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How to Invest in Copper Stocks

Matthew DiLallo, The Motley Fool

Copper is one of the most versatile metals. It runs through our homes as part of both our plumbing and electrical systems. It's a key component in our cars, which contain an average of 44 pounds apiece, including nearly one mile of copper wire. The metal is also an important building product, part of our money supply (it coats the penny), and essential for telecommunications.

Given its versatility and importance for so many industries, the global economy uses an increasing amount of it. In 2018, worldwide copper consumption hit 23.6 million tons a year and should reach 29.8 million tons by 2027. While recycling old copper helps meet about 45% of global demand, rising consumption requires continued development of new copper resources.

That rising demand has the potential to boost the price of copper in the future, which could drive up the stock prices of companies that mine the metal. That makes it an intriguing industry for investors to get to know. With that in mind, let's take a look at how to invest in copper stocks.

A jar of pennies surrounded by pennies.

Image source: Getty Images.

An overview of the copper industry

Copper is one of the most abundant metals. According to an estimate by the U.S. Geological Survey, the earth contains more than 8.1 trillion pounds of copper. We have only mined about 1.1 trillion pounds of copper so far, most of which is still in use due to its recyclability. That leaves plenty of available copper resources to meet future demand.

The problem, however, is that only a small fraction of the earth's copper resources are economically viable to mine at present-day prices and using current technologies due to reserve quality. For a copper resource to be commercially viable, it needs to contain a high concentration of copper ore, which is copper in its natural state. Most top copper deposits contain between 0.5% to 1% of copper ore.

There are two main types of copper ore: Oxide and sulfide. Copper oxide is more abundant closer to the earth's surface but is typically a lower-grade ore due to less concentration. Because of that, mining companies need to extract and process more ore to produce the same amount of pure copper, which is known as a cathode. Copper sulfide deposits, while less abundant, contain higher amounts of copper. However, it's more expensive to process copper sulfides, making it less economical than oxides in producing copper cathode.

Companies usually use an open-pit method to mine copper, which as the name suggests consists of digging a large hole in the earth to extract the ore from rocks. They drill holes into the ground and insert explosives that break apart the rock. The boulders are then hauled away where they're crushed down to the size of golf balls. From there, oxide ores go through a three-step process known as hydrometallurgy that uses water-based solutions to extract and purify copper to create a cathode. Copper sulfides, on the other hand, go through a four-step process known as pyrometallurgy that uses heat to create a pure copper cathode. From there, it gets shipped to end users that transform it into a variety of useful products such as wiring and piping.

Many companies produce copper, either as their primary focus or as a secondary product. The five largest copper companies in the sector, as measured by their copper reserves -- which is the known copper resources underground -- are on the following table: 

Copper Company Copper Reserves
Codelco (Owned by the Chilean government) 78 million tons
Southern Copper (NYSE: SCCO) 69 million tons
BHP Group (NYSE: BHP) 47 million tons
Freeport-McMoRan (NYSE: FCX) 45 million tons
Glencore (OTC: GLNCY) 28 million tons

Data source: Southern Copper investor presentation. Note: Reserve data as of Sept. 5, 2019. 

While all five of these companies produce significant amounts of copper, only Codelco, Southern Copper, and Freeport-McMoRan make most of their money on this versatile metal. BHP Group and Glencore, on the other hand, are much more diversified miners. Because of that, BHP's largest profit contributor was iron ore in 2018 at 39% the total while Glencore's top earner was coal at 33% of the total that year. 

Stacks of copper cathode.

Image source: Getty Images.

Key industry metrics

Investors who are interested in the copper mining sector need to learn several key terms to better understand the industry. Here are five of the most important ones to know:

Ore grade: An ore grade measures the percentage of copper oxides or sulfides in a rock. A commercial copper deposit will usually contain between 0.5% to 1% copper ore as well as other metals and such as gold, silver, molybdenum, lead, and zinc. While higher ore grades typically suggest a mine is more valuable, that's not always the case. That's because ore type (oxide vs. sulfide) and consistency of the resource also factor into a mine's ability to produce economically viable copper.

By-product credits: A by-product credit is a cash payment that a mining company receives for producing another metal as a by-product of mining its primary target. For example, most copper mines contain small quantities of other raw minerals that a miner will sell to another company for processing. Southern Copper, for example, produces zinc, silver, and molybdenum at its copper mines. It sells these raw products to help offset the cost of producing its primary target, which in this case is copper.

Net cash costs per pound: This metric measures what it costs a miner to produce a pound of copper after factoring in the benefits of the by-product credits. For example, it cost mining giant Freeport-McMoRan $2.05 per pound to produce copper out of its North American mines in 2018. However, because these mines also produced some gold and silver, Freeport-McMoRan was able to sell those precious metals in their raw form to other miners for processing. The by-product credits it received from those sales helped reduce its net cash costs by $0.26 per pound to $1.79 per pound of copper, thereby improving the profitability of its mines. In the 2018 to 2019 time frame, copper traded at an average market price between $2.50 and $3 a pound.

