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.

At the end of last year I expressed my nervousness about the copper markets and how the price at that time of $3/lb. was incredibly expensive. Since then copper fell to a low of $2.40 before rebounding to $3.75. Currently, it’s selling for $3.34 and I am more bearish on copper now than I was before.

My negative outlook on copper is based on a slowdown in the US economy and the likelihood it will drag the other economies of the world down along with it, which should reduce demand for base metals.

I believe that copper along with other commodities are 5 years into a secular bull market that typically lasts for 10 to 20 years. However, no asset price rises in a straight line and copper along with other base metals will eventually enter a cyclical bear market (or may have already entered one given copper prices are down 10% since May 2006) within a secular bull market.

A chart I like to look at to put the current real value of copper into historical perspective is the copper-gold ratio.

It can be misleading to determine copper’s real value by looking at its US dollar price. The US dollar and all fiat currencies decline in value over time, which makes everything priced in them more expensive. If instead we price copper in terms of gold we can get a better understanding of copper’s value since gold’s real value is stable over time.

I could only find a chart dating back to 1995, but looking at data since 1980, the ratio reached its highest value of 0.6 last year. Currently, the ratio is not far off at 0.5. This is well above its historical average of 0.3.

It is warranted that copper should be trading above it’s historical average given that the world is experiencing a period of synchronized growth like never before. However, if the global economy slows down the copper-gold ratio might decline to around 0.3. At current gold prices, that means copper could fall to $2. If gold declines to $550, then copper could collapse to $1.65.

Copper isn’t the only metal that looks risky. Aluminum, nickel, and zinc prices are all dependent on a strong global economy. If you are also worried about a looming US slowdown, now may be a good time to sell your base metal stocks.

By the start of this year, I had liquidated all of the stocks in my portfolio which had exposure to base metals. In fact, a collapse in base metals prices has me worried that it could temporarily affect the gold price; therefore, I have been selling some of my gold stocks, too.

There is an interesting article in the NYTimes that discusses the recent excitement over uranium:

Not many. Prices for processed uranium ore, also called U308, or yellowcake, are rising rapidly. Yellowcake is trading at $90 a pound, nearing the all-time high, adjusted for inflation, of about $120 in the mid-1970s. The price has more than doubled in the last six months alone. As recently as late 2002, it was below $10.

A string of natural disasters, notably flooding of large mines in Canada and Australia, has triggered the most recent spike. Hedge funds and other institutional investors, who began buying up uranium in late 2004 to exploit the volatility in this relatively small market, have accelerated the price rally.

But the more fundamental causes of the uninterrupted ascendance of prices since 2003 can be traced to inventory constraints among power companies and a drying up of the excess supply of uranium from old Soviet-era nuclear weapons that was converted to use in power plants, coupled with the expected surge in demand from China, India, Russia and a few other countries for new nuclear power plants to fuel their growing economies.

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Strathmore, with a market capitalization of $300 million, is one of about 400 publicly traded “uranium stock” companies (most of them, like Strathmore, trade on the Toronto Stock Exchange). Many of the firms are much smaller. Some are essentially shell games.“There’s so much money pouring into this sector,” said Julie Ickes, editor and publisher of StockInterview.com, which tracks uranium prices and companies. “If you put ‘uranium’ in your company name, you can look like you’re looking for property,” he said. “It’s a lot of talk.”

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Globally, 180 million pounds of processed uranium is consumed each year by nuclear power plants. Production worldwide from mines amounts to only 100 million pounds. Roughly 75 million pounds come out of utility company stockpiles. What is actually traded in the spot market is only about 35 million pounds.

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Some industry watchers fear the uranium market is entering the bust phase of another boom-bust cycle.

“It’s like the tech bubble,” said James Finch, senior editor of StockInterview.com. “We’re waiting for the crash.”

