What’s Going on With Copper?

Source: Thinkstock

Over the past couple of weeks, the price of copper has broken down to multi-year lows. Last week, I argued that this breakdown was likely a result of economic weakness. Given copper’s ubiquitous appearance in industrial and consumer goods found across the world a fall in the copper price is often a signal that the demand for these products is weak. This means that the global economy more generally is weak as well, by extension.

However, since then another explanation has come up that needs to be addressed. It turns out that copper is used to collateralize Chinese loans, and if several of these loans are called in by creditors at the same time, then we could see forced selling in the copper market. This explanation is certainly plausible, especially given the troubles we have seen coming out of China’s banking system, which is massively overleveraged.

Nevertheless, I wouldn’t immediately throw away the “weak economy” explanation, and I say this for the following reasons. First, recall that in the article I wrote last week, I maintained that weakness in the copper price is just one sign among many that we are seeing economic weakness. While one could argue that the fall in copper prices is the result of an aberrant market occurrence such as forced selling by Chinese debtors, we cannot blame other weak market signals such as weak retail sales on this.

Second, if the economy were strong and the sell-off in copper was due to forced selling by Chinese debtors, then we would have seen a sharp rebound given the strong demand for copper resulting from strong demand for industrial and consumer goods. We can still see this as the sell-off is still young. But so far we haven’t.

Third, if the sell-off in copper were the result of forced selling by Chinses debtors then it follows that there is a credit contraction — at least on some level — in China, and this would likely be due to economic weakness in China. This, in turn, would imply that there is some weakness in China’s trading partners, of which the U. S. and the E. U. are the two biggest. Thus, while Chinese selling could be the trigger driving copper prices lower, this isn’t necessarily the fundamental reason, and we would have likely seen lower copper prices anyway in the not too distant future.

With that being the case, investors should tread extremely cautiously in the copper market. There appears to be some technical support at around $2.70/lb., but if that level doesn’t hold then it is possible for copper to fall to below $2/lb.  towards the depressed levels we saw during the height of the 2008-9 financial crisis.

Traders who want to play copper as a contrarian bet should consider limiting their exposure. One way of doing this is by buying a company like FreportMcMoRan (NYSE:FCX). Freeport McMoRan is trading like a copper company, however, the company mines a lot of gold as well, which should perform strongly if the economy is weak.

Furthermore, the company recently diversified into oil and gas. While a weak economy can put pressure on these commodities, investors should keep in mind that oil and gas prices can spike in the event of a geopolitical event such as a a heightening of the ongoing conflict between Russia and the U.S. Freeport McMoRan is a relatively inexpensive stock as it trades at less than 12-times earnings with a 4 percent dividend yield. While the company’s earnings will likely take a hit due to falling copper prices, the company’s exposure to other commodities will mitigate this decline.

Disclosure: Ben Kramer-Miller has no positions in any of the stocks mentioned in this article.

More From Wall St. Cheat Sheet: