Unless you expect the unexpected you will never find truth, for it - - PDF document

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“COPPER’S ROLE IN THE MONEY GAME” BY SIMON HUNT CEO SIMON HUNT STRATEGIC SERVICES AT THE CLSA ASIA CONFERENCE SAN FRANCISCO 2ND MARCH, 2010

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Good morning Ladies and Gentlemen. First, I would like to thank CLSA for inviting me to speak at this prestigious conference; and secondly to say straight away that I absolve CLSA from everything I say. The thoughts, ideas and forecasts are mine and mine alone. And thus the responsibility for being wrong should be laid at my door – not, of course, do I think that the direction of my thinking will be anything but correct! Adventuring into the future is a perilous exercise. Models which extrapolate from the past into the future are normally useless, because the future is invariably defined by developments outside the realm of regular expectations, or, by Nassim Talib’s Black Swan

• events. In fact, a friend recently lunched with him and asked “You might wait a long time for

the next Black Swan” to which his reply was, “You might. You might not. No one can know. But we live in volatile times.” Slide 1:

“Unless you expect the unexpected you will never find truth, for it is hard to discover and hard to attain.” Heraclitus, the pre-Socratic “Weeping Philosopher”

• f Ionia

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But we have to venture onto this journey despite knowing that the future will be different from yesterday or today. In fact, “Unless you expect the unexpected you will never find truth, for it is hard to discover and hard to attain”. The history of successful thinkers about

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the future dates back before Christ so we should rely more on assessing exogenous events than the power of computer simulations. Slide 2:

Speech Title should have read: “What Drives Copper Prices? Real Fundamentals or The Money Game”

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Perhaps, too, the title of my speech is too simplified and should have read “What Drives Copper Prices? Real Fundamentals or The Money Game”. For, most commodities have just become another unit in the business of securitisation for banks to sell onto their pension fund and other retail clients, using sophisticated simulations of the past. The question, of course, is “Will the past give us an accurate direction of prices for the future”. I doubt that the recent past will do so for markets are in a period of transiting from years of secular high economic growth, to a large extent based on leverage and debt, to one

• f secular lower, but sustainable, growth. The transition will be marked by volatility with the

risk of the next Black Swan appearing, as hinted at by Nassim. Copper is an integral part of this business. The user industry has little response because the collective resources of the financial sector are infinitely greater than those using the metal as part of their daily business. Their response is not financial and, not necessarily short- term, but industrial, by designing copper either out of their products or limiting its use. This is why I make no apology for focusing so much of this talk on the outlook for the global economy and the direction of financial markets. Slide 3:

Presentation Divided into

• Macro-Overview
• Fundamentals of the Copper Industry
• Pricing

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I will divide this presentation into three main parts. First, an overview of the global economy

• ut to 2015; second an analysis of how we see the fundamentals of the copper industry; and

third a look at some of the structural changes in how copper is being priced, together with

• ur forecasts for their direction.

Slide 4:

“Business Cycles End in Recessions; Credit Crises in Depression” Michael White, Global Strategist

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Market noise often detracts from an ability to understand the large picture which is unfolding; and it is this big picture which will determine the profile of global economic activity for the coming decade. Consider some simple historic facts. The 1960s were the decade of the Nifty 50s; the 1970s their demise. The 1980s the decade

• f Japan and the Asian Tigers; the 1990s their collapse. The 2000s was the decade of China;

and this decade? Guess what in my view? China will founder and its foundering will be one

• f the great shocks of the coming decade, as financial and commodity markets look upon

China as their bee-all to end-all. And of course the 1930s were the exact opposite of the

• 1920s. The bullish events of these prior decades all fell on the sword of outliers.

Slide 5:

A Stair-Step Decline

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As a simple person, I find it incongruous that the world can evolve from teetering on the cliff’s edge to transiting into recovery and sustainable growth in just a year. Massive fiscal and monetary stimulus provided the band-aids, but they have done little or nothing to cure the wounds. I keep this graph on my desk to remind me that in the 30 months of the 1930s the Dow fell 86% but had seven rallies each averaging 24%. Slide 6:

Four Exogenous Events:

• Sovereign Debt
• Demographics
• Protectionism
• China

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There is a long list of potential outliers that could create road blocks for the world’s economy, but I will make some brief comments on just four for the sake of time, since each carries a risk to the global financial system and hence business activity. Slide 7:

The cost of the Banking Crisis (Reinhart & Rogoff estimates)

$33,029 86% Rogoff, Average $15,309 40% Rogoff, Best Case $10,239 27% IMF Estimate Pr Projected B Bond Issuan ance ( ($billi billion

• n)

De Defi fici cit (% (% o

• f G

GDP)

Source: CIA World Fact Book, IMF, Rogoff & Reinhart

Taken from Niels Jensen, Absolute Return Partners LLP

It really is quite easy to see where the next crisis will come from by searching for where leveraging is being created today. History shows that yesterday’s credit crises often morph into tomorrow’s government debt crises. The cost to governments of financing this pile will be high in terms of real interest rates and the ability to raise those funds without offering greater real returns than equity markets can offer. Indeed, the Greek crisis is an early warning that sovereign balance sheets are in play.

