copper review 2008

8/9/2019 Copper Review 2008

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Paradigm Capital Inc, IIROC/TSX Member 1 September 24, 2008David Davison, Analyst 416.360.3462Jacob Willoughby, Analyst 416.361.9557Michael Bandrowski, Associate 416.360.1397

A s w e c l o s e o u t 2 0 0 8 , t h e c o m m o d i t y a n d e q u i t y m a r k e t sremain very uncer t a in and very vo la t i l e , d r iven by the ongoingconcerns o f the fa l t e r ing U.S . economy and the g loba lf inanc ia l c r i s i s .

M o s t b a s e m e t a l s a r e u n d e r v a l u e d r e l a t i v e t o t h e c u r r e n tsupply /demand s i tua t ion a l though in the case o f copper the rer e m a i n s a s p e c u l a t i v e e l e m e n t t h a t h a s a l l o w e d i t t oo u t p e r f o r m i t s p e e r s .

We se e s h o r t t e r m r i s k t o t h e p r i c e b u t t h e l o n g e r t e r m t h e s i sremains essen t ia l ly in tac t . The copper equ i t i es haveo v e r r e a c t e d o n t h e d o w n s i d e p r e s e n t i n g s o m e c o m p e l l i n gi n v e s t m e n t o p p o r t u n i t i e s.

Global Economic Overview From Confusion Comes OpportunitySince our July base metals update, the U.S., European and Chinese economieshave all been scrambling to curb the current economic downturn. The FederalReserve has been busy trying to calm the financial markets. In an effort to ensurefinancial soundness the Federal Reserve placed mortgage lending giants FannieMae and Freddie Mac under federal protection. Last week it also threw AIG a $85billion life line and injected $55 billion into the US capital markets. Merrill Lynchwas recently engulfed by Bank of America and Lehman Brothers has just filed thelargest Chapter 11 in US history. In addition, global stock markets have beensubject to drastic declines including the Russian exchanges which saw the headsof the Russian central banks suspend trading due to a 20% slide, primarily due tosinking oil prices and declining money markets. The recent $81 rise in thebenchmark U.S. gold contract for December delivery was gold's biggest one-dayrise in absolute terms since 1980 and the biggest one-day percentage gain for goldfutures since February 2000. The global economy is stuck between slowingdemand in developed economies and rising global inflation, particularly in emergingeconomies. Many economists expect global growth to decelerate through 2008 andslowly recover through 2009. Currently, inflationary pressure has put addedpressure on policy makers as they try to avert the risk to growth. It is now quiteclear that the US economy has dragged down the rest of the developing world. Asfar as the metals are concerned, 2007 and the first half of 2008 was a recessionyear in the U.S. with demand being negative for the first time in five years. Asia, inparticular China, has been the engine of global economic growth since 2001,averaging in excess of 10% for the past five years. There are legitimate concernsabout how sustainable this growth is as the Chinese government attempts tostimulate the economy after the manufactured Olympic slowdown. Most forecastersexpect China to have slower growth but still maintain high single digit GDP growthfor the next 2-3 years; long enough to see us well through the balance of themetals bull market. Europes economy continues to churn sideways with exportsslowing considerably over the past quarter. Japan has begun to give indications ofweaker growth due to reduced U.S. exports.

Copper Companies CoveredName Target Rec.African Copper $1.50 Buy

Anvil Mining $19.00 BuyChariot Resources $1.75 BuyEquinox Minerals $5.50 BuyFirst Quantum $82.50 BuyKatanga Mining $20.00 BuyLundin Mining $10.00 BuyMarengo Mining $1.05 BuyNorsemont Mining $6.00 BuySherwood Copper $7.75 HoldTaseko Mining $8.00 BuyQuadra Mining $32.00 Buy

Research Team

David Davidson Analyst 416.360.3

[email protected] WilloughbyAnalyst 416.361.9

[email protected] BandrowskiAssociate 416.360.1

[email protected]

Sales

Toronto 416.361.1Calgary 877.513.1

Paradigm Capital research is available on First Call,Reuters or at www.paradigmcap.com

Refer to last page for official disclaimer

Issued by Paradigm Capital Inc.

Base Metal Sector Copper Overview

Copper Price Defying Gravity ?


