The mining and refining of copper is extraordinarily energy intensive.  As such, it’s not surprising that so far this century, copper prices have shown a tight connection with the price of crude oil.  The past four months, however, have been an exception.  Since October 7, 2022, high-grade copper prices have risen from $3.38 per pound to over $4.00, while the price of West Texas Intermediate (WTI) crude oil has fallen from $91 per barrel to around $80 (Figure 1).

Figure 1: The recent divergence of copper from crude is a rare exception

This unusual divergence in copper prices versus WTI occurred on the heels of a number of developments, including:

  • The passage of an infrastructure bill in the U.S. that involves over $550 billion in new spending
  • Exceptionally low levels of copper inventories
  • The lifting of COVID-19 restrictions in China, alongside an easing of credit conditions for Chinese property developers 

These developments in the copper market have not been lost on options traders.  Implied volatility on copper options as measured by CME’s CVOL has been trading at around 26%, very much within its post-March 2020 range.  This range, however, is significantly higher than the CVOL leading up to the pandemic when implied volatility was mostly trading in the 13-20% range (Figure 2). 

Figure 2: CVOL is CME’s new, comprehensive calculation of implied volatility across strike prices.

Copper CVOL also suggests a somewhat higher degree of upside skewness than we have seen in recent years. Out-of-the-money copper call options have been trading at a higher implied volatility than out-of-the-money copper put options (Figure 3).  By all appearances, copper options traders are more concerned with the potential for extreme upside risks stemming from low levels of supplies and potentially strong demand than the potential for extreme downside risks that could stem from higher interest rates and the associated impact on the health of the construction sector. 

Figure 3: Upside implied volatility has been trading at a higher price than downside implied volatility

Upside Risk 1: A Boom in U.S. and European Infrastructure Spending

In November, the U.S. Congress passed the $1.2