London, September 2011: Reuters

Chile's copper production figures for July were a shocker, even for a market in which chronic supply-side underperformance is the norm. The world's largest producer of the red metal reported a whopping 18.0-percent year-on-year drop in output, equivalent to 81,800 tonnes less metal.

Annualised production hit a multi-year low of 4.40 million tonnes. Cumulative production over the first seven months of this year was 2.95 million tonnes, down by 4.2 percent, or 130,000 tonnes, on the same period of 2010. And this despite the incentive from historically high prices for producers to maximise run rates. And also despite the ongoing ramp-up of Antofagasta's new Esperanza mine.

Its impact has been submerged in the broader Chilean copper decline. For those scratching their heads as to why the copper price is showing such resilience amid the broader risk-assets turmoil, look no further. Constrained supply defines this market and Chile defines constrained supply.

Diego Hernandez, president of Chile's state copper producer Codelco, told Reuters earlier this month he expected the nation's copper production this year to be at least 5 percent below analysts' estimates. That may yet be a conservative assessment depending on whether production recovers over the second half of this year.

HIGH PRICES CAUSE PRODUCTION DISRUPTION

Key to understanding last month's slump in production in Chile was the strike at Escondida, the world's largest copper mine. The walk-out lasted over two weeks, only ending on Aug. 5. BHP Billiton, majority owner and operator, declined to put a precise figure on how much production was lost. But, based on a daily production rate of around 3,000 tonnes contained metal, a back-of-the-envelope calculation suggests the strike may have cost around 40,000-45,000 tonnes of output.

Moreover, the Escondida strike was merely the latest manifestation of worker unrest in the Chilean copper industry. Codelco experienced sometimes violent protests by thousands of contract workers at its El Teniente operations in May and June and a separate 24-hour strike across its divisions on July 11. The Collahuasi mine was also hit by a one-day strike last month.

Chile has historically enjoyed relatively low levels of strike disruption in its copper sector, thanks largely to tough laws on how, when and where industrial action can be taken. However, the high copper price is fuelling growing worker demands for a piece of the action.

The Escondida walk-out, for example, took place outside of the usual bargaining frame-work and was about one thing only, the size of a bonus payment. This is the flip side of a high-price environment. As well as incentivising producers to maximise output, it also incentivises unions and their members to ratchet up the pressure for greater participation in the profits that result.

It's not just Chile where this is happening of course. The market's current focus is on the potential for more strike action at the Grasberg mine in Indonesia.

BENEATH THE HEADLINES

There is a reflexive symmetry about all this. The copper price is where it is because of not enough supply. By being where it is, the price causes that supply to shrink further, helping to keep the price elevated. The transmission mechanism is the litany of daily headlines about labour unrest, pending or actual. Try a keyword search of "copper" and "strike" in your favourite search engine.

But the headlines distract from what is the underlying driver of copper's supply shortfall, namely declining ore grades, first and foremost in Chile. Escondida itself is a prime example. Last year the mine produced 1,087,000 tonnes of copper in a combination of cathode and concentrates. In 2007 it produced 1,485,000 tonnes.

That 400,000-tonne drop had nothing to do with strikes and everything to do with a decline in average ore grades. In the third quarter of 2007 they were as high as 1.72 percent. By the second half of last year they were 1.25 percent and by the second quarter of this year they had fallen further to just 1.06 percent.

Other mines in Chile are experiencing the same phenomenon. Indeed, Codelco executives would probably argue that falling ore grades at that company's mines, most of them considerably older than Escondida, are an even more acute problem. To the extent that much of the Codelco's current investment drive is intended merely to stabilise production. But Escondida is the largest mine in Chile and the largest mine in the world and the steady downtrend in ore grades over the last few years has been a major influence on both national and global mine production trends.

It's easy to forget but then ore grades don't exactly make for exciting headlines.

DEFINING THE CYCLE?

So make a note in your diary now for the second quarter of next year. That's the scheduled completion date for a major $319 million overhaul of mine operations at Escondida.

The project involves moving the in- pit crushing and conveyor infrastructure to allow access to higher-gade ore. The project was 43 percent complete as of June and is running on budget and to time.

BHP Billiton is being a little coy as to what to expect in terms of ore grade from June next year onwards but given the size of the production drop over the last few years, the potential recovery could be equivalent to a major new mine entering production.

Of course by that stage several new mines will have entered production. And in Chile specifically two major expansions, at Los Bronces and Collahuasi, will be starting to make themselves felt. Will some of these projects run behind  schedule? Almost certainly. But the supply-side response is coming and even the most ardent bulls know it is.

It's interesting, for example, that Barclays Capital, a perennial beater of the bull drum, has started recommending a copper spread trade, running from December this year through June next year. That's the expected period of maximum copper market tightness, according to the bank.

In the interim there's still plenty of potential for more strikes, disruptions and shocking Chilean production figures. But just as the the Chilean copper sector's woes are currently defining the global supply shortfall, so at some stage will the country start defining the supply-side recovery. It's just a matter of time. Keep watching those ore grades!

Ends --

By Andy Home, Reuters market analyst – for Commodities Now.

The views expressed here are his own.