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Figure 2: Copper Price Indexed in Major World Currencies

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Source: Paradigm Capital, Bloomberg

China The Copper DragonChina continues to be the primary engine of global economic growth and mostforecast much the same, albeit at a slower pace, for the foreseeable future. In 2007Chinas GDP growth accounted for approximately 15 - 20% of the worlds total andapparent copper consumption is expected to reach almost 5 million tonnes annuallyin 2008, or approximately 25% of the global total. China also represents nearly 75%of the annual demand growth in the copper market of approximately 600,000 tonnes.China surpassed the United States as the largest consumer of steel, coal, copper,and iron ore in 2002 even though the per capita intensity of use is still very low, SeeFigure 3. Exports still drive the economy of China but evidence suggests thatdomestic consumption is increasing dramatically with most of it directed toinfrastructure. How China will cope with the post Olympic hangover is the biggestquestion on peoples minds. China has recently announced its first interest rate cut insix years and has indicated that more cuts can be counted on if growth drops toorapidly. If there is one country in the world that has the resolve and the capital tostimulate growth, it is China. As most have realized of late, it may not be wise to betagainst her.


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Figure 3: Copper Intensity of Use

Pound per Capita Intensity

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Investment Themes Due for a ReboundThe past 12 months have been characterized by deteriorating trends in both thecommodity and related equity prices. However, since early summer we have enteredthe stage where extreme volatility has become much more prevalent. The recentprice movements in copper, gold and oil are evidence of the new environment the

markets will have to endure for the next several months. The longer termfundamentals still remain positive for most commodities if one subscribes to thetheory that China is not on the verge of economic collapse. Of the base metals,copper, while not immune to a bout of short selling, should lead the way as theinventory levels remains acceptable, and production is being hampered by capitalconstraints, natural disasters, strikes and political interference. Consequently wecontinue to recommend selectively buying a basket of copper stocks.

In Figure 4, we plot the TSE Metal and Mineral Index back to 1977 and it becomesquite obvious that we had a outstanding run of performance during this sixth majorbull cycle. After peaking at 23,990 in October 2007 the index has retrenched by 25%as of September 2008. We view this as more than just a normal correction but moreof a panic knee jerk reaction. While we do not expect to scale the heights reached inOctober 2007 we strongly believe that after the recent period of consolidation of theequities, we could see the market push to 22,000, up at least another 20% from thecurrent level.


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Table 1: Copper Supply, Demand & Market Forecasts (000s tonnes)

Source: CRU International, Paradigm Capital

While most observers fear a U.S. recession it is important to realize that as far asmetal consumption goes, the U.S. market has been in recession since 2007 with de-stocking in all parts of the pipeline. At some point manufacturers will restockproviding a significant shock to overall demand.

In Figure 5, we have provided the historical copper price plotted against the quarterending level of industry and exchange inventory expressed as weeks of consumptionin inventory. Currently, the market is at just over 3 weeks which is similar to last yearat this time. Looking ahead to the last half of 2008, we are forecasting essentially abalanced market and have inventories rising in 2009 on the back of a surplus of200,000 tonnes. The reader will notice the normal inventory level is dynamic and overthe past few years somewhat seasonal due largely to Chinas influence. Even withthe build in inventories the exchange level is unlike to increase significantly as mostof the inventory build will occur at the manufacturing level as the industry restocks.This should continue to provide good support for the copper price well into 2009. InJanuary we had forecast an average copper price of $2.95 for the year with anaverage of $3.25 in the first half falling to $2.65 per pound during the second half.The actual price for the first half of 2008 was $3.65. As expected prices started toerode during the second half but should average $3.35 for 2008 and $2.95 for 2009.

Copper - Supply, Demand & Market Balance Forecast (000s Tonnes)

2003 2004 2005 2006 2007E 2008F 2009FSupply Western World Refined Production 11,475 11,850 11,750

12,150

12,450

13,000

13,500

Annual % Change -0.6% 3.3% -0.8% 3.4% 2.5% 4.4% 3.8% Net East Bloc Exports (250) (250) (175)

(100)

(50)

(50)

(50)

Annual % Change -350.0% 0.0% -30.0% -42.9% -50.0% 0.0% 0.0% Total Western World Supply 11,225 11,600 11,575

12,050

12,400

12,950

13,450

Annual % Change -3.6% 3.3% -0.2% 4.1% 2.9% 4.4% 3.9%

Demand Western World Primary Consumption 11,000 11,504 11,750

12,200

12,650

12,865

13,250

Annual % Change -6.0% 4.6% 2.1% 3.8% 3.7% 1.7% 3.0%

Market Balance 225 96 (175)

(150)

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85

200

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2.8

3.5

Average Price (LME three month, US$/lb.) $0.81 $1.27 $1.67 $3.03 $3.22 $3.35 $2.95Price Year to Date (US$/lb.) $3.55

1 Difference = "Market Balance" - "Change in Stocks"; Reported stocks do not always represent actual stocks.2 Total Stock Ratio = "Total Stocks" / "Primary Consumption".

