Emerging Markets Slow

In These Interesting Times, Use Economic Ju-Jitsu to Make an Outsized Profit

Freedom Financial Archive | Originally posted Jan 14, 2023
  • Even though the economy is slowing down, we’re short important metals.
  • Copper and aluminum are critical base metals we need to build stuff with.
  • Greenwashing, ESG, and coal: it’s time to use economic ju-jitsu to make an outsized profit with this month’s opportunity.

Perhaps you’ve heard of the old Chinese curse, “May you live in interesting times.”

It’s a polite-sounding way of wishing someone chaos in their lives. Ah, the Chinese even mastered verbal misdirection. Sun Tzu must weep with pride from the Great Beyond.

Well, how’s this for interesting times?

On the one hand, we’re living through a phase where we’ve got weakening demand as a global recession kicks off.

On the other hand, the world is also increasingly short supply in some key commodities.

Usually when you’ve got weakening demand, you have a surplus in commodities. Not a shortage.


Why on earth is this happening?

Before I answer that question, let me lay out the characteristics of one of those metals we’re short of: copper.

A Penny for Your Thoughts

Copper is one of those metals we intuitively understand. It's important for everything we build.

But rarely are those important reasons spelled out.

I don’t mean to patronize you at all; I just want you to have this information in one place.

Copper is an important metal because it’s an excellent electricity conductor. It’s also a good heat conductor, which makes it useful in a variety of applications. Copper is also corrosion resistant.

Think ductile, one of my favorite 50-cent words. Copper is ductile, in that it can easily be drawn into wire without breaking. It can also be molded into various shapes, making it useful in a wide range of products.

Copper is an essential trace element for many living organisms, including humans.

That’s all well and good, but how about copper’s industrial uses?

Let’s list them out:

  1. Electrical wiring: Because copper is an excellent electricity conductor, which makes it the preferred choice for electrical wiring in homes, businesses, and vehicles.
  2. Building construction: Copper is often used in roofing, flashing (a strip of metal that stops water penetration), and gutters for buildings. It’s also used in the construction of plumbing pipes and fittings.
  3. Industrial machinery: Copper is used in a variety of industrial machinery, including motors, generators, and transformers.
  4. Transportation: Copper is used in the production of cars, trains, and airplanes. It’s used in the manufacturing of motors, brakes, and electrical systems for these vehicles.
  5. Renewable energy: Copper is used in the production of solar panels, wind turbines, and hydroelectric power plants.
  6. Telecommunications: Copper is used in the production of telecommunications equipment, including wire and cable.
  7. Electronics: Copper is used in the production of a wide range of electronic products, including computers, smartphones, and other consumer electronics.

How important is copper?

Copper is one of the pivotal base metals – perhaps the pivotal base metal – the average person takes for granted. In fact, John Q. Average may know nothing of the importance of copper to his everyday life.

As we’ve laid out, companies use copper in everything from electrical wires and generators to everyday appliances.

And with that, copper is also one of the most important ingredients for the green transition. That’s thanks to the huge amount of copper electric vehicles, wind turbines, and solar farms consume.

But, funnily enough, some of the countries responsible for mining copper have reduced mining activity because of the ESG implications.

But First, A Word on ESG

I’m not the biggest fan of ESG. But just to make sure we’re all on the same page, let’s define the term.

ESG investing refers to the practice of considering environmental, social, and governance (ESG) factors in investment decisions. These factors can include issues such as climate change, labor practices, and board diversity, among others. Investors who focus on ESG factors believe that these considerations can lead to better risk management and long-term performance.

ESG investing can influence how companies operate in several ways. For example, companies may choose to adopt more sustainable practices in order to attract ESG-conscious investors. They may also be more transparent about their ESG-related activities, in order to appeal to these investors.

Additionally, companies that perform poorly on ESG metrics may face reputational risks, which can affect their bottom line.

Overall, the influence of ESG investing on company behavior is likely to vary, depending on the company and the specific ESG factors at play. However, as interest in sustainable investing continues to grow, it is likely that the influence of ESG considerations on corporate behavior will increase.

ESG investing also known as sustainable, socially responsible, or impact investing.

Essentially, the countries producing copper say it isn’t environmentally friendly to extract it from the ground. One of (if not) the most important raw material for the energy transition has been deemed unclean.

The Two Critical Metals

Two of the most important materials in these conversions are aluminum and copper, both of which consume a significant amount of electricity and diesel to extract from the ground and process.

The below chart helps put into perspective just how important each commodity is for the energy transition to take place:

Before I go any further, let me also lay out why aluminum (aluminium, if you’re in the UK, of course) is critical to our overall economy.

