Steve Parsons Takes a Shine to Copper
Source: The Gold Report (10/6/09)
In this exclusive Gold Report interview, Steve Parsons, Senior Research Analyst for Wellington West Capital Markets, explains how investors might capitalize on a theme that's picking up momentum on the copper concentrate side of the industry. He also sheds some light on a great copper story that's unfolding on the northern shore of Lake Superior in northeastern Minnesota.
The Gold Report: Steve, it's often said that copper is a great way to play a period of economic growth. Do you agree with that?
Steve Parsons: I absolutely agree. Copper is an essential metal for developing nations. Generally speaking, an increase in GDP/person coincides with an increase in copper usage. The story here is that China and India are still coming from a low base. If you look at where copper usage is in developed nations, it is upwards of 9 kilograms of consumption per person annually. China's consumption currently weighs in at approximately 3.5 kilograms per person. So China is still at an early stage of development. The move to urbanization should keep upward pressure on copper usage. By 2025, it is projected that China will have 221 cities with a population of more than one million. At present, Europe only has 35.
TGR: Some are saying that $2 will be the new copper floor. What's your thinking on that?
SP: Deposits are getting deeper and they're getting lower grade. In certain cases in Chile, whether it's Escondida or Chuquicamata, the deposits are moving into ores with more impurities, such as arsenic. A general deterioration in the quality of deposits will almost certainly push operating costs higher, in turn helping to underpin a higher copper price.
Although $2 is not unreasonable, we use $1.85 long term—with long term starting in 2014. That $1.85 is actually very conservative, and it's really a function of currencies too. We're tying the $1.85 figure to an 85-cent Canadian dollar. To the extent we start using a 90-cent or current FX rates, we'd be closer to $2, if not higher.
If you believe in the Chinese story and if you believe there are going to be 221 cities with a population north of a million, $1.85 copper is likely too conservative.
TGR: You mentioned that a lot of this copper is getting deeper and, thus, more expensive to produce. Do you see a scenario where we are at peak production now and that we face a scarcity of copper as we move forward? Or there's plenty of copper, but it just costs more to produce?
SP: Of course, it takes a long time to discover a new copper deposit, then get it through permitting and regulatory hurdles. A good example of that is the Ivanhoe Mines Ltd. (NYSE:IVN) Oyu Tolgoi in Mongolia. It's a fantastic copper deposit, but it's taking a long time to get into production. So there are some very large copper projects out there. The Chinese are developing a couple of very large copper projects in Peru. I think we have the potential to produce more copper than we are today, but many of those opportunities come with higher operating costs. In many of the cases, they are second-tier assets with lower grades than today's world-class deposits. You might have higher production, but it will come with certainly higher capex costs and higher operating costs.
TGR: Could you review for our readers the differences in terms of investment opportunities between copper concentrate and the actual metal?
SP: Sure. It is important to make the distinction. At the mine level, copper is produced either in concentrate form or as cathode. Concentrates require further upgrading via smelting and refining, whereas copper cathode can be LME grade at the mine gate.
The opportunity we see—and it's probably one of the most prominent themes in the copper space—is that in the copper concentrate market specifically, there is too much smelting capacity chasing too little concentrate. Smelting and refining capacity expansions in China, Korea and India have bred stiff competition for dwindling sources of Cu concentrate. We believe that China's mandate to protect employment requires the country to maintain smelter output, thereby exacerbating the situation. Their decision to keep those smelters open has forced treatment and refining charges—levied by the smelters to the miners—to all-time lows. We don't see this situation changing at least until 2013.
With TC/RC (treatment charges and refining charges)rates falling and the availability of concentrate and scrap copper limited, we believe smelter groups are likely intensifying their efforts to become fully integrated—that is to acquire interest in mines or development projects with copper concentrate production. Such a move not only keeps the smelter fed, but also supplants third-party concentrates that are currently being processed at low treatment and refining charges. Under the current economic environment, the tactic also has the potential to conveniently deliver assets at a discount to NAV while at the same time negating the adverse effect of low TC/RCs on smelter operating margins. This goes back to a model that was more typical of the 1970s and 1980s, when it wasn't such an adversarial relationship between the smelters and the miners.
TGR: Do you see this trend of foreign smelters buying copper mining companies continuing for the next year or two? Will it result in the whole industry being consolidated under the umbrellas of a few smelters?