Source: CRU International, Paradigm Capital estimates


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Figure 5: LME Copper Inventories and 3 Month Copper Price

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LME Copper Inventory LME Copper Price

Source: CRU International, Paradigm Capital

To provide a back drop to our price forecasts we include the most recent forwardcurve compared to the forward curve as of July 2008 and the forward curve as ofOctober 2006, See Figure 6. Comparing the following forward curves suggest thefollowing observations. First, our metal price forecasts appear very conservative,particularly our long-term price of $1.75. Secondly, the forward curve is surprisinglyflat with the five year anchor price of $2.93. Thirdly, the change in slope for the pasttwo years suggests copper could flip into a five year contango, similar to whathappened to oil in late 2007. Whatever the outcome, professional traders remain verypositive on the long-term price.


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Figure 6: Copper Copper Forward Curve

Cu Forward Curve

$1.700

$1.800$1.900$2.000$2.100$2.200$2.300$2.400$2.500$2.600$2.700$2.800$2.900$3.000$3.100$3.200$3.300$3.400$3.500$3.600$3.700$3.800$3.900

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U S $ / l b Current Forward Curve

Oct 2006 Forward Curve

Jul 2008 Forward Curve


In Figure 7, we have provided the historical copper price plotted against the quarterending level of industry and exchange inventory expressed as weeks of consumptionin inventory. Currently, the market is at approximately 2.8 weeks. This compares to2.6 weeks last year at this time. Looking ahead to 2009, we are forecasting a modest

surplus and the weeks of inventory remaining at a historically low level of about 3.5weeks. We believe 5-6 weeks could be considered as normal and the copper marketcan function for a significant period below this level if there are no supply shocks. Thereader will notice the normal inventory level is dynamic. We believe it has declinedover time as a result of efficiencies in delivery and because just-in-time inventorytrends have become rampant as it allows for less capital tied up in inventories.


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Figure 7: Copper Price vs. Weeks of Consumption

Copper - LME Cash Price Versus Stock Consumption Ratio

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Copper Supply Can Industry Really Deliver?In previous cycles the industry was much more responsive to the market dynamicsand initiated new mine development fairly quickly after higher prices repairedstretched balance sheets. During this prolonged cycle balance sheets have beenlargely used to fuel a massive wave of consolidation in the industry. While it would bewrong to assume that there are few copper projects to develop, there is a large list,and their impact is expected to come later in the cycle which should continue tosupport the longevity of the current cycle. In Figure 8, we have projected theproduction of 35 higher profile new copper projects, each with greater than 100,000tonnes of annual capacity, likely to be in production before 2015. This new capacitycombined with existing mine expansions and the development of numerous smallermines could add approximately 7m tonnes to the world production base,approximately 35% cumulatively until 2015 or at an annual average of 4.5%.However, as illustrated in Figure 8, this increase is skewed to the back end of thetime frame, from 2013-2015. In our analysis we have assumed demand growth of 2%in both 2008 and 2009 increasing to average 3% over the time frame 2008 to 2015.This compares to a global demand growth rate of 3% from 2000 to 2007. Thiscapacity build is subject to many risks and uncertainties, not the least of which ispermitting, political risk, financing and sourcing the equipment and manpower to buildand operate the projects. Past experience suggests that at least 30 40% of thiscapacity can be expected to be either significantly delayed of not built at all. Oneother factor that comes into play is that the industry has become highly consolidatedand several of these billion dollar projects are owned by the same company. At lastcount, Xstrata was the proud owner of at least five of the top 35 projects costing inaggregate $16.5 billion. Building of all of these projects within the next six years? Nota chance!