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Slide 8:

The US Debt Overhang

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Source: Boeckh Investments Inc.

The central issue, as we all know, is deleveraging, a dynamic that has years rather than months to run. Households are going to continue to save, forsaking the borrowing creed of the past two decades. The implications in the Old World, which consists of N America, W Europe and Japan, of households hunkering down are far reaching. GDP growth slows, imports from Asia and elsewhere slow, savings rise and so on. And they are just as significant for China and the rest of Asia given their dependence on exports to the Old World. Slide 9:

The Age of the Aging

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23 23.5 44 44,765 65 18. 18.1 64 64,951 51 20 2025 21 21.5 41 41,064 64 16. 16.1 55 55,748 48 20 2020 19 19.9 37 37,735 35 14. 14.3 47 47,617 17 20 2015 18 18.4 34 34,712 12 13. 13.0 41 41,155 55 20 2010 16 16.0 29 29,265 65 12. 12.4 35 35,621 21 20 2000 14 14.5 25 25,546 46 12. 12.3 31 31,438 38 19 1990 14 14.6 24 24,915 15 11. 11.2 25 25,722 22 19 1980 13 13.0 21 21,683 83 9.8 9.8 20 20,603 03 19 1970 11 11.4 17 17,315 15 9.2 9.2 17 17,117 17 19 1960 10 10.3 14 14,462 62 8.3 8.3 13 13,042 42 19 1950 % P Popu pula lati tion W.

• W. E

Europe rope + 6 + 65 ye year olds % Po % Populat lation US USA + 65 65 ye year o

• lds

lds

I have borrowed the title of this slide from George Magnus’s excellent book. A decade or so

• f deleveraging is starting during a period when yesterday’s baby boomers are becoming

tomorrow’s retirees. Whilst the age group of 65 and above is growing alarmingly in the USA, the numbers are quite frightening for W Europe. Focussing on rising home values and equity markets as the rump of savings for retirement have now been skittled down the alleyway to be replaced by a desire to build more cash

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savings and a search for income. One affect of this rising dynamic may well be a fundamental switch from equities to government bonds over the coming decade, another megatrend in the making, one which is an integral part of the age of frugality and austerity which I believe lies ahead of us, or as Thomas Friedman wrote recently, “There are no more fat years to eat through”. Slide 10:

Herb Stein’s Law: “What Cannot Go On Forever, Won’t”

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Now almost everyone is extrapolating debt and government deficits to the skies. It was not so long ago that most people, including the US government, were forecasting budget surpluses forever. Remember Herb Stein’s law, “What cannot go on forever, won’t”. The age of borrowing beyond ones means and the profitability of Wall Street, often at the expense of Main Street, are fast approaching their end, as profits will switch from the former to the latter and saving replaces borrowing. Household savings, together with government bonds beginning to offer better real returns over time, will enable these deficits, not only to fall, but for the USA to have the capacity to finance them domestically. It is a part of the New World, whose structure will undergo quite radical changes over the next decade. A significant part of this change will be the revitalisation of manufacturing in the USA. Slide 11:

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It says a lot about the US economy that employment in manufacturing is now at a level lower than that of 1941, a collapse which cannot be explained just by productivity and technology. One megatrend of the last decade was the flood of companies out of the USA and the rest of the Old World into China and elsewhere in Asia for cost and other reasons. Slide 12:

No longer an advantage

Total landed cost savings or losses for producing midrange server in Asia instead of United States:

Index labour savings in 2003 = $100

• 16
• 16

64 64 To Tota tal la l lande nded-cost

• 5
• 5
• 5
• 5

Hi Hidden c costs sts

• 10
• 10
• 6
• 6

Product r t retu turn rns

• 12
• 12
• 1
• 12

In Inven ventory c carr rrying ying 11 11 87 87 Di Direct rect Cos Cost savin savings

