Oil Prices Could Short Circuit, While Copper Charges Ahead

When trying to wire up a trade in commodities, go for copper, The conductive, soft metal offers a long-term demand tailwind that makes buying related stocks on weakness a solid risk/reward. Shares of Freeport McMoRan (FCX)  , for example, have pulled back about 40% from March highs as copper prices softened with global economic weakness.

Now, this might seem counterintuitive, as investing in commodity stocks often proves difficult for investors. It’s tempting to jump in when fundamentals are strong. For instance, oil and other commodity stocks are notoriously cyclical, often leading to disappointment for those chasing strength. Plus, the mounting deleterious effects of climate change are prompting governments worldwide to incentivize alternative forms of energy production other than fossil fuels, making oil a slippery target. 

But back to Dr. Copper. Freeport’s long-tenured CEO still contends that the supply/demand imbalance favors higher long-term prices for the red metal. S&P Global’s Dan Yergin published a report recently that copper demand will double by 2035, accompanied by huge supply deficits.

While copper prices have historically been viewed as a key economic bellwether, the transition to renewable energy and the electrification of transportation has created enormous demand drivers that are less correlated with economic growth. The Inflation Reduction Act provides incentives for additional copper-heavy electric-vehicles, charging stations, and renewable energy sources. For instance, a three-megawatt onshore wind turbine uses over four tons of copper; and almost three-times as much as offshore wind turbines. Solar farms use about five tons of copper per megawatt.

Copper use in EVs is dramatically higher than in conventional gas-powered vehicles. A typical Tesla (TSLA) contains around 180lbs of copper compared to around 50lbs for a gas-only car. The ramp in EV production for commercial and personal use is still in a nascent stage with a clear path substantially higher.

A clean energy future involves the flow of electrons through copper instead of the flow of oil. It’s easy to focus on short-term market dynamics amid soaring energy prices, especially in Europe, and miss the forest for the trees: High energy prices are accelerating a shift to renewables. Energy prices have been elevated for several critical reasons, notably Russia’s invasion of Ukraine, a slow production recovery from the pandemic-related recession, and limited domestic refining capacity. Copper prices plunged in recent months due to macro-related recession fears.

If the Fed and other central banks continue to drive up interest rates to curb inflation, the resulting softer economic growth will hurt most commodity prices. Copper won’t be exempt from recession-related demand weakness, but prices would likely be quicker to recover. Freeport can withstand copper weakness with a balance sheet much stronger, and its mining locales more stable, than a decade ago when it teetered on bankruptcy.

Freeport had net debt of over $18 billion in 2013; now, it’s back to around $1 billion. The company continues to opportunistically repurchase debt and buy back shares. The company plans to return 50% of its free cash flow to shareholders in dividends and buybacks. They added $2 billion to their authorized buyback in July, and FCX sports a 2% dividend yield. Earnings and cash flow have significant leverage to the price of copper — Freeport would have annual cash flow of $4.5 billion at $3/pound copper, ranging to $11 billion for $5 copper.

Recent insider buying at Freeport bolsters confidence along with management’s current assessment of a relatively tight physical market and low inventories. However, the weak macro economy, especially in China, may push out any recovery in copper prices into 2023.

Importantly, Freeport has tremendous operational strength after recently completing the largest underground mine worldwide in Indonesia. Freeport does have a hidden asset in the form of already mined rock where copper can now be extracted using new leaching techniques. This low-cost source of copper could translate into tens of billions of pounds of copper for Freeport in years to come.

Investing in commodity stocks takes an extra layer of risk than most other sectors. Fundamental research on individual companies is often less meaningful than the underlying commodity price as a driver of shares. Still, with long-term demand drivers for copper in place and new supply less secure, it’s worthwhile to buy the largest copper miner, FCX, on recent weakness. Buying into oil stocks has been en vogue on Wall Street, while the enthusiasm for copper stocks has faded with the underlying commodity. The case for strong copper demand for years makes FCX a compelling long-term buying opportunity.