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Figure 8: Copper - Supply/Demand Until 2015

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While the collective industry balance sheet remains extremely robust, and availablefor aggressive capital investments the availability of debt financing has been severelyconstrained due to the financial crisis precipitated by the sub prime debacle in theU.S. The capital cost required to build a reasonable size copper mine in 2007 hasnearly doubled in the past 5 years. This comes on the heels of rapidly escalating rawmaterial costs such as cement and steel, shortage of skilled labour, and higher front-end environmental outlays. A quick look at the financing requirements of the universeof mine under consideration, Figure 9, suggests approximately one third can be builtfor less the $9,000 per tonne of annual copper output. Another one third appears tohave capital estimates in excess of $12,500 per tonne, the balance in the range of$9,000 to $12,500 per tonne. For a company to obtain a 12% IRR on these projects,

which we believe is appropriate considering the financial, technical and political risk,infers the copper price need to obtain this return. For the lower cost third, thoseprojects below $9,000, a long term copper price of $1.75 per pound would perhapsbe adequate. However projects with projected capacity intensity in excess of $12,500would need a long term copper price in excess of $2.50 per pound, perhaps as highas $3.00 per pounds to realize an adequate return. Few companies, to myknowledge, use a copper price much in excess of $1.75 in their long term planning.Although we have seen tighter prices used in feasibility studies. BHP recently used$2.80 in a scoping study for Olympic Dam and Xstrata used $2.65 for the El Morrostudy. Consequently we believe that at least 30% of the projected mine increasesmay not developed due to marginal economics.


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Figure 9: Copper Projects

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If we recast our supply/ demand forecast out to 2015 but eliminated 12 of the mostcostly projects the large surplus projected in Figure 8 is essentially eliminated, SeeFigure 10. this may in fact be closer to reality than current market expectations.

Figure 10: Copper - Supply/Demand Until 2015 Eliminating 10 High Cost Projects

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The Market Doubting the Supercycle?How does this view of the copper market affect the copper-leveraged equities? Partof this has been the longevity of this cycle, longer than any in recent memories, and

the markets astute realization that a copper price well above the long-term trend lineis unsustainable forever. The key issues going forward are: what is the long-termsustainable copper price and how quickly the market factors in potential greenfieldproduction. On the former, the long-term copper price of $1.75 is more than realistic,but probably too low, in light of capital requirement to bring on new capacity.Additionally, the rebound of the Canadian and Australian currencies for the betterpart of this decade as well as inflationary pressures has contributed significantly tohigher and potentially stranded operating costs. Future brown-field expansionshowever, should be able to provide a significantly better return. Many projects waitingin the wings, such as Reko Diq in Pakistan, generally lack infrastructure or are facinggeo political challenges making it very difficult to obtain a decent return at or below acopper price of $2.00. We do not see copper dropping to the trend line until late 2010or early 2011. This will provide the industry with another three to four years of healthyprofitability. This added to the three great years to date will put this cycle in thehistory books.

SummaryNormally the market is much more generous with base metal equity valuations at thispoint in the commodities cycle than it is now. With the general equity marketsremaining in disarray and hedge fund managers under severe pressure it perhaps isnot surprising that fundamentals are taking the preverbal back seat. We believe thevaluation gap will be overcome and we still strongly recommend being selectivelyoverweight copper equities, at least until the summer of 2009. The party is not over,but some exhaustion has definitely set in. We believe a correction was long over duebut certainly underestimated the full extent. Many companies in the Paradigm Copperuniverse are trading below 75% NAV which is what the market values these

companies at during the trough of the market, when balanced sheets are bloated andeven good operations are losing money, and exchange inventories are as high asEverest. Considering the shell-shocked state of the market small cap companieseven with a strong growth profile are expected to under perform the larger moreliquate names. Our top picks in the copper universe remain Equinox, First Quantum,Quadra and FNX.


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Paradigm Capital Inc, IIROC/TSX Member 13 September 24, 2008David Davison, Analyst 416.360.3462Jacob Willoughby, Analyst 416.361.9557

Disclaimer Section: 1. David Davidson does not have an ownership position in African Copper (ACU-T), Anvil Mining (AVM-

T), Chariot (CHD-T), Equinox (EQN-T), First Quantum (FM-T), Katanga Mining (KAT-T), LundinMining (LUN-T), Marengo Mining (MRN-T), Norsemont (NOM-T), Sherwood Copper (SWC-T),

Taseko Mines (TKO-T), Quadra (QUA-T).2. Jacob Willoughby does not have an ownership position in African Copper (ACU-T), Anvil Mining(AVM-T), Chariot (CHD-T), Equinox (EQN-T), First Quantum (FM-T), Katanga Mining (KAT-T), LundinMining (LUN-T), Marengo Mining (MRN-T), Norsemont (NOM-T), Sherwood Copper (SWC-T),Taseko Mines (TKO-T), Quadra (QUA-T).