• 6
• 6
• 6
• 6

Sh Ship ippin ping r rela lated

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• 28
• 7
• 7

Fr Freight eight 45 45 100 100 La Labou bour Sa Saving ngs 200 2008 200 2003

Source: McKinsey

This trend is about to change for economic and political reasons. The cost advantages of manufacturing in some far distant land, like China, and shipping or air freighting those goods back into the USA or Europe, are being whittled away. Manufacturers want their goods or components close to their customers. Multinationals, who are producing their products in China or elsewhere in Asia, often now have balance sheet issues in the form of financing a long pipeline, something which was not important a decade or so ago. China, too, is becoming a less inviting host nation. James McGregor, a former chairman of the American Chamber of Commerce in China, writes, “Visiting CEOs banquet table chatter is now dominated by swapping tales of arrogant and insolent Chinese bureaucrats and business partners. The litany includes purposefully inconsistent and non-transparent enforcement of regulations, rampant intellectual property theft, state penetration of multinationals through union and communist party organisations, blatant market impediments through the rigged product standards and testing and so on.” He goes on, “But many are looking ahead and losing sleep over expectations that their one- time partners are morphing into predators and that their own technology and know-how will be coming back at them globally in the form of cut-price products from subsidised state-

• wned behemoths.”

Some senior policy makers when asked by my partner in Beijing what do they fear the most in China quite separately answered “Arrogance”. And in its relations with foreign governments China is becoming increasingly assertive stretching from arms sales to Taiwan, to the disputed borders between India and China, to its stance at the Copenhagen climate change conference, to its truculence over the alleged hacking of Google and other foreign companies, to trade issues and even, so I am told, in its dealings with foreign central banks.

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Moreover, protectionism is alive and well in China. One of my friends in China, with a plant supplying components for a significant sector of infrastructure development, told me that local governments had been instructed to give orders only to Chinese companies, despite the presence there of very large foreign manufacturers. This example is in keeping with new regulations encouraging local governments and others to buy Chinese made goods. Changes in the structure of globalisation have started, if only in a trickle for now. GE is building a new appliance factory in Louisville rather than in China for “cost and logistical”

• reasons. A number of small companies are already exiting China.

Panasonic, in an interview last quarter in the European edition of the Wall Street Journal, stated that they would relocate some factories out of China and bring them to Europe also for cost and logistical reasons, but above all, to be close to their customer base. Panasonic’s move is highly significant, because the Japanese move in their traditional Geese formation. The leader makes the first move with the flock following. But, the flock includes their entire supplier chain. The economics of this reverse globalisation, as I call it, fit a changing geopolitical world. The Old World experiences high and still growing unemployment, a lot of which will be

• structural. There are domestic political and other pressures in the USA and Europe to make

global trade a more level playing field. In the USA, Pete Peterson, amongst others, calls for business leaders to re-enact the non- partisan Committee for Economic Development that was formed in the midst of WWII, or something along those lines, to try and solve the nation’s structural problems. The time has come, as he says, for industrialists to take over the leadership in restructuring the economy away from government intrusion. Part of this coming revolution will surely be to bring back within American borders much of the manufacturing capacity needed for its own economy, rather than having that capacity located offshore. The same is true also of the EU. The economics of producing goods in America will be revitalised by using America’s prowess in science and technology to develop state-of-the-art manufacturing methods and goods. In time, the political infrastructure will be put in place under the prodding by people like Pete Peterson. Once in place, the trickle of companies returning to their homeland will become a flood. Meanwhile, the US government has begun the process by wielding a stick, threatening to curtail many of the financial benefits and tax breaks that US companies currently enjoy from their offshore operations. The next stage will be to offer the carrot by granting tax and

• ther incentives for US multinationals to help them make that move.

These developments are part of a trading world which is becoming increasingly

• protectionist. On my last count, the US International Trade Commission – with whom I have

come up against on two occasions, both thankfully successfully – had nine active cases they were investigating against China with another nine in the pipeline.

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Slide 13:

The Sleeping Dragon Awakes

Since 1993, I have been spending almost three months each year in China, mostly criss- crossing the country visiting plants. The 1990s were exciting times as one saw the positive changes on the shop floor and the baby companies growing into monsters and the old monster SOEs producing for little more than inventory. But, in recent years I have grown increasingly cautious. Call it what you like, instinct or a gut feel, which I have learnt to trust, but a combination of cheap money, oodles of liquidity created a speculative fever last year, the like of which I had never seen before. Too much bank lending went into the stock, real estate and commodity markets; and too much new capacity is being built on top of an existing pile of surplus manufacturing capacity. Slide 14:

China Fixed Asset Investment As a Percentage

• f Nominal GDP 1990 - 2010

20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0% 55.0% 60.0% 65.0% 70.0% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

If nothing else will scare you about the country surely a ratio of 67% of fixed asset investment as a percentage of nominal GDP will. We know that investment includes a

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number of items which other countries do not include, but nevertheless this is a very scary number. Slide 15:

