take a further hit, leaving even less money to repay the debt. 
You can observe the impact of a reduction in Indonesian copper shipments on Freeport’s valuation using our interactive graph below:Notes:
- China’s role in copper’s collapse: Why investors should care, MarketWatch [↩]
- Copper’s ‘fall out of bed’ underscores China woes, CNBC [↩]
- Chaori Solar defaults on bond payment, MarketWatch [↩]
- China Angst Slams Prices for Copper, WSJ [↩]
- Freeport says Indonesian unit may need to declare force majeure, Reuters [↩]