EBITDA: EBITDA is an acronym that stands for earnings before interest, taxes, depreciation, and amortization. It's a non-GAAP metric that measures an asset's underlying earnings. Miners highlight this metric because they often record large depreciation expenses as they deplete the reserves of a mine, which reduces their net income. Southern Copper, for example, reported $1.5 billion of net income in 2018, which was well below the $3.6 billion of EBITDA it produced. One of the factors causing that difference was that it recorded $674 million of depreciation, amortization, and depletion expenses that made it seem like the company made less money than it actually did that year. 

Debt to EBITDA: This ratio measures how much debt a company has compared to its annual earnings. Ideal debt-to-EBITDA ratios vary by industry. Miners typically like to have this ratio below 1.0 times due to the volatility of commodity prices. 

Headwinds facing the copper industry

Copper demand tends to be economically sensitive since it's a key material in the construction industry as well as for consumer goods like cars and electronics. Because of that, when the global economy slows down, copper demand follows suit, which also weighs on pricing.

The Chinese economy is particularly important to the copper market since it was the largest copper consumer in the world at 49% of the total in 2018. Thus, when China's economy slows, it can have a significant impact on copper prices. That's why inventors who are interested in the sector should keep an eye on things that could impact this economy, such as trade disputes with major partners and slowing export growth.

Another major issue facing many mining companies is labor unrest. The copper mining sector alone had six notable work stoppages in the decade from 2009 through 2019. Chilean copper giant Codelco, for example, had production at its key Chuquicamata mine disrupted for two weeks in 2019 after workers at the site went on strike. This dispute was over pay and the start-up of a new underground section at that mine. The state-owned company had to increase wages and other benefits to get workers to approve a deal. As a result, the strike cost it money not only during the production curtailment from the work stoppage but also after that from the higher labor costs. Because of how much these disputes can impact miners, investors should look for miners with a history of positive labor relations.

Governments play a key role in regulating the mining industry. That authority helps keep mining companies in check so that they don't destroy the environment or exploit the local population. This government oversight can also be an issue for mining companies. That has been the case for Freeport-McMoRan in Indonesia. For years, the company had controlled the Grasberg mine, which contains one of the world's largest copper and gold deposits. The government, however, wanted that strategic natural resource under state control. After years of disputes and production stoppages, Freeport ultimately agreed to sell a majority stake in the mine to a local company. Given the potential issues with government intervention, investors should look for miners that focus on regions where there is a clearly defined regulatory framework to operate within.

With copper demand expected to rise, the industry needs to invest in increasing its capacity. But building new mines is costly, with Freeport-McMoRan estimating that a greenfield project requires copper prices in the range of $8-$10 a pound to be economical. That's due to the massive up-front investment in infrastructure, permitting, and equipment required to bring a new copper mine on line. Therefore, the industry won't be able to greenlight very many major new mine developments until copper prices improve to the needed levels, and its main focus will be on expanding existing mines, which somewhat limits the sector's growth prospects.

Copper mining requires lots of water to turn oxide ores into cathodes. However, due to environmental concerns, miners are facing increasing pressure to reduce their fresh water consumption. Consequently, they have to recycle water and invest in desalinization projects to use more salt water, which add to mining costs.

An open-pit copper mine.

Image source: Getty Images.

Tailwinds benefiting the copper sector

Global copper demand is expected to increase from 23.6 million tons in 2018 up to 29.8 million tons by 2027 -- according to an outlook by Fitch Solutions -- implying 2.6% annual growth. Driving that forecast is the anticipated increased consumption of copper by the power industry (especially in China), the rising adoption of electric vehicles, and the overall positive outlook for the global economy. As copper consumption continues growing, it will drive the need for expansion projects in the copper mining sector, which enhances the growth prospects of producers.

While copper consumption is growing, supplies haven't been keeping up due to underinvestment in new mining capacity. Because of that, Fitch and other analysts expect that the copper market won't have enough supply to meet demand through at least 2021. That should help boost prices to incentivize miners to invest in new copper expansion projects to meet long-term demand growth.

Opportunities in the copper industry

Copper is an essential component in vehicles. The average car with an internal combustion engine has nearly a mile of copper wiring and a total of 44 pounds of the metal in car components like the motor, radiator, brakes, and bearings. However, it's even more vital for electric vehicles (EVs). The average hybrid, for example, has almost double the amount of copper while battery-powered EVs have nearly four times as much -- a regular EV charger has about a pound and a half of copper in it.