China’s Inflation& Core Inflation

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Nominal GDP exploded in last year’s 4th Quarter, rising by 27% year-on-year and 51% quarter-on-quarter. Money supply and bank lending rose by over 30% last year. With money growth continuing to grow at a level above that required for an 8% increase in GDP, the most elementary money demand function would point to double digit inflation sometime this

• year. In fact, according to one well known Chinese economist, excess liquidity within the

economy was between RMB 4.5 trillion and RMB 7.4 trillion last year. This potential inflation outcome is far removed from what Chinese policy makers and most global economic strategists are talking about, but it is starting to be seen on the ground. In an Austrian sense, inflation is already evident in asset prices – the doubling of land prices in

• ne year, the big rise in the average price of residential real estate, let alone the +60%

increase in the major cities, the stock market and speculative buying of base metals and in the fourth quarter of last year many semi-producers and those of finished goods were producing for inventory. If this is not inflation, I don’t know what is, notwithstanding the

• fficial data.

Inflation is, however, very evident in the export sector. Exporters have been under severe margin pressure from rising wages, rising raw material input costs, rising electricity and water rates etc. After the Chinese New Year, prices of many exported goods will rise by at least an average of 10% and for some items much more. Buyers knew these increases were coming and had bunched up orders to pre-empt the increases. Government will continue to take mini-actions to control inflation but it does seem that the genie is out of the bottle. Sometime around mid-year, a more dramatic tightening in policy will need to be pursued. China’s domestic debt, too, is more worrying than most official data represents because of the huge debt that local governments have accumulated. Last year alone, it is reported that

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local governments borrowed some $735 billion alone, though no one seems to know the exact figure. In fact, Nouriel Roubini estimates that local government debt is around $1.6 trillion, equivalent to about one-third of China’s GDP last year and 70% of its foreign exchange reserves. Nor should one become complacent about China’s huge holdings of foreign exchange reserves, as Michael Pettis pointed out in one of his recent blogs. On two prior occasions in modern history, great powers have accumulated the same amount of forex reserves in terms

• f global GDP. The first was the USA in the 1920s and the second was Japan in the late
• 1980s. We know what followed. This does not mean that China will follow a similar fate, but

as Michael writes, high reserves are in fact symptoms of terrible underlying balances. I will conclude my remarks on China with a couple of comments. Over the next five years, many foreign companies will leave China and only keep that capacity to serve the domestic market, if at all. Sometime post 2010, China is going to pass through a couple of very rough years caused by its mal-investments and a further slowdown, if not collapse, in the global

• economy. If I had to hazard a guess the timing will be 2012/2013, though stock markets

may anticipate this event long before it occurs. Slide 16:

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Industry:

• Innovation Driven by Technology = Growth
• Industry Consolidation & Transformation
• New Business Models

The New Normal World

Companies:

• Less Leverage
• Stronger Cash Positions
• More Conservative

Governments:

• Protectionism = Reverse Globalisation

= Re-industrialisation

• Problems for Asia including China
• Government Intrusion into Industry,
• Finance = Profitless Environment,

Declining Innovation, etc. Consumers:

• Risk Averse
• Increase Savings
• Baby Boomers:

Retirement Concerns Global Economy:

• Lower GDP Growth
• Risk of Renewed Downturn in 2012 – 2015
• Final Trough Maybe Not Until 2015 – 2017
• Thereafter, New Period of Sustainable Growth

The next five or ten years will be quite different from what has gone before us. It will be characterised by austerity and frugality as the world deleverages from the past. So, I conclude my macro comments with the following economic profile.

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Slide 17

Global Economic Profile

• Global slowdown 2nd & 3rd quarters this

year

• Modest recovery in 2011
• New credit crisis breaks out in 2012
• Global economy sinks back into recession,

lasting for 2-3 years

• A new long period of sustainable growth

starting around 2018

Slide 18:

World Refined Copper Balances 2000 – 2015 – Kt-Cu

S 14500 15500 16500 17500 18500 19500 20500 21500 22500 23500 24500 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

• 11. World Refined Production
• 12. Refined Consumption

Sources: Production ICSG. Consumption: SHSS

In talking about copper, I won’t dwell on the supply side of the equation since this is well documented, because the issue will not be the lack of supply but a shortage of actual

• consumption. The devastating earthquake in Chile has caused little interruption to copper

production with the lost tonnage being small. There are, however, some logistical problems

• n routing copper out of El Teniente to the ports.

The fundamental issue is what constitutes the two simple words demand and consumption. Nearly everyone uses the word demand either because they understand the meaning of the word or because they assume that demand is the same as consumption, which is rubbish. Consumption is material that goes into a furnace to make a copper or copper alloy semi of some description. Demand is material that does go into a furnace but is sold also to the financial sector and others and which mostly ends up being warehoused outside the reporting system.