But others see plenty of room for prices to climb further. One is Bob Mitchell, founder of Adit Capital, a small hedge fund in Portland, Ore. In December of 2004, he became one of the first hedge fund managers to start buying uranium.

Since then other hedge funds and institutional investors have jumped into the market, some of them hoarding uranium while the price keeps rising. Even some established mining production companies are spinning off or partnering with hedge funds.

Uranium executives, investors and analysts alike agree that a major underlying cause of the current bull market is that mines are not generating enough uranium to meet growing demand. The supply constraints can be traced back to the end of the cold war when the United States and the former Soviet Union started converting enriched uranium from dismantled atomic weapons into nuclear fuel for peaceful purposes.

That program, and huge incentives offered to uranium companies by the Nuclear Regulatory Commission, flooded the market with excess supply. At the same time, demand shrunk. The price of uranium fell sharply.

As a result, most uranium producers scaled back or closed their mines. Some companies sold themselves to French, Canadian and British corporations, which now dominate the industry. Meanwhile, some nuclear power companies sold off some of their inventories when the price was low to avoid storage costs.

But by 2003 uranium inventories held by utilities in the United States were coming back into balance. Then a series of natural disasters — flooding of the world’s largest uranium mine, McArthur River in Canada, and more recently at other mines in Canada and Australia — further pinched supply. Power companies now find themselves competing with aggressive institutional investors for high-priced uranium.

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Meanwhile, the people staking claims and drilling underground are happy to see the frothy market get frothier. So far this year, 2,700 new uranium claims have been filed with the Bureau of Land Management in Colorado alone. That is nearly half of the claims filed in all of last year, and a big jump from the 104 claims for 2004.

The WSJ, too, has recently chimed in on the subject:

Financial investors aren’t licensed to possess the radioactive mineral, which is subject to tight government controls aimed at keeping it out of the hands of terrorists and rogue states. Instead, several of those investors have secured access to ownership rights of material stored at licensed repositories in North America and Europe, exploiting legal channels previously used only by utilities and suppliers.

But even with only paper rights to the material, hedge funds are exacerbating what was already the biggest nuclear-fuel supply crunch in decades, according to utilities, miners and large traders. The market represents the latest corner in which hedge funds — private partnerships that cater to wealthy investors and large institutions — are seeking outsize returns, an increasingly challenging task as the number of funds multiplies.

Many funds say they are holding their uranium off the market because they expect the price to climb.

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The market began taking off about two years ago. In May 2005, several months after Adit entered the market, Uranium Participation Corp. raised about $80 million for a uranium investment fund via an initial public offering on the Toronto Stock Exchange, and has raised roughly twice as much since. Managed by executives of the Canadian mining concern Denison Mines Corp., UPC controls more than 6.8 million pounds of uranium yellowcake or gas. It says its average yellowcake acquisition cost was $31.75 a pound.

A similar fund, Nufcor Uranium Ltd., went public last July on the London Stock Exchange’s AIM small-stock market and now controls 2.3 million pounds, the company says. Regulatory filings show that hedge funds invested in that IPO, including GLG Partners, Citadel Investment Group and QVT Financial LP.

Shares of both funds are trading at about 20% more than the current market price of their uranium, suggesting that investors see prices continuing to climb.

Ux says financial funds have purchased about 20 million pounds of yellowcake since entering the market in late 2004. That is roughly a fifth of the supply being mined each year. Such funds bought about 25% of the uranium sold on the spot market in 2005 and 2006. They are husbanding most of their supplies, having sold only two million pounds so far, Ux officials say.

When I first started to invest, uranium was selling for only $15/pound and it was the commodity that I was most bullish on. However, with its recent parabolic rise I have liquidated pretty much all of my uranium investments.

Some of the stocks I held were Strathmore Minerals (TSXV:STM), Energy Metals (TSX:EMC), Western Prospector (TSXV:WNP) and Strateco Resources (TSXV:RSC). I was able to make 37%, 40%, 31% and 421%, respectively on my investments in these names. For full disclosure, the only uranium stock I still own is Altius Minerals (TSX:ALS), however uranium is one of many commodities this company is involved with.