SP: We initially saw the smelter integration theme emerge in late 2007/early 2008, with the acquisitions of Northern Peru Copper Corp., Peru Copper, Monterrico Metals plc and Tyler Resources (all of which are expected to produce copper concentrate) by China Minmetals/ Jiangxi Copper Company Limited (OTCBB: JIXAY), Chinalco (Aluminum Corporation of China Limited (NYSE:ACH), Zijin and Jinchuan (all of which have smelting capacity), respectively. The movement seemed to take a hiatus late last year as surplus conditions emerged bringing visibility for higher TC/RCs. Earlier this year the theme re-emerged in no uncertain terms with Japan's second-largest copper producer Sumitomo Metal Mining Co. Ltd. (STMNF:US) publicly stating plans to take a stake in at least one copper mine in a bid to gain more control over the source of ore feed, with the ultimate goal of increasing the proportion of internally supplied ore to 70% from the current 40%. The opportunity here as it relates to copper concentrate stories is that in an environment where development assets remain at depressed valuations due to a lack of conventional financing, we believe the emergence of smelter groups as motivated buyers should help alleviate these concerns and ultimately enable a re-rating of company shares.
A few recent data points demonstrate that this theme is taking hold, with the most recent one being the deal between Copper Mountain Mining Corp (TSX:CUM) and Mitsubishi. Mitsubishi acquired a 25% stake at the project level and has agreed to arrange a $250 million project loan. This is a good example of how smelters will help finance mine development, all in an effort to secure a steady supply of copper concentrate.
This is a near-term theme and we believe other deals are probably in the offing. In fact, I wouldn't be surprised to see more deals come out of the LME Metals Conference in mid-October.
TGR: What are some of other potential plays?
SP: One of the most logical plays that could benefit from the same theme is the Augusta Resource Corporation (NYSE/AMEX:AZC) project—Rosemont in Arizona. It's one of the largest undeveloped copper stories that has no off-take deal in place. Importantly, the concentrate should be of a very high quality, with a high copper grade and few deleterious elements. Of course, the smelters also want stability of supply, which should be very good in Augusta's case because it's coming from the U.S. For these reasons, I'd say smelters probably are vying for the Augusta concentrate.
TGR: Do you see other companies with similar potential?
SP: Taseko Mines Limited (NYSE/AMEX:TGB; TSX:TKO) also the potential to deliver substantial amounts of copper concentrate. They're looking to get a permitting decision on their very large Prosperity Copper-Gold Project in British Columbia probably by the end of 2009. This is the largest undeveloped copper-gold project in Canada, and Taseko quite likely will look to do a deal similar to Copper Mountain's—where they get a smelter to earn-in on the project, negotiate an off-take agreement, inject cash and help provide the debt financing.
TGR: So these smelters are essentially taking on specific projects rather than ownership positions in the companies themselves?
SP: I think that's going to be the case in North America if you look at Augusta, Taseko and Copper Mountain. That's true in Australia, too, where there is also, in effect, more resource nationalism and the Chinese have come to realize that it actually might be hard to acquire such companies outright. They're better off approaching it at a project level.
However, the situation in South America is a little different. Various Chinese groups were involved in taking over outright some very large strategic copper assets in Peru—Peru Copper, Northern Peru Copper and Monterrico Metals. I think that possibility still exists in Peru and maybe some other South American countries.
TGR: If the trends you're seeing continue, with Chinese smelters acquiring either projects or entire companies, won't the smelters end up dictating copper prices?
SP: I don't think this will have much impact on the copper price. Certainly the mining companies will have less ability to negotiate cheaper refining charges. Right now they have the smelters over the barrel. They can dictate very, very low terms for treatment and refining—to the point where they run the risk of putting the smelters out of business. These integrations will put the ball back in the smelters' court to a certain extent, and give them a better chance to negotiate on higher TC/RCs.
TGR: How should individual investors take advantage of this trend?
SP: I think you want to get in on copper development plays, particularly ones that produce copper concentrates, as the offtake contract can be a source of financing. Ideally, you want something that will produce a high-quality copper concentrate and have a mine life of 15-plus years. In addition to Augusta and Taseko, you might look at Norsemont Mining, Inc. (TSX:NOM) and even some newcomers such as Nevada Copper Corp. (TSX:NCU).