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Just to illustrate how wrong the much used word demand is consider this fact. Between the years 2004 and 2007, six of the leading analysts of the copper industry – myself excluded

• f course – had an average deficit between world refined production and demand of 1574kt.

At the end of 2003, total world stocks were reported as 1780kt. If these average deficits had been correct, global reported stocks would have been only 205kt at the end of 2007. They were not. They were over 1 million tonnes with probably a large tonnage also being held

• utside the reporting system.

Slide 19:

Global ICSG Usage versus SHSS Global Refined Consumption 2000-2009 MT-Cu

14 14.5 15 15.5 16 16.5 17 17.5 18 18.5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E ICSG SHSS

mt

It is difficult to estimate what the actual difference between the two systems is, but one way

• f judging the degree is by comparing the International Copper Study Group’s numbers

versus our own. I think ours are closer to the truth, a view shared by many large consumers. Note that up to 2004 the differences were small. It was in 2004 that markets turned from being bearish to bullish and note how large the differences became since 2005. During this period, fabricators and end users had no difficulty in buying spot copper, nearly always at premia lower than official producer ones. Had these deficits been correct fabricators would have been unable to make such purchases because the deficits being so widely reported implied there was virtually no copper left within the system.

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Slide 20:

World Intensity of Use (Using GDP) & Trend Growth Rates

1.1 0.45 2000 – 2015 0.9 0.27 2000 – 2010 2.1 0.72 2000-2006 2.7 1.04 1990s 1.2 0.16 1980s 3.5 0.97 1970s 4.8 0.85 1960s Trend Growth Intensity The 1980s is the best analogy to what is likely to happen to copper over the coming decade. The 1980s were characterised by low global economic growth, the consequences of the previous decade’s high oil prices and subsequent monetary tightening. For copper it was a period of low global growth and falling intensity of use as substitution impacted end uses following the price spikes up to 1981. It was also a period when financial institutions bought physical copper as a hedge against inflation and a falling US dollar. In fact, the chief economist of a large mining house told me that they had estimated that at least 1 million tonnes was being held outside the reporting system by these and other accounts. I then had as a client a very large US chemical company who admitted to me after the event that they alone had bought 200kt and that when they came to undo the trade they lost money. They lost money because actual consumption was falling in line with weak economic activity following Volcker’s tough stance against inflation and a falling US dollar. Consumption’s growth rate is determined by economic activity and the metal’s intensity of

• use. The former will disappoint in our view and the latter will be impacted not only by on-

going substitution but by new technology. On-going substitution results from the normal evolution of “making more with less” through improved designs and tighter specifications, an inevitable development is a world environment of little if any pricing power. In the wire and cables sector, which consumes around 65% of the world’s copper, a senior executive of Nexans, the world’s largest wire and cable company, stated to an industry meeting in 2007 that around 1 million tonnes of copper would be lost to aluminium and fibre optics by the end of this year, a target which is being met.

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Slide 21:

Losses in the Wire & Cable Sector

• In LV cables for Buildings around 175kt/a
• In Power infrastructure around 260kt/a
• In Speciality Industrial Application Cables

around 360kt/a

• In Telecom around 225/kta

This slide shows you the breakdown of these losses by product. Even in China, Power Supply Bureaus started to specify aluminium conductors for MV power cables last year. Not to be outdone, at another industry meeting, the CEO of another major global wire and cable company stated that high copper prices, together with its volatility, were forcing their customers to substitute copper by other materials and to use less copper per product through design improvements. Between 2007 and 2012, they plan to spend about US$4bn

• n R&D with three quarters being spent on new products and new technologies. Those

mentioned were high-temperature superconducting cables, carbon nanotubes and metal Nano powders. His conclusion was simple and worth repeating. I quote: Slide 22:

“Electric Wire & Cable, Energy: Copper to Aluminium, Superconductivity Automotive: Copper to Aluminium Electronics: Copper to Aluminium Information & Communications: Copper to Optical Fiber”

Later on he stated that in building wires copper will one day be replaced by carbon nanotubes.

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The growing uses of high-temperature superconductors, or HTS as they are commonly called, and developments in nanotubes will revolutionise the use of copper. It is worth saying a few words about these two developments. Many materials can be used to develop HTS, but Sumitomo Electric, one of the most advanced companies in this field, uses a bismuth-based superconducting wire called “Di- BSCCO.” It uses inexpensive liquid nitrogen - costs about 50yen/litre – as the refrigerant, whereas conventionally dominant low-temperature superconductors require liquid helium costing around 1500yen/litre. Slide 23:

Comparison of cross-sectional area (for carrying same magnitude of current)

Source: Sumitomo Electric

Superconductors can carry 200 times as much current as copper wires of the same cross- sectional area. They are compact in size; in fact the cross-sectional area is four times greater for a conventional copper cable. It is also a perfect conductor of electricity carrying direct current with 100% efficiency because no energy is dissipated by resistive heating, unlike conventional copper cables where the loss is about 5%, though over long distances losses can be as high as 8.5%. Trials using HTS have been carried out in many countries. The main uses will be for electrical power transmission cables, motors, transformers and generators, electric vehicles, marine motors, medical equipment and maglev trains.