There are three reasons why I turned bearish on uranium. First, as the above articles state, speculators have purchased approximately 20 million pounds of yellowcake in the past 2 years. When this is compared to the 35 million pounds that are traded on the spot market each year, there is little doubt that investors are the main driver for the uranium price right now. If for whatever reason investors turn bearish, the uranium price could plummet just as quickly as it has spiked. Just look at how badly uranium performed in the late ’70s.

Second, the number of uranium exploration companies has increased by 40-fold in the last few years. That means that at some point, the supply of uranium is going to increase substantially.

And third, a higher uranium price will curtail demand from utilities. The mistake that many uranium investors are making is that they assume that demand from uranium users is inelastic since the cost of buying uranium is small compared to the costs of keeping a nuclear power plant running. However, this is not necessarily the case.

Utilities could reduce the amount of uranium that is used in their reactors by increasing the enrichment process. Enriching uranium has a cost, too, but for a given cost of uranium and enrichment, there is an optimal amount that minimizes costs. So when the price of uranium increases to over $90/lb. as it recently has, the utility will use less uranium and more enrichment to fuel its reactors. According to some calculations I have seen, this could significantly reduce the demand for uranium.

I am not predicting that the uranium price is about to crash. After all, uranium is such a small market that only a single billion dollar hedge fund is necessary to push its price up significantly. Also, supplies are currently tight and despite the increased exploration activity, it takes several years for uranium to be found, mined and delivered to the market.

However, when supply does eventually catch up with demand, prices will plummet and investors will get hurt badly. I don’t know when that will be, but I feel more comfortable watching from the sidelines.

Earlier this year President Bush called for America to cut its petroleum consumption by 20% over the next decade, largely by using more ethanol which creates less pollution and can be produced using home-grown corn. Already there are numerous subsidies for biofuel producers which have allowed them to significantly increase ethanol production.

In the past 12 months, this has caused the price of ethanol to rise from just over $1/gallon to $1.75/gallon and corn prices to double from $2/bushel to nearly $4/bushel. Currently, corn supplies are at their lowest levels in 34 years.

The most recent CPI report seems to indicate that beef and poultry prices are being affected by higher corn prices. Most of the corn grown in Iowa is used to feed farm animals and make corn syrup for processed foods. The rising price of corn is also resulting in farmers, nationwide, planting more of it and less wheat and other crops. Therefore, rising corn prices could lead to general food price inflation.

The US could reduce these cost pressures by importing more ethanol from Brazil, where sugarcane is used as feedstock. Brazil can produce ethanol for 22 cents a liter compared to 30 cents a liter for corn-based ethanol. However, the US government is unlikely to reduce the high tariffs currently imposed on imported ethanol in deference to America’s powerful farming lobby.

This means that the Bush administration’s emphasis on ethanol as a fuel source is going to put upward pressure on food prices for the foreseeable future. I’m not sure how significant this pressure is going to be, but it’s worth keeping an eye on food prices.

The NY Times highlights the recent improvements in oil recovery methods that have helped old fields to become an important source of new oil supply. I don’t believe we are running out of oil any time soon because there are abundant reserves of heavy oil in the world, and improved technology — along with a high oil price — will help us to extract it.

Find below some of the main points of the NY Times article:

Within the last decade, technology advances have made it possible to unlock more oil from old fields, and, at the same time, higher oil prices have made it economical for companies to go after reserves that are harder to reach. With plenty of oil still left in familiar locations, forecasts that the world’s reserves are drying out have given way to predictions that more oil can be found than ever before.

