How the mighty have fallen. Copper, one of the most prolific commodity fund darlings of the great 2006 bull market has fallen on hard times.
There was a time in early 2006 when it looked like there was no limit as to how high copper prices could rise. The housing market in the United States had not yet turned all the way down, and demand from China looked insatiable. Copper has many industrial uses, not the least of which is wiring in commercial and residential buildings. Thus, when the construction business is healthy, demand for copper and prices tend to be firm. Caught up in a wave of bullish hysteria affecting many raw materials, copper prices climbed to their highest levels of all time, topping out at $4.44 per pound in April of 2006.
However, as in any bull market, high prices will eventually cure high prices. Prices had attained levels that started to curb Chinese demand. The Chinese government began to take steps to keep the economy from “overheating.” In response, Chinese copper imports fell 19% over the course of 2006.
Probably more crucial, however, was the abrupt and severe slowdown in U.S. housing starts. Builders account for 46% of U.S. copper use, with the average new U.S. home containing about 400 pounds of the metal. Thus, a slowdown in new housing will have a substantial effect on copper demand.
To add to the bearish mix, $75 crude oil had many believing the U.S. and world economies were headed for a slowdown, or worse. Slowing economies mean slower demand for industrial materials.
Copper prices responded by declining for the remainder of 2006 and continued to slump as we began 2007. Indeed, at the time of this writing, copper prices have receded more than 40% from their 2006 highs. Is this simply a correction in a long-term bull market or do prices still need to adjust lower to account for a now hefty build in supplies?
The answer to both could be “Yes.” In the longer term, the outlook for copper and other industrial commodities appears to be bright. However, as for the first half of 2007, prices remain high by historical standards and in light of existing fundamentals, are probably still too high to mount any kind of substantial recovery rally in the near future.
If the trend is your friend, copper should be friendly to call sellers in 2007.
The primary barrier facing copper in the near future is high stockpiles, a hangover if you will, from last year’s unprecedented price explosion. As demand rose and prices soared, mining operations ramped up production at a torrid pace. When global demand began to wane, producers continued to extract the metal at the same rate. Thus, as we began 2007, copper stocks in London, Shanghai and New York were at the highest levels since mid 2004. In addition to high warehouse stocks, it is estimated that global mine reserves are adequate to meet 16 years of world demand.
Producers, however, are still quite content with current prices. Copper’s climb to more than $4.00 per pound last year was unprecedented. Until 2005, copper prices had never traded above $1.61 per pound. It is estimated that most copper miners break even at about $1.10 per pound. That means today’s price of $2.45 per pound still allows copper companies to enjoy an historically high profit margin and thus, creates no incentive to scale back production.
Quite the contrary, miners continue to increase production. In 2007, world refined copper output is expected to rise 5% over 2006 figures. In addition, global supply of copper concentrate is expected to increase by 5% as well, to 13.2 million tons in 2007.
Bulls will argue that Chinese demand is set to resume in 2007, which will help buoy prices. Indeed Chinese copper demand is expected to increase by 7% over 2006. We believe that if this figure is truly realized, it may serve to curb the selling in copper and may even help bump prices off current levels by late in the year. However, the promise of increased Chinese demand will not be enough to start another bull market in the metal.
China is only part of the equation when it comes to copper demand. As the world’s growing economy, China currently accounts for about 20% of the world’s copper production. Respectable? Yes, but not the whole story. The United States and Europe account for over 50% of global copper consumption. Yet, projections for demand growth in these nations are not quite as rosy.
Phelps Dodge estimates that U.S. refined copper consumption will grow by only 1% in 2007 with European demand expected to grow at the same pace. Meanwhile, Japan, another top copper consumer whose demand rose by 5% in 2006, is expected to see less than 1% growth in consumption this year.
With 2007 production expected to increase by 5%, we find it difficult to envision copper prices mounting anything more than limited rallies in 2007, especially in the first half of the year. In fact, unless there is a sudden and substantial turnaround in demand for U.S. housing or U.S. automobiles, we think the market will need increased demand from China just to sustain current levels.
I’ve often been asked, if we feel a market is going to move lower, why don’t we just short the futures in our portfolios? The answer is that we don’t know the market is going to move lower. Nobody knows. We see the fundamentals as being bearish, but that does not mean that futures prices cannot make price moves to the upside in the meantime. Our contention is that, based on the current supply/demand fundamentals, the market will have a hard time mounting a rally to substantially higher levels. For selling calls, this is all the analysis we need. An investor can sell call options, collect the premiums, and as long as prices remain anywhere below his strike price, the options expire worthless and the investor keeps the premiums as profit.
We feel this is an excellent strategy in the copper market right now because fundamentals for the copper market remain bearish for the immediate term, and volatility left over from last year’s wild price moves has left overpriced call options available to astute option sellers. Long term charts for copper remain in a bearish set up, helping confirm our fundamental views
We would view any strength in copper prices in the coming two to four weeks as opportunities for selling call premium at far out of the money strikes. One note about copper options: Open interest is not as liquid as in markets such as soybeans or crude oil. A bit of patience and homework is necessary if you are selling these on your own.
If you would like more information about selling options in the commodities markets or building a portfolio based on the option selling approach, please feel free to call to request an option seller’s information pack or visit us on the web at www.optionsellers.com.
James Cordier and Michael Gross
Liberty Trading Group
401 East Jackson Street
Tampa, FL 33602
Be sure to catch Liberty Trading’s James Cordier live at the World Money Show, Gaylord Palms Resort, Orlando, Florida, this weekend (Feb. 7-10, 2007). James will be speaking as part of the Futures Magazine Panel of Experts and will be discussing option writing strategies and his outlook for 2007 commodity prices.
James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. James’ market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.