The Impact Of Unwinding Copper Financing Deals On Freeport-McMoRan

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Freeport-McMoRan Inc. (NYSE:FCX) is one of the world’s largest producers of copper. Though the company diversified into oil and gas in 2013, copper mining is still the mainstay of its business, with the sale of copper accounting for 60% of its consolidated revenues in 2014. [1] Thus, the company’s fortunes, to a large extent, are determined by the trajectory of copper prices. Copper prices have fallen quite considerably over the course of the last year, with London Metal Exchange (LME) copper prices averaging roughly $5,800 per ton in Q1 2015, as compared to approximately $7,100 per ton in Q1 2014. [2]

Copper has diverse applications in industry, particularly in the construction, consumer products, and power sectors. The decline in copper prices over the last year was mainly due to concerns over copper demand from China, due to recent signs of economic sluggishness. China is the world’s largest consumer of copper, accounting for nearly 40% of the world’s demand for copper. [3] The weak Chinese economic prospects are captured by the Manufacturing Purchasing Managers’ Index (PMI). The Manufacturing Purchasing Managers Index (PMI) measures business conditions in the manufacturing sector of the concerned economy. When the PMI is above 50, it indicates growth in business activity, whereas a value below 50 indicates a contraction. Chinese Manufacturing PMI, reported by China’s National Bureau of Statistics, stood at 50.1 in March and below 50 for the remaining months of the quarter. [4] The weak PMI numbers are indicative of sluggishness in the Chinese economy. China’s GDP growth is expected to slow to 6.8% in 2015, from 7.4% and 7.8% in 2014 and 2013 respectively. [5]

Apart from the worsening Chinese economic prospects there is a second factor that could significantly impact prices. Copper is also widely used as collateral for financing deals in China. In common copper financing deals, traders uses copper purchased as collateral to take out U.S. Dollar loans at low interest rates and invest the proceeds in higher yielding Chinese assets, paying back the U.S. Dollar loans with the return from their investments. [6] In addition, copper smelters, refiners and fabricators have also been using their copper inventory as collateral to obtain financing. [6] It is estimated that up to a third of China’s copper imports may be tied up in financing deals. [6] Thus, an unwinding of these deals could result in large quantities of copper being dumped in the market.

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With interest rates expected to rise in the U.S. starting this year, and given the worsening economic conditions in China negatively impacting the prospects of companies involved in copper smelting, refining, and fabrication, there is a fear that Chinese copper financing deals may not be sustainable for long. An unwinding of these deals could result in a sharp increase in global copper supply, which would depress prices. In this article, we will look at the impact of this scenario on Freeport’s stock price.

Impact of Unwinding of Copper Financing Deals on Freeport-McMoRan

With the strengthening of the U.S. economy, the Federal Reserve is expected to start raising interest rates sometime in 2015. [7] Though the exact timing and extent of the hike over the next few years depends upon the pace of economic and jobs growth, the start of the Fed’s interest rate hike cycle this year is quite likely. Assuming that the U.S. economy grows as per expectations and the Fed raises interest rates over the next couple of years, there is a chance of the unwinding of copper-backed financing deals. A rise in interest rates will raise the costs of financing deals involving copper, which is likely to result in the unwinding of these deals, particularly given the deteriorating Chinese economic conditions.

China accounts for less than 10% of the world’s mined copper production, but around 40% of the global demand for copper, resulting in considerable quantities of copper imports. [8] Given that a third of the country’s copper imports are estimated to be tied up in financing deals, the dumping of this inventory on the market would significantly boost supply and depress prices. This would negatively impact both the realized prices and margins for all of Freeport’s copper mining divisions. In addition, we will assume that the company’s production plans and capital expenditure remain the same in this alternative scenario. Since we forecast capital expenditure as a percentage of EBITDA, in order to model this new scenario we have modified our forecasts in order to keep capital expenditure at the same absolute levels in the new scenario. If we factor in these assumptions on the various drivers impacted in our stock price model, our price estimate for Freeport decreases by about 51% from $17.41 to $8.46. Thus, there is significant potential for a downward revision in valuation in case of the unwinding of copper-backed financing deals.

See our complete analysis for this scenario

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Notes:
  1. Freeport-McMoRan’s 2014 10-K, SEC []
  2. LME Copper Prices, LME []
  3. Copper Ends at 5-Month Low on China Worries, Wall Street Journal []
  4. China Manufacturing PMI, Trading Economics []
  5. World Economic Outlook, IMF []
  6. China Fears Trigger Dramatic Drop In Copper, Financial Times [] [] []
  7. Powell says Fed could hike rates mid-2015; cites low inflation, Reuters []
  8. Global Copper Production, U.S. Geological Survey []