London, 19 February 2011

The cornerstone of copper's bull market narrative is one of supply shortfall. Expressed in its simplest form, not enough of the stuff is coming out of the ground to feed demand. It hasn't for several years and it won't for at least a couple more years. Secondary (scrap) supply can fill some of the gap, particularly given the current price incentive, but systemic mine underperformance remains the defining feature of copper's production side. It is why just about every analyst out there is forecasting a coming period of widening market deficit.

Signals from the copper raw materials sector are therefore particularly relevant right now. Are they confirming or undermining this core narrative?

This is the time of year when copper miners and smelters lock horns to decide on concentrates treatment and refining terms (TC/RCs) for the coming 12 months. The resulting "benchmark" should generate the year's single most important snapshot of what is happening upstream from the refined copper market.

However, even by the murky standards of the concentrates market this year's talks have been shrouded in layers of confusion. To the point that it is worth asking whether there is anything that can realistically even be termed a "benchmark" deal any more. And what does that say about the state of mine supply?

THE PAIN BARRIER AND BEYOND

This year's concentrates negotiations have been defined by what happened last year. Benchmark 2010 terms came in at $46.5 per tonne (for smelting) and 4.65 cents per pound (for refining).

With price participation clauses consigned to the history books, such low terms were equivalent to breaking the pain barrier for many smelters. They were also a confirmation of just how tight the concentrates market had become with too many processors chasing too little supply.

When terms fell further to around $40 per tonne and 4.0 cents per pound in the mid-year talks, it wasn't so much a threshold of pain but one of outright survival. As one Japanese smelter candidly admitted, "at our current TC/RC level, the more we produce, the more we incur losses."

With their backs against the wall, smelters had no choice but to fight tooth and nail for higher processing fees this year. They were helped by a rise in spot treatment charges to around the $80 and 8 cents level late last year, although to what extent there was a degree of self-help involved is a moot point. Miners talk, with a degree of reluctant admiration of the smelters' "discipline" leading into this year's talks.

For which read a collective withdrawal from the spot market. Without buyers spot fees were only going to move in one direction. But last year's super-low fees also meant that there has been a profusion of claims for "benchmark" status this year, all of them from the smelter side and all significantly higher than most neutrals were expecting.

ELUSIVE BENCHMARK

Pan Pacific, Japan's largest copper smelting entity, took the lead by announcing it had managed to get $80 and 8 cents for this year as part of a two-year deal with an unnamed South American miner.

The impact was somewhat undermined when another Japanese smelter said it had signed a similar term deal with a U.S. miner with a 2011 TCRC of just $56 and 5.6 cents per pound.

Those two "benchmarks" define the broad range of settlements reached for this year's deliveries with the rest falling into the unusually wide middle ground. Most analysts now think that it is the lower end of the range that is most representative of the bulk of deals concluded. At least two major miners are rumoured to have settled at that level.

Smelters can legitimately claim the "real" fees are higher by using the quotational period (QP) to supplement the headline TC/RC. Most concentrates are priced three months after month of arrival. That sort of QP has significant potential value when the copper market is in backwardation, to the point that a smelter could translate $56 and 5.6 cents into something over $60 and 6.0 cents.

But QP alone cannot explain Pan Pacific's high settlement. As always with concentrates, though, the devil could be in the detail. Each mine's concentrates are unique. "Dirty" concentrates with higher levels of difficult trace minerals command higher processing fees. Some deals fall out of the "benchmark" talks completely, reflecting longstanding relationships between miner and smelter. And some, it seems, are no longer really annual deals at all. The most significant development this year has been a partial move to shorter-term pricing, six-monthly rather than annual. These deals seem to have been done in the mid-to-high 60s (if you're a miner) or the low 70s (if you're a smelter prepared to leverage the QP).

It also seems to have been BHP Billiton that has been the prime promoter of this break-up of the traditional annual pricing period. The same company has been a pioneer in the drive to move iron ore from annual to quarterly pricing and alumina from aluminium-linked to spot-indexed pricing. However, the shift in copper concentrates pricing seems to be less preplanned revolution than an escape from what one participant called "the paralysis" of stalemated talks characterised by a yawning, unbridgeable gap between the two sides' positions.

CONFUSED SIGNAL

And it could well be that it is the six-monthly "annual" settlement that is the best signal of what is happening in the copper concentrate market.

By agreeing to move terms closer to the prevailing spot market, the smelter is vindicated in its view that the current market is in a state of relative oversupply with no short-term pressures on feed availability. That, after all, is what higher spot treatment terms are saying.

The miner is happy to acquiesce, based on a view that the current oversupply is highly temporary and due more to short-term changes in demand (smelter downtime in H2 2010 and a lack, possibly coordinated, of spot buying) than supply, where longer-term constraints are still in play.

In other words what the miner gives in the first half of the year, it is confident of getting back in the second half, based on a view that spot fees will have fallen by that stage.

It is a confused signal but nevertheless a useful one. Yes, copper concentrates availability has improved. But no, it's not expected to be a lasting phenomenon, at least as far as the miners are concerned. As such, copper's bull narrative of mine shortfall may be slightly tarnished but in essence remains intact...for now.

The mid-year negotiations have historically not been as significant as the annual talks in tonnage terms. But this year they assume a critical role in determining whether miners or smelters are right in their views about the copper concentrates market.

That also suggests that the annual "benchmark" is living on borrowed time.

Ends --

METALS INSIDER: Andy Home, Reuters Columnist.

The opinions expressed are his own.