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Slide 24:

Market Penetration Curves for High Temperature Superconductors in USA

Sourc urce: A Anal alysis is o

• f F

Future re Pri Prices & & M Marke rkets for H r High T gh Temp mperat ature ure Sup upercond nduc uctors rs 20 2006 06: by by J Joseph ph M Mulholland

I was told that commercial development has reached a similar stage as fibre optic cables some 40 years ago. It is a question of achieving that initial critical mass to make HTS cables cost competitive with existing systems. Well, we know what happened to fibre optics. Nanotubes are allotrops of carbon with a nanostructure. They can have a length-to- diameter ratio of greater than one million. They are very thin being 10,000 times smaller than the human hair, which is rather difficult to envisage. In theory, they can have an electrical current density more than 1000 times greater than metals, such as copper or

• silver. They are strong materials and have good thermal conductivity.

Slide 25:

Nanotube Markets Expected to Grow Significantly

Nanotubes are now being used in the electronics, auto and aerospace industries amongst

• thers. As mentioned earlier, a future use could be for building wires.

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Both these technologies will cause substantial tonnages of copper to be lost over the next ten years. Slide 26:

What Actually is China’s Refined Consumption?

Kt-cu

S

4. 4.0% 3. 3.1 14 14.2 .2 6. 6.3 7. 7.6 % Change % Change 463 4635 445 4457 432 4322 378 3784 3561 561 331 3310 Aver Average o age of All 4. 4.0% 3. 3.3 7. 7.6 7. 7.2 6. 6.6 % Change % Change 437 4370 420 4203 406 4069 378 3782 3528 528 331 3310 Co Correlatio ion 5. 5.3 1. 1.1 16 16.0 .0 4. 4.0 8. 8.9 % Change % Change 463 4630 440 4400 435 4350 375 3750 3603 603 331 3310 SH SHSS 10 10.5 .5 8. 8.0 19 19.0 .0 7. 7.5 7. 7.3 % Change % Change 542 5424 490 4909 454 4546 381 3819 3552 552 331 3310 BG BGRIMM RIMM 200 2009 200 2008 200 2007 200 2006 2005 005 200 2004

What actually is China’s refined consumption is one of the most difficult questions to

• answer. Published data is almost meaningless being full of double counting and use of scrap

figures as gross rather than net copper. 40% of wire rod production originates from small Chinese Upward Cast Machines whose activity depends to a large extent on scrap availability and price and working capital. In the first quarter of last year, for instance, around 25% of these plants closed down giving the larger plants an average 15% improvement in business. Many analysts assumed that this was an industry average which was clearly wrong. At least 40% of brass mill output comes from small mills with similar structures. Analysing copper consumption in China is a humbling experience. We have correlated first GDP to electricity production and then to copper consumption. The analysis worked well up to 2006. In 2007, we know that fabricators produced a lot of semis for inventory, speculating on an ever increasing copper price. When prices began falling around mid- 2008, this inventory was liquidated. Speculation boosted consumption in 2007, but cost it tonnage in 2008. A repeat of this process started in the latter months of last year. At one centre of semis activity, a friend reported back that between 20% to 40% of production was going into inventory, speculating on rising copper prices.

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Slide 27:

China % Breakdown of Copper in the Export of Goods

% Breakdow n of Copper Content in the Export of Goods Kt-cu Direct Semis Wire & Cable Household Appliances Transport Computers, etc. Office Equipment Electrical Equipment Machines & Misc. Others

33.3% 4.8% 2.4% 5.4% 15.7% 6.7% 12.3% 19.3%

The first point then is that actual consumption is being over-stated by most people. The second is that the growth rate for last year is also inflated by almost everyone. About 35% of China’s consumption consists of copper being exported in one form or another, either as a direct semi or contained in the export of a finished product, such as an aircon. We estimate that around 16%, or 300kt, was lost through exports last year, implying that domestic consumption would have to increase by some 7% just to stand still. Slide 28

China’s Refined Consumption by Sector – 2007 – 2015 - Kt-cu

6.5 3.8 0.4 2.2 3.2 8.5 5.3

• 1.8

Growth Rate % Change per annum 5750 5400 5200 5300 5185 5025 4630 4400 4350 Total 150 140 140 150 150 145 140 135 150 Rest 960 920 950 1130 1200 1250 1200 1220 1260 Consumer Goods 300 280 300 320 310 310 290 275 260 Industrial Equipment 3290 3090 2910 2700 2475 2250 2000 1870 1730 Infrastructure 1050 970 900 1000 1050 1070 1000 900 950 Construction 2015 2014 2013 2012 2011 2010 2009 2008 2007

The real story of China’s copper industry last year was not soaring consumption, but an aggressive purchasing of copper as a speculation on rising prices by Chinese institutions,

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private individuals, industries having nothing to do with copper, such as toy and textile makers and the industrialists in the city of Wenzhou. We are told on good authority that around 40% of copper cathode imports are owned by foreigners with most of the material warehoused outside the reporting system. On our analysis some 1.9 million tonnes of copper is sitting in China surplus to consumers needs of which over 1m tonnes is owned by foreigners. China is the residual dumping ground for much of the world’s surplus. This is part of the speculative fever now built into the country and part of the ‘game’, for want of a better word, being played out by the world’s financial sector. Slide 29

World Refined Consumption 2007 – 2015 – Kt-cu

3.9 2.4

• 3.2
• 1.0

3.7 5.8

• 10.0
• 2.2

% Change 17068 16429 16043 16578 16751 16146 15267 16961 17351 World 834 787 804 876 885 826 774 1130 1211 Rest of the World 145 140 135 138 140 135 135 145 146 Oceania 554 550 533 551 567 543 519 590 546 S America 353 337 320 340 336 312 282 281 265 Africa 915 910 910 950 930 855 805 749 710 Middle East 9347 8895 8611 8826 8823 8555 8062 8246 8278 Asia 2110 2070 2040 2143 2170 2120 2070 2472 2682 North America 2810 2740 2690 2754 2900 2800 2630 3348 3513 Western Europe 2015 2014 2013 2012 2011 2010 2009 2008 2007

03.02.10

The horrifying story is that with a forecast of a weak global economic environment and declining intensity of use, world refined consumption will still be lower in 2015 than it was in the peak year of 2007.

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Slide 30: The strong message I want to convey is that prices are not being driven by real fundamentals but by financial markets. The gap between production and real consumption is being filled by the financial sector and others by acquiring metal and tucking it away

• utside the reporting system with a large chunk being held in China.

Who owns the material lying outside the reporting system is largely guesswork, but most is probably owned by investment banks on behalf of their clients or for their own account. These would include pension funds that want exposure to the metal but do not want

• delivery. As one friend recently wrote, “there are now plenty of tactical allocation advisors

suggesting that they increase the exposure to 10% - of commodities – with wonderful PowerPoint slides showing efficient frontiers, Sharpe ratios and the like..” Not only is the market becoming overcrowded, but there is a real question about the validity

• f this exposure. By overcrowded I mean that in the earlier years of this diversification into

commodity markets, these markets were uncorrelated or even negatively correlated to bonds and equities. Now it is these markets which are the principal drivers to base metal prices, like copper, because the players have become so numerous that in many cases they have driven units into negative carries. The perception of tight markets is driven by the very activities of these players. This is why industry users are placing so much research into finding materials which are not traded on exchanges and why they are doing their best to limit its use. For investors, like pension funds and others, the attraction has been to find an investment unit which is uncorrelated to equity and bond markets and which is a hedge against inflation and a falling US dollar. Everyone has their own view about the future. The meticulous work undertaken by Carmen Reinhart and Kenneth Rogoff in their book, “This Time is Different”, illustrates that periods of deleveraging last for many years and that they are deflationary. Government debt might be rising, but private sector debt is collapsing even faster. That

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surely is not inflationary. A cursory look at US nominal GDP shows there is no evidence of inflation nor does nominal M2, let alone the inflation adjusted number, suggest that inflation is about to rear its ugly head. We will be living through a deflationary period with a brief but modest break out in late 2011. It is the activities of the banks operating for both their own accounts and those of their clients who are at the centre of what we call the Money Game. Their size allows them to ‘game’ the markets at the expense of physical users. They have encouraged the development of and sponsored Exchange Traded Funds, or ETFs, to attract retail investors into the commodity complex with some success. ETFs provide the banks with a flow of income and a means of transferring some of the risk onto their retail customers. For a serious and objective analysis of ETFs I recommend you read Jonathan Compton of Bedlam Asset Management piece, “The Ozone Layer, Tectonic Plates and Ostriches”, in which he sifts out the good and the bad and reminds the reader that when one or two blow up they all will together with the underlying equities. Much of this business is conducted away from the exchanges where large deals can be seen and can suffer in the process. ETFs and other such investment vehicles are starting to reduce volumes on individual commodity contracts and so increase volatility. There are also three main vehicles outside the exchanges which are becoming increasingly important to the pricing of copper and other base metals. It is worth a moment to look at them since they are an integral part of trading outside the recognised exchanges. The first is the Dark Pools of Liquidity. This is a recognised off-exchange function where large commercial companies, especially banks, create hidden pools of bids and offers in