I just can't see this thing stopping. The reason I say you want to play copper development stories is, one, because you've got the opportunity to get a bid from a smelter and help you finance a project or they take you outright. Larger cashed-up companies such as HudBay Minerals Inc. (TSX: HBM), Quadra Mining Ltd. (QUA.TSX) , Thompson Creek Metals Co Inc (NYSE:TC; TSX:TCM) and KGHM Polish Copper Ltd. (KGHMF) are all talking about rolling up the mid-cap copper space. But the reality is that there's very little to roll up, so they're going to have to look at near-term copper development stories. That means they're competing with the smelters for the same assets.
There is a logical argument to be made that copper development is the place to be.
TGR: One of the data points you mentioned early on involved Copper Mountain and Mitsubishi. That deal was just finalized in late July. What do you see now that this has been finalized?
VSP: Copper Mountain just completed an equity deal, about $50 million, which quite likely provides full financing through to production. The stock trades about 0.5 times our NAV estimate, which is among the cheapest in our coverage universe. We believe the potential for a re-rating is high. As they start building and get close to production, we would expect Copper Mountain shares to re-rate toward 1.0 times our NAV estimate, which is C$3.00/share.
A while ago we were talking about these cashed-up companies looking to roll up the mid-cap producer space. While there aren't a lot of companies to acquire, this one is logical target. I think the fact that a couple of weeks ago Taseko put together a proposal to merge the two companies—Taseko and Copper Mountain—lends credence to that view.
TGR: Are you looking at any other copper plays?
SP: PolyMet Mining Corp. (NYSE/AMEX:PLM; TSX:POM) is a story that I haven't mentioned yet. PolyMet differs slightly from the copper concentrate theme. It's another topical story that I think would interest investors. It has a development story in Minnesota. Minnesota has been an iron mining state for many, many years, but hasn't had a commercial non-ferrous operation. We believe that is poised to change and PolyMet's large NorthMet project could be Minnesota's first.
PolyMet been involved in permitting activities for several years now, and it would appear that they're finally down to the fine strokes. The Draft Environmental Impact Statement is expected to be filed in the coming weeks. Getting the Draft EIS prepared and filed is arguably the most critical step in the permitting process. There's a very good opportunity of being issued final permits within six months of the Draft EIS.
So come 2011, we could see Minnesota's first non-ferrous mine in what is the third-biggest copper-nickel district in the world after Sudbury and Norilsk Nickel (NASDAQ:NILSY, LSE:MNOD).
SP: The district has been known by geologists for many years, but it is relatively new to the investment community. I think that is about to change. You ask, "Where is copper going to come from?" If you look at deposits owned by PolyMet, Duluth Metals Ltd. (TSX:DM), Franconia Minerals Corporation (TSX:FRA) and Teck Cominco Ltd. (NYSE:TCK; TSX:TCK.A; TSX:TCK.B) —which are all in the Duluth Complex—this is among the largest copper/nickel districts in the world that is available for development.
TGR: How close are Duluth and Franconia to getting permitting?
SP: They're years behind PolyMet, but I believe PolyMet has helped pave the way. Any subsequent studies should be completed at a faster rate, and that should only make Duluth's and Franconia's lives a little bit easier. If the final permits are received, as we believe they will be, that will send a strong message that Minnesota is open for business, which in turn should help spur merger and acquisition activity.
TGR: That's just so amazing that no one's really talking that much about it.
SP: Very surprising, given that the projects are close to railway, close to power. Moreover, PolyMet is a brownfield development. The company purchased a bulk tonnage taconite mill from Cliffs, so the capex intensity is lower than it would have been otherwise. So the stars are aligning for PolyMet and the other companies in the Duluth Complex. And to top it off, this could materially transform Northern Minnesota economically.
TGR: One of the greatest stories never told. Thanks, Steve, for all of your insights.
DISCLOSURE: Steve Parsons
I personally and/or my family own the following companies mentioned in this interview: None.
I personally and/or my family am paid by the following companies mentioned in this interview: None.
Steve Parsons, P.Eng., a member of Wellington West Capital Markets' equity research team since April of 2008, is a Senior Research Analyst focused on the mining sector. Wellington West is an institutional equities firm that specializes primarily in the mining, energy and technology sectors. After earning his bachelor's of engineering degree in mining at Queen's University, Steve worked as a metallurgical engineer for Placer Dome, and then moved on to a metallurgical consulting firm. Shifting to the investment side of the business after that, he signed up as a Research Associate with GMP Securities, concentrating on base metals initially and later joined MGI Securities as a Research Analyst.
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