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Copper - Leading Indicator



NOTE: Also included is an option play on FCX.

copper

Introduction

Obviously copper is a base metal BUT it is also important as it is classed as one of the most accurate leading indicators of global growth and especially producer sentiment in emerging markets. That’s why the dour outlook from mining heavyweights in recent days is such a cause for concern. Rio Tinto (RIO), Cargill, and Codelco have all provided warnings about weakening demand as their customers seek to delay shipments.

Traders and investors constantly search for leading indicators in the market to gain an edge in money management. Most trading platforms offer a ton of indicators and oscillators but they are best lagging indicators that show excellent entry points after price has moved away. But intermarket comparisons can often provide an insight to future price action.

Copper and Its’ Effects on Economic History

history of copper mining

For decades, copper has served as an effective barometer of the economic health of a region. This amazing consistency of ability to gauge a realistic prognosis of an area’s economic vitality is precisely why financial experts have traditionally referred to copper as “Dr. Copper!”

Copper is a relatively inexpensive and extremely plentiful metal with numerous useful properties. It effectively resists corrosion and is a very effective conductor of both electricity and heat.

Picture: Burra Mine, South Australia, 1857

This quite naturally makes copper a prominently relied upon and utilized “center piece” of any emerging or expanding industrial economy. From electrical wiring to plumbing, from radiators to air conditioners, they all require the services of Copper.

Now, we aren’t just talking “Dr.” as in “medical practitioner” bringing health and vitality to the region, but also using the term “Dr.” to refer to an educated “doctorate” or Ph.D. in economics!

You see, consistently throughout the decades and across the entire globe, one can very effectively see precisely where we all as a whole, and any particular country is heading economically, simply by watching the price and what they are currently doing with copper.

This is because copper is such a greatly relied upon, highly valued and widely utilized metallic element within every aspect of a society undergoing a serious growth phase and process of advancing toward a more “state of the art” existence.

This means whether you’re talking about massive construction projects, infrastructure renewal, telecommunications modifications, medical, technological and /or energy option exploration and research, if it’s happening, then “Dr Copper” is heading up the surgical team at work!

Over the past century, just “industrial” demand alone for refined copper has increased from 500,000 metric tons to over 19 million metric tons. As our increasingly smaller world continues to experience population growth along with progressive expansion, the demand for copper will exponentially increase.

The dramatic rise in need for copper will naturally increase the demand for new mines and processing plants, as current facilities are upgraded and expanded. As those “less developed” regions begin to expand their infrastructures, copper naturally serves as the most reliable building block” from which to build a new civilization and improve upon average living standards. A perfect example is what we have been observing in the recent Chinese construction boom!

Demand for copper has been surging in China. How that fact might affect prices of the metal is another story.

The metal, dubbed “Dr. Copper” for the apparent ability of its price to forecast global industrial activity, has gone on a ”volatile ride” over the past year — not surprising amid will-they-won’t-they budgeting in Washington, default fears in Europe and Middle Eastern turmoil.

China is the biggest buyer of copper, but looking at the country’s sustained high level of economic growth isn’t making it any easier to predict what will happen with the metal.

At Present

The outlook on commodity demand and especially copper has shifted from positive to vaguely negative over the last several weeks. Price action has been decisively bearish, with December copper futures closing Tuesday down 17% from their recent July highs.

HG December Copper Futures

HG December 2011 Copper Futures. Source: Interactive Brokers



The fundamental situation at the moment seems to be that demand is holding steady in Asia, but is moderating everywhere else.
bhp billiton-copper mining

As China keeps popping up new empty metropolises, it will still need more iron and coal and copper, so diversified miners like BHP Billiton (BHP) and Vale (VALE) are probably better positioned than some of their peers.

Picture of a BHP Billiton Copper Mining Operation

But Freeport-McMoRan (FCX), for example, is a purer copper play. Never mind the gold mines: on a daily basis, the FCX one-year rolling correlation to JJC averages 0.80 – 0.95. FCX fell 4% on Tuesday and is trending steadily lower.

FCX Chart

FCX: Daily Price Chart and Copper Correlation. Source: Amibroker



Even with copper prices down so much, it is still not too expensive to get bearish here, considering that the 60-day historical volatility is around 48%, November at the money options are priced at about the same implied volatility level. And the skew between November and January is very flat.
FCX Volatility Skew

FCX: Volatility Skew. Source: Livevol



Action to Take

Let’s put on a short-time spread to profit from large price swings in the short-term as the copper outlook remains uncertain. By buying the November puts, we get to own exposure to October earnings at reasonable prices. Our risk profile is like a long straddle, so we want FCX to stay volatile.

Conclusion

It is important to remember that tracking copper to win in the equity markets is not the secret formula for success and it may not work in future.

But, even as one of the most reliable indicators of the global economy, be wise and remember the old adage, “what goes up, must come down!” Copper is famous for doing precisely what the economic conditions are doing all around it, so when things are financially great, copper is way up and soaring with the eagles.

There are no secret formulas to succeed in the markets and players have to adapt constantly to the changes the market throws at them.

”Success is simple. Do what's right, the right way, at the right time.”





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