Base metals prices have collapsed this year with losses particularly steep in just the past few weeks. For the last two years, I have been writing bearish posts on base metals with the viewpoint that when the global economy slumps, demand for industrial metals will decline significantly, and prices will fall. I even put my money where my mouth is and shorted base metals stocks last year. Now that prices of industrial metals have substantially declined, it is worthwhile to examine whether they have fallen too much. Here is a price chart of copper dating back to 1980.

I prefer to view the prices of commodities in terms of a stable monetary unit such as gold rather than a depreciating one such as the US dollar. This ignores the effect of monetary inflation and more precisely shows the real value of the commodity. Here is a long term chart of the price of copper in terms of ounces of gold per 100 pounds of copper dating back to 1840.

Here is a chart of the real price of copper in terms of gold since 1980.

The ratio peaked at 0.579 in September 2006 and is currently 0.239 which is slightly below its average since 1980 of 0.277. A glance at this chart suggests copper is significantly undervalued when its price is less than one-fifth of the gold price.

The real price of copper has been declining over the past 170 years. This should be expected given that technological advancement and accumulating savings has reduced the real cost of production over time and will continue to do so in the future. In the long run, the price of any commodity is equal to its cost of production plus a reasonable profit for the producer. However, in the short run there could be wild price swings as there is a time lag to when supply can increase or decrease to meet demand.

The speculator can make profits by betting on commodities when the market price is well below the cost of production as the market is signaling to producers that supply needs to be reduced. Eventually, the price will have to rise otherwise the commodity won’t be produced. On the other hand, money can be made shorting a commodity when its price is significantly above the cost of production because it will encourage greater supply until demand is met, at which point the price will fall.

To get a sense of what the current cost of production of copper is I took a look at the financial statements of copper producers Southern Peru Copper (NYSE:PCU) and First Quantum Minerals (TSX:FM). A summary of their quarterly results are provided below using both recent and current base metals prices.

As can be seen, the projected earnings for PCU and FM using current metals prices are still quite healthy, though they have declined substantially. Only if the copper price were to fall another 50% to $0.85/lb. would either be at risk of losing money. These companies operate some of the higher margin mines in the world. A copper price below $1/lb. would cause many miners to lose money. However, it is also important to keep in mind that if the decline in the copper price is accompanied with a drop in other commodity prices, then a mining operation’s energy costs (which account for approximately 50% of total costs) and labor costs would fall as well. So the cost of production would be lower.

In recent years there has been a lot of money spent on investment and development to expand production from current copper mines and to bring online new greenfield projects. This will add to supply. As the previous analysis shows, miners can still make money at current metals prices so there still exists an incentive to increase production. However, the global economy is beginning to contract which will cause a reduction in copper demand. Together, these factors will put downward pressure on the copper price. The best time to be bullish on copper is when the world economy is about to expand. I don’t see this occurring for the next few quarters, at least.

So what would get me to bet on copper? First, I want to be confident that the global economy is on the verge of emerging from the current downturn. Second, the copper price should be below most mining operations’ cost of production, which I estimate to be around $1/lb. And third, the real price of copper, as measured in term of gold, should be well below its long time average of the past; I think an attractive ratio would be around 0.2 ounces of gold per 100 pounds of copper.

I will concede that these are very strict conditions that are rarely met. But they were satisfied in as recently as 2002 and 2003 which, in retrospect, were terrific years to buy copper. If the market continues to value copper above where I think it is very cheap, then I will simply look elsewhere to speculate where the risk/reward ratio is more favorable.