Freeport-McMoRan Is Not Immune to Copper Downside

Is China's shadow banking system bigger than it seems? It might be, as one of China's biggest ports, Qingdao, starts counting copper and aluminum in warehouses. The investigation started as copper and aluminum could have been used as collateral for bank loans more than once. Thus, the physical volume of metals could be significantly lower than their volume on paper. This news is negative for copper producers like Freeport-McMoRan , as copper's use as collateral increases demand for the metal. Previously, Chinese investigations on the use of iron ore in loan transactions have put additional pressure on prices.

While copper is unlikely to follow iron ore's path...
The crackdown on the use of copper as collateral for financing deals could push prices further down. That said, the extent to which copper is involved in those deals is yet to be determined. Importantly, copper doesn't suffer from oversupply as much as iron ore does, which should protect the metal from an iron ore-like price slump.

The big picture in the iron ore and copper markets differs, so copper producers should not expect the same downside in prices. There have recently been no announcements of major new copper projects. On the other hand, new iron ore projects are always being announced. For example, Rio Tinto has recently signed a deal to develop the southern part of the gigantic Simandou mine in Guinea.

Notably, Rio Tinto brought in $5.9 billion of revenue from copper last year. Rio Tinto is participating in Grasberg mine together with Freeport-McMoRan, and it has a 40% share of production from Grasberg above specified levels until the end of 2021, as well as a 40% share of all production after 2021. Rio Tinto has several copper projects on the pipeline, but they are in the early stages of their development.

Freeport-McMoRan's current copper projects are expansions. The company has two major projects in the pipeline -- Cerro Verde mill expansion and Morenci Mill expansion. As a result of these expansions, Freeport-McMoRan expects to increase its copper sales to 5.7 billion pounds in 2016 from 4.1 billion pounds in 2013. This year, the company estimated sales of 4.3 billion pounds, but there are doubts that this estimate will be reached. The estimate was based on the premise that Freeport-McMoRan will be able to start copper concentrate exports from Indonesia in May, but this did not play out and negotiations with the Indonesian government continued.

...price downside pressures the bottom line
While the situation on the copper market looks more favorable than iron ore fundamentals, copper prices stay under pressure. Just like Freeport-McMoRan, Teck Resources is suffering from copper price downside. Teck Resources' first-quarter revenue declined more than 10% compared to the first quarter of 2013 because of weaker copper and met coal prices. Copper contributed $652 million to Teck Resources' revenue in the first quarter, which was 31% of total revenue. At the same time, its gross profit margin for copper greatly exceeded its gross profit margin for coal in the first quarter. Thus, copper remains the main profit driver for Teck Resources, and further downside in copper prices will materially impact the bottom line.

In Freeport-McMoRan's case, copper is king. The company diversified into oil and gas in 2013, and this segment contributed 25% of revenue in the first quarter. While Freeport-McMoRan has big plans for its oil and gas operations, copper will continue to be the main revenue driver for the foreseeable future. That said, the share of mining segment in the company's capital spending will decrease from 58% in 2014 to 39% in 2016, highlighting Freeport-McMoRan's focus on growing its oil and gas business.

Bottom line
At current levels, copper prices are unlikely to put additional pressure on Freeport-McMoRan's shares. Yet, further downside would affect the company's profitability and likely send its shares lower.

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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