• rder to shift massive orders. If these were put on the exchanges their positions would be

revealed and their execution would suffer. The downside is that on-exchange traders are seeing prices suddenly move for no apparent reason. Dark pool trading is normally the

• culprit. A recent development is that the major players have converted their dark pools into

Multilateral Trading Facilities, which are regulated by the FSA, and which can still have the same function. An important question here is whether the foxes are guarding the henhouses as they have tended to do in recent years. The second is High Frequency Trading, or HFTs. They have grown out of the success of algorithmic trading and use plug-in systems to execute trades at certain prices. Very sophisticated software and almost light-speed computers enable trades to be executed faster than the human brain can follow. When a price is triggered it can send prices rocketing giving the appearance of high liquidity and volatility when in fact it is only someone with an HTF program and a large order. The third is Trading Arcades. These have developed rapidly in recent years. They pull together smaller traders and non-professionals into one group so enabling them to have significant presence in the market and an ability to stand up to the big guns. They have become very large in India and in Dubai.

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These developments show how divorced the pricing of copper, and other commodities, is from the real world of industry. They show also the exponential growth of the speculative nature of these markets and also how far down the chain they have grown. In fact, they have reached such a level as to overwhelm the markets’ ability to accommodate the volumes. We should remember once more Herb Stein’s law because as the world changes from short- termism and trading to frugality and austerity these activities will disappear, triggered by the coming of the second credit crisis around 2012. Slide 31:

Copper Price Outlook

Finally, what is the outlook for prices? I have tried to show how copper’s pricing is now driven by developments in financial markets and not by what is actually happening in

• industry. Dr Copper is no longer in practice, having retired about six years ago.

We need, then, to take a view on markets, especially the dollar and equity markets. I realised to my cost, back in 2005, that I needed a handle on financial markets to help in forecasting copper prices, because then my call on prices was based on a true fundamental analysis, that is to say consumption as opposed to demand. Of course my call was horribly wrong. For some years, I have collaborated with WaveTrack International, based in Munich, to provide me with cycle and technical data with some notable successes, so now I tend to marry my fundamental analysis with the cycle and technical work of WaveTrack

• International. When the two converge we have a powerful story to tell.

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Slide 32:

S & P 500

S

First, equity markets using the S&P 500 as our bell weather. Technical developments since drafting this paper may alter the profile of the S & P 500 as depicted in these charts. Although the January high at 1150 has met most of the measured criteria that identifies the termination of this counter-trend, there exists a smaller probability of an additional leg higher which carries the S & P towards a target of 1195. This will only be possible if the 1150 high is exceeded, a sequence of little more than 3.8% before larger declines begin. The falls should then be followed by another rebound after which equity markets enter a period of falling prices in line with our calls for deflation and global recession. This is part of the Kondratieff K-winter, or, in a Schumpeterian sense the need to destroy bad investments to make way for the new technologies. In our world of copper this includes super conductors and nanotubes. Slide 33:

Oil Prices

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These two charts well illustrate the deflationary environment which the world is very likely to encounter with a break-out in 2011. Slide 34:

US Dollar Index

These charts show first how strong the US dollar recovery is likely to be this year, but how thereafter the currency continues to decline until 2016. What is interesting is the divergence between the US dollar index and oil prices, suggesting that the deflationary forces will be greater than the fall in the US dollar. So what does all this mean for copper prices? The bad news is that prices should fall to around $5300 by mid year and around $4000 in

• October. The good news is that over the following year they should explode to $10,000+.

As we get into 2012 the global economy is once again going to sink back into deep recession with the onset of the second credit crisis. By 2013 copper should be around $2000, but 2 years later below $1500. The collapse in prices will be a function of the global economy and all that good stuff that had been bought and warehoused outside the reporting system having to be forcibly liquidated. Finally, remember truth can be hidden, but never forever. “More deals have been set in this dining room than the chef has set jellies”, wrote Morris West in his brilliant novel Cassidy, which could even have been a template for today’s activities in commodity markets.

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Slide 35:

THANK YOU

The The C CLSA A Asia ia Confer eren ence Sa San F Francisc sco Mar March 20 2010 10

Now you know why I absolved CLSA from everything I would say today and I thank you for your patience in listening to my story.