3. Michael Bandrowski does not have an ownership position in African Copper (ACU-T), Anvil Mining(AVM-T), Chariot (CHD-T), Equinox (EQN-T), First Quantum (FM-T), Katanga Mining (KAT-T), LundinMining (LUN-T), Marengo Mining (MRN-T), Norsemont (NOM-T), Sherwood Copper (SWC-T),Taseko Mines (TKO-T), Quadra (QUA-T).

4. Paradigm Capital Inc. has assumed an underwriting liability for, and /or provided financial advice forconsideration to the following companies during the past 12 months: Anvil Mining (AVM-T), MarengoMining (MRN-T), Norsemont (NOM-T) and Taseko Mines (TKO-T).

5. Paradigms disclosure policies and research distribution procedures can be found on our website atwww.paradigmcapinc.com.

Research Rating SystemParadigm Capital uses the following rating recommendations in its research:

Speculative Buy Expected returns of 10% or more over the next 6-12 months on high-risk development or pre-revenuecompanies, such as junior mining and early stage biotech companies. (15% of Paradigms coverage list consists ofSpeculative Buy recommendations).Strong Buy Analysts top sector picks, with expected returns of 10% or more over the next 6-12 months. (1% ofParadigms coverage list consists of Strong Buy recommendations).Buy Expected returns of 10% or more over the next 6-12 months. (66% of Paradigms coverage list consists of Buyrecommendations).Hold Expected returns of +/-10% over the next 6-12 months. (13% of Paradigms coverage list consists of Holdrecommendations).Sell Expected returns of 10% or more over the next 6-12 months. (5% of Paradigms coverage list consists of Sellrecommendations).

About Paradigm Capital Inc.Paradigm Capital is a research driven, independent, institutional equity investment dealer focused on sectors andcompanies that have attractive long-term secular growth prospects. Paradigm Capitals research is available on ourwebsite at www.paradigmcap.com. Please speak to your Sales or Trading Representative if you require access to thewebsite.

The analyst (and associate) certify that the views expressed in this report accurately reflect their personal views about thesubject securities or issuers. No part of their compensation was, is, or will be, directly or indirectly, related to the specificrecommendations expressed in this research report.

Analysts are compensated through a combined base salary and bonus payout system. The bonus payout is determinedby revenues generated directly or indirectly from various departments including Investment Banking, based on a systemthat includes the following criteria: reports generated, timeliness, performance of recommendations, knowledge ofindustry, quality of research and investment guidance and client feedback. Analysts are not directly compensated forspecific Investment Banking transactions.

The opinions, estimates and projections contained herein are those of Paradigm Capital Inc. (PCI) as of the date hereofand are subject to change without notice. PCI makes every effort to ensure that the contents herein have been compiledor derived from sources believed reliable and contain information and opinions, which are accurate and complete.However, PCI makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for anyerrors and omissions which may be contained herein and accepts no liability whatsoever for any loss arising from any useof or reliance on this research report or its contents. Information may be available to PCI, which is not reflected herein.This research report is not to be construed as, an offer to sell or solicitation for or an offer to buy, any securities. PCI, itsaffiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securitiesmentioned herein as principal or agent. PCI may act as financial advisor and/or underwriter for certain of the corporationsmentioned herein and may receive remuneration for same. Paradigm Capital Inc. is a member of The Toronto StockExchange, The TSX Venture Exchange and The Investment Industry Regulatory Organization of Canada.

To U.S. Residents: This report was prepared by Paradigm Capital Inc. which is not subject to U.S. rules withregard to the preparation of research reports and the independence of analysts. Paradigm Capital U.S. Inc., affiliateof PCI, accepts responsibility for the contents herein, subject to the terms as set out above. Any U.S. person wishing toeffect transactions in any security discussed herein should do so through Paradigm Capital U.S. Inc.

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