In a wide-ranging study published in 2000, the U.S. Geological Survey estimated that ultimately recoverable resources of conventional oil totaled about 3.3 trillion barrels, of which a third has already been produced. More recently, Cambridge Energy Research Associates, an energy consultant, estimated that the total base of recoverable oil was 4.8 trillion barrels. That higher estimate — which Cambridge Energy says is likely to grow — reflects how new technology can tap into more resources.

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The oil industry is well known for seeking out new sources of fossil fuel in far-flung places, from the icy plains of Siberia to the deep waters off West Africa. But now the quest for new discoveries is taking place alongside a much less exotic search that is crucial to the world’s energy supplies. Oil companies are returning to old or mature fields partly because there are few virgin places left to explore, and, of those, few are open to investors.

At Bakersfield, for example, Chevron is using steam-flooding technology and computerized three-dimensional models to boost the output of the field’s heavy oil reserves. Even after a century of production, engineers say there is plenty of oil left to be pumped from Kern River.

“We’re still finding new opportunities here,” said Steve Garrett, a geophysicist with Chevron. “It’s not over until you abandon the last well, and even then it’s not over.”

Some forecasters, studying data on how much oil is used each year and how much is still believed to be in the ground, have argued that at some point by 2010, global oil production will peak — if it has not already — and begin to fall. That drop would usher in an uncertain era of shortages, price spikes and economic decline.

“I am very, very seriously worried about the future we are facing,” said Kjell Aleklett, the president of the Association for the Study of Peak Oil and Gas. “It is clear that oil is in limited supplies.”

Many oil executives say that these so-called peak-oil theorists fail to take into account the way that sophisticated technology, combined with higher prices that make searches for new oil more affordable, are opening up opportunities to develop supplies. As the industry improves its ability to draw new life from old wells and expands its forays into ever-deeper corners of the globe, it is providing a strong rebuttal in the long-running debate over when the world might run out of oil.

Typically, oil companies can only produce one barrel for every three they find. Two usually are left behind, either because they are too hard to pump out or because it would be too expensive to do so. Going after these neglected resources, energy experts say, represents a tremendous opportunity.

“Ironically, most of the oil we will discover is from oil we’ve already found,” said Lawrence Goldstein, an energy analyst at the Energy Policy Research Foundation, an industry-funded group. “What has been missing is the technology and the threshold price that will lead to a revolution in lifting that oil.”

…

Since the dawn of the Petroleum Age more than a century ago, the world has consumed more than 1 trillion barrels of oil. Most of that was of the light, liquid kind that was easy to find, easy to pump and easy to refine. But as these light sources are depleted, a growing share of the world’s oil reserves are made out of heavier oil.

Analysts estimate there are about 1 trillion barrels of heavy oil, tar sands, and shale-oil deposits in places like Canada, Venezuela and the United States that can be turned into liquid fuel by enhanced recovery methods like steam-flooding.

“This is an industry that moves in cycles, and right now, enormous amounts of innovation, technology and investments are being unleashed,” said Mr. Yergin, the author and energy consultant.

After years of underinvestment, oil companies are now in a global race to increase supplies to catch the growth of consumption. The world consumed about 31 billion barrels of oil last year. Because of population and economic growth, especially in Asian and developing countries, oil demand is forecast to rise 40 percent by 2030 to 43 billion barrels, according to the Energy Information Administration.

Back in California, the Kern River field itself seems little changed from what it must have looked like 100 years ago. The same dusty hills are now littered with a forest of wells, with gleaming pipes running along dusty roads. Seismic technology and satellites are now used to monitor operations while sensors inside the wells record slight changes in temperature or pressure. Each year, the company drills some 850 new wells there.

Amazingly, there are very few workers in the field. Engineers in air-conditioned control rooms can get an accurate picture of the field’s underground reservoir and pinpoint with accuracy the areas they want to explore. None of that technology was available just a decade ago.

“Yes, there are finite resources in the ground, but you never get to that point,” Jeff Hatlen, an engineer with Chevron, said on a recent tour of the field.