The International Copper Association already assumes that demand for EVs will rise in the coming years, taking copper consumption with it. In its view, there will be 27 million EVs on the road by 2027, up from 3 million in 2017. That should boost EV-related copper demand from 185,000 metric tons in 2017 up to 1.74 million metric tons in 2027. However, if the adoption of EVs accelerates at a faster pace than currently anticipated, it would drive even greater consumption of copper in the future.

Copper is also a vital component in renewable energy, which is good news for the mining industry since these systems use more of the metal than traditional energy sources. One wind farm, for instance, can contain between 4 million and 15 million pounds of copper for things like wiring, bearings, and mechanical parts. Meanwhile, large-scale solar projects and energy storage systems can contain thousands of pounds of copper. With climate change concerns driving increased investment in renewables, demand for copper from the sector could grow at an even faster pace than currently expected in the coming years.

Risks of investing in the copper industry

Copper is a commodity business, meaning companies make money on the difference between the cost of producing a pound of copper and its market price. This price can be highly volatile, with it often moving sharply lower on the hint that consumption could slow down due to a weakening global economy. As the following chart shows, the price of copper has bounced around quite a bit in the decade from 2009-2019:

Copper Price Chart

Copper price data by YCharts.

That volatility can have a significant impact on the cash flow of copper-producing companies. Freeport-McMoRan, for example, noted in early 2019 that every $0.10 per pound change in the price of copper from its $2.75 a pound assumption would impact its full-year cash flow by $315 million. That's significant for a company that expected to produce $1.8 billion in cash flow for the year. If copper, for example, averaged $2.65 per pound, the company would haul in only $1.5 billion in cash. That wouldn't be enough to cover its $2.4 billion of planned spending on mining projects for the year. Because copper prices have such an impact on producers, investors need to focus on the lowest-cost miners since they should still make money during weak markets.

The mining industry is very capital-intensive, which means that companies need to continually invest money to maintain their existing mines as well as build new ones. That's because their copper reserves gradually deplete as they produce from a mine. As Freeport-McMoRan's spending shows, capital expenses can outstrip cash flow when copper prices are low. So, mining companies often need to borrow a significant amount of money to make ends meet. This debt can prove problematic when industry conditions deteriorate. That was the case for Freeport-McMoRan in 2015 and 2016, when slumping oil and copper prices cut into its cash flow. That forced the company to suspend its dividend and sell assets so that it could pay down the debt it took to expand when market conditions were more favorable. Because debt can be such a big issue, investors should avoid copper miners that have high leverage ratios and a history of heavy borrowing to fund growth.

Aside from investing in expansion projects, the other way copper mining companies expand is through acquisitions. Many, though, have chosen to diversify outside the copper sector so that they could grow earnings at a faster pace. Both Freeport-McMoRan and BHP Group, for example, made deals in the oil and gas sector. Unfortunately, those transactions have proven disastrous. In Freeport's case, it spent $20 billion to buy oil and gas properties in 2013. Two years later, it wrote down their value to a mere $3 billion, incinerating $17 billion of shareholder value. It eventually exited the oil and gas sector to pay off debt and refocus on copper mining. BHP, in the meantime, spent $20 billion on oil and gas properties in the U.S. in 2011. It subsequently sold those assets for $10.8 billion in 2018 and returned those proceeds to shareholders. Given the sector's poor acquisition track record, investors should review a proposed merger with a very critical eye.

Ways to invest in the copper sector

Copper is a crucial metal to the global economy. Because of that, demand for it should grow over the next several years as the economy expands. Meanwhile, adding to the sector's growth prospects is the accelerated adoption of both renewables and EVs, which use more copper than traditional means. That makes copper a unique way to invest in renewables. This growth has the potential to drive up the price of copper. That should boost the profitability of copper producers, which should help bolster their share prices.

However, given all the sector's headwinds and risks, investors need to carefully consider prospective copper investments. First, though, they must determine whether they want to invest in a pure-play copper producer such as Freeport-McMoRan and Southern Copper, a more diversified miner like BHP Group and Glencore, or an exchange-traded fund (ETF). While there are some small ETFs that focus specifically on copper, most are more broad-based across the entire mining industry. 

Those who want to invest directly in shares of a copper-producing company should look for one that has high-quality resources with low production costs and a strong balance sheet with a low debt level. That it will enable these producers to make more money during periods of higher copper prices, which increases their upside potential. Another factor investors should consider is a copper company's growth prospects. Southern Copper, for example, expects to more than double its copper output from 2018's level by 2026. Because of that, it has much more upside to the growth of the copper market than Glencore. That's because the more diversified miner only sees its copper production growing at a 3% annual rate from 2018 through 2021, which is a slower rate than most of the other metals it produces.

Given the differences between copper producers, investors need to dig deeply into the financials before buying shares of a copper stock.   

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Matthew DiLallo owns shares of BHP Group Ltd. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com