It’s Not Just About Reynolds Wrap

Aluminum is an important material for a number of reasons. 

It’s lightweight, strong, and corrosion-resistant, making it useful in a wide range of applications. It’s also a good conductor of electricity and is widely used in the construction of electrical transmission lines.  

Aluminum is also widely used in the construction of airplanes, automobiles, and other transportation vehicles, as well as in packaging materials and consumer products. 

In addition, aluminum is widely used in the construction of buildings and infrastructure, such as bridges, because of its strength and durability. 

Some of the largest industrial uses of aluminum include: 

  1. Transportation: Aluminum is widely used in the construction of airplanes, automobiles, and other transportation vehicles because it’s lightweight and strong.
  2. Packaging: Aluminum is often used to make packaging materials, such as beverage cans and foil, because it’s an excellent barrier to light, air, and moisture, which helps to preserve the quality of the product.
  3. Construction: Aluminum is used in the construction of buildings and infrastructure, such as bridges, because of its strength and durability.
  4. Electrical transmission: Aluminum is a good conductor of electricity and is widely used in the construction of electrical transmission lines.
  5. Consumer products: Aluminum is used in a wide range of consumer products, including appliances, sports equipment, and furniture.

Ok, now that we’ve got ourselves caught up on both copper and aluminum, let’s return to the issue of ESG and how it’s interfering with the metals’ extraction.

Greenwashing, China, and Coal

Here’s where it gets idiotic: our reliance on China increases even more because of their responsibility for refining the raw materials.

This is a perfect example of greenwashing.

Greenwashing is the practice of making false or misleading claims about the environmental benefits of a product, service, or company. Companies use it to give the impression that they are more environmentally friendly than they really are, to appeal to consumers who are concerned about the environment.

Here’s how it works in this case: we extract the raw material in an emerging market like Chile and have it sent to China to be processed.

About 65% of China’s grid is powered by coal. For context, China’s use of coal for power would be enough to cover the full electricity needs in the U.S.

Essentially, China is using fossil fuels and “less than desirable” methods to process raw materials.

This enables to green transition companies to buy the intermediary goods and claim use them to create green products.

If we do cradle to grave analysis, I think we can all agree that many of these products are far less “green” than the marketing would imply.

Chile and the Copper Supply

Chile is one of the most important countries in the world when it comes to copper production. It’s the largest producer in the world, but Chile’s current government is looking to curb investment and expansion of production.

Even as the world slips into a recession, we still need raw materials for our everyday lives.

So far, governments around the world are increasing subsidies for green technology and supporting the energy transition. This will provide a strong tailwind for long term demand for key raw materials, such as copper and aluminum.

The slowdown in housing is an important headwind that can’t be ignored because it’s also a huge consumer of raw materials.

But, even with housing slowing, storage of these key commodities is at multi-year lows.

The below chart puts into perspective just how low the world is in copper inventories.

It’s important to consider that copper inventories have dropped through a floor even as housing and manufacturing has slowed considerably. There is still some active demand from housing because we still have a significant amount under construction, which has helped maintain demand even as new permits have fallen through a floor.

The problem is this: even as demand slows, we’re getting a huge move down in supply. Chile is the largest producer of copper in the world, but they are currently producing at the lowest level going back to 2013. (The thick blue line is 2022, which is far below most years’ production.)

When we factor in slow production and multi-decade lows in global inventories, there’s going to be a lot of pricing support even in the face of a recession.

There are still homes to be built.  A record number of houses remain under construction, and we still have a record amount of 5+ multi-family buildings still being built.

We expect this to be near term support. But as the homes are completed, we don’t expect terrible data going forward.

But as production remains low and global storage is at the lowest level since 2010, there is a lot of stability in current commodity pricing.

As headwinds grow for new mines, it makes the current ones all that more important and valuable.

And who better to capture the upside than Freeport-McMoRan (ticker: FCX)?

The Opportunity: FCX

They own and operate some of the largest mines in the world. FCX spans the globe with activity in Peru, Chile, Indonesia, and the U.S.

The mines in South American and Indonesia are some of the largest in the world, which provides diversification while capturing upside.

Energy infrastructure around the world is a shambles, with shortfalls and aging assets around the world across all facets of our everyday lives.

We’ve seen firsthand the issues with our grid and available dispatchable electricity.

Any of the solutions from new natural gas-fired to wind turbines all require a significant amount of copper.

Countries will also need to run new power lines, which are… you guessed it… FILLED with copper.

We’ve ignored our aging infrastructure for decades, and it has to be addressed today.

The “Inflation Reduction Act” (which will do everything except reduce inflation) and the “Build Back Better” bill haven’t even begun to deploy cash into the U.S. markets.

This will provide another tailwind for spending across various green initiatives and other infrastructure projects that all consumer a significant number of base metals.

FCX is very closely tied to the value of copper from an EBITDA and cash flow perspective. Even in a recession, there is a lot of staying power in copper’s price. In the chart below, you can see FCX’s EBITDA and cash low sensitivity to copper’s price. In this environment, we think this is a massive positive.

As grids around the world are expanded, repaired, and rebuilt, copper will be at the forefront of the boom.

Let’s here from Richard Adkerson, who’s been Freeport’s CEO since 2003in the Q3 2022 earnings call:

Global Copper inventories remain at historical levels. You see production reports from producers across the globe, reporting challenges in meeting their production targets. And the industry is facing increasingly challenges in developing new suppliers. In the current environment, stretch supply chains, production shortfalls are becoming commonplace and cost curves are rising.

Balance Sheet Repair and Return to Rude Health

The company has also been deleveraging, which is a great time to manage debt maturities and avoid the need to issue new debt.

There is nothing better for long term growth than a “balance sheet repair story.” Freeport has been cleaning up its balance sheet while deploying capital strategically to grow production in favorable locations.

From the above snapshot, FCX retired $1.1 billion worth of senior notes at a 5% discount to par, saving about $50 million annually in interest payments.

FCX also has about $8.6 billion in cash and cash equivalents, while carrying a total debt load of only $10.7 billion. That means its net debt (debt minus cash) is only $2.1 billion.

That gives FCX a net debt-to-EBITDA ratio of only 0.2x.

The net debt-to-EBITDA ratio is a debt ratio that shows how many years it would take for a company to pay back its debt if net debt and EBITDA are held constant.

In plain English, FCX would only need about two-and-a-half months to pay back its debt.

This is self-evidently good. But for reference, when that ratio hits 4 or 5 (years), then investors start to worry.

Other Geopolitical Advantages

Freeport is in an ideal position to benefit from the electrification push around the world, and the focus on building new infrastructure.

They are in the right place, at the right time, with the right assets to benefit from a steady rise in copper prices. Low inventories, steady and rising demand, and limited global production puts them in a fantastic position.

FCX is also deploying new technology to increase recoveries while managing their carbon footprint:

Another exciting area that we wanted to talk more about … is our leach innovation initiatives. This is really focused in the Americas and our drive for capturing higher recoveries from leach stockpiles is gaining a lot of momentum. The economics of this opportunity are extremely attractive, very low capital intensity, low incremental operating costs, low-carbon footprint, the lowest-cost copper units in our Americas portfolio. And the carbon intensity is low because the mining costs have already been incurred. And so, essentially, we're doing here is extracting more copper from what historically would be considered waste.

The growing demand for copper in the U.S. will make this a huge win over time with fantastic paybacks for invested capital.

Geopolitical risks also play well into Freeport’s hands.

Vale is facing uncertainty with President Lula back in power, and other uncertainties facing Rio Tinto and BHP with their exposure to Russia. The Russia-Ukraine situation complicates the mining and refinement of many raw materials, which is something that FCX has the luxury of avoiding. But the shortfalls created by the Russian war and geopolitical uncertainty provide a strong pricing backdrop that they can capture.

Copper prices are kicking off the year with a bang. While there are obvious headwinds, the medium to long term trend is moving in their favor.

Freeport management is very aware of the headwinds ahead:

The macroeconomic sentiment continues to be weak, and you all see that in your everyday lives. On the other hand, the fundamental physical copper market is strikingly tight, globally right now. The macroeconomic situation is driven by the strengthening US dollar, the Fed and Central Banks tightening, concerns about China dealing with COVID in its property section and then the serious problems in Europe coming out of the Ukraine situation, and how that's affecting energy prices and economic outlook.

China is in the process of reopening.

Even though it will be well below market expectations, it still provides a positive tailwind for production.

As China reopens it will help offset slowdowns in the ASEAN nations which has started to pick-up steam.

Just China moving back to a more “normal” operation versus strict lockdowns will provide a boost to demand. It won’t be huge given the global recession, slowdown in trade, and their housing issues.  But they will have to purchase new supplies to get factories back to somewhat normal operations. This will help put a floor in pricing even as manufacturing worsens in other areas of the world.

All-in-all, FCX will benefit from a stable pricing environment with more upside as the electrification and rebuild of global infrastructure forges ahead!

Our Recommendation

***BUY FCX up to $45.50***

If the governments, NGOs, and ESG investors want to make our lives miserable, let’s use their momentum to slingshot our way to massive profits.

Kind regards,

Freedom Financial News