In 1978, when he started his career here, operators believed the field would be abandoned within 15 years. “That’s why peak oil is a moving target,” Mr. Hatlen said. “Oil is always a function of price and technology.”

I have been nervous about base metal prices, particularly copper, for some time now. Low interest rates worldwide have allowed many hedge funds to engage in the carry trade by borrowing capital in places like Japan and investing it in everything from real estate to emerging market stocks. Earlier this year commodities became the target for their speculative buying.

How else can one explain that from December ‘05 to May ‘06 aluminum was up 50%, copper was up 100%, nickel was up 70%, and zinc was up 120%? Surely increased demand from China nor supply disruptions can entirely account for such spectacular gains.

Gold, too, increased by 60% even though the US dollar hardly fell. This was most likely due to hedge fund managers who entered the commodity markets and bought gold along with other base metals without realizing that precious metals are monetary assets that have very different factors affecting their prices. Therefore, my concern for base metals stems from the belief that once the speculators exit commodities (or start betting against them), gold could also be sold off.

Many speculators have already exited with copper down 25%, aluminum down 10%, and gold down 15% from their May highs. Incidentally both nickel and zinc are up an astounding 50% and 23%, respectively since then. Despite this, more downside could lie ahead for base metals and by extension gold as the supply-demand fundamentals paint a bearish picture.

Copper, which is often seen as a harbinger for economic trends, looks particularly vulnerable. While the common perception is that China is the main driver for copper demand, in reality, the US economy is far more important. It may be true that China consumes 22% of global copper production compared to 13% for the US. But most of the Chinese demand can be attributed to manufacturers who use the copper they buy to produce goods that are eventually exported to the US.

Another source of copper demand is China’s growing infrastructure investments which are meant to expand manufacturing capacity. Therefore, a slowdown in the US will hurt China’s export sector and will cause a reduction in Chinese copper demand. I believe a US recession is imminent.

Already China is starting to move away from its investment-driven growth, shifting toward a more goods-related economy — a situation expected to tame its previously voracious appetite for copper. Chinese copper consumption declined by 4.7% in the first 10 months of the year according to the World Bureau of Metal Statistics.

In addition, copper demand from direct US consumption could suffer if the housing market, which consumes a quarter of the US copper demand, deteriorates. The average 2,100 sq.ft. single-family home uses 439 pounds of copper, most of which is for wiring and plumbing. If US housing starts were to fall by one million homes (about 50%) the reduction in US demand would be just under 200,000 tonnes of copper. This translates to an 8% reduction in US demand and a 1.25% reduction in global demand.

At the same time, the extended period of high copper prices has reduced demand, as alternatives have been found in aluminum and plastics. Independent industry consultant Simon Hunt estimates that around 3.5 million tons of copper in all forms could be replaced by alternative materials by 2010.

Global copper inventories monitored by exchanges in Shanghai, London and New York are the largest since 2004 after almost tripling in the past 18 months. Next year copper supplies will continue to rise, as several large-producing mines — Escondida, Codelco’s Chuquicamata, Grupo Mexico’s La Caridad and Cananea — return to full production, while expansions at Codelco’s Andina and Antofagasta’s Los Pelambres will also hit the market. Other mines such as BHP Billiton’s Spence, Phelps Dodge’s Cerro Verde, Equinox Minerals’ Lumwana and First Quantum’s Frontier will also come online for the first time.

Based on the median forecast of 11 analysts surveyed by Bloomberg copper is expected to fall to $2.61 a pound on average and will reach $2.10 in 2008. However any sort of collapse in the price of copper should be supported by a falling US dollar which I expect to pick up pace in 2007. This would cause copper’s US dollar price to appear stronger than it really is. My own forecast is that copper could trade between $2.50 and $2 per pound by the end of next year. I wouldn’t be surprised if it declines below $2 at some point in the future. However, if it reaches $1.50 I may go long.