Friday, November 13, 2015

Southern Peru Copper

Post Number 7 - Southern Peru Copper

I said in the last post that I was going to start a series on the milk and egg markets, both of which have some interesting prospects. But I've gotten several emails asking me to spend some time on more specific trades. So I've added a new page about the trades I actually have on. You can get to it from the right hand side on this page. Here's one that I have on now...

One commodity strategy that has proved profitable over the years is to buy the low cost producer during the down part of the cycle. This is a highly contrarian trade for two reasons. First, all producers will be doing badly when prices of their product are low. Second, P/E ratios are normally very high since earnings are so low. The key is being able to wait out the cycle and eventual high returns.

But not all producers are able to wait it out. Some will go broke. Others will survive but have to have severe recapitalizations. That's the reason I like the low cost producers. Normally they will continue to make some profit even in the lean years. So their chances of survival are high.

So let's talk about copper. Prices are down from their highs, but still not extremely cheap. Here's the graph I introduced in Post Number 2, but for copper only:

Remember the x-axis is the deflated price going back to 1980, and the y-axis is the ten-year forward return. (If you are unsure about the graph, I explain it in detail in Post 2.) The red line is where the price is now. So the model is forecasting a return of 0.75, or a (25)% loss. Using a multi-factor model, the ten year return is (15)%. Still bad.

Now the stocks of commodity producers often bottom before the commodity itself. This is because the producers have the ability to cut costs and run lean. So they can make do even in poor markets. Along this line I want to be involved in the lowest cost major copper miner. Here is a list of costs I got from various annual reports:

Company           Ticker    Operating Cost/Lb.
Southern Peru    SCCO     1.06
Freeport             FCX        1.52
Rio Tinto           RIO         NA
Billiton              BHP        1.13
Codelco                             1.35
Antofagasta      ANTO     1.40
Quantum           FM          1.40
Anglo Amer      AAL        NA

These numbers are mine from various sources. SCCO is the lowest cost major. It is also close to a pure copper play.

So this is a dilemma. I'm still bearish copper, but I like the company. Sounds like a spread trade to me!  Here's a graph of the spread at aproximately one to one value ratio of stock to copper.

(Apologies for the poor graphic; I was in a hurry and just lifted it from my trading platform. I usually prefer to do stats and graphics in R even tho it takes a little work.) The point is that this looks like it has gone parabolic since 2014. Actually, the scale is pretty tight, and I think it has a ways to go yet.

One more thing: if you are willing to pay some more in trading costs, you can look at the SCCO junk bonds instead. These are yielding 7.4%. Of course their delta to copper prices is a little less, so you wind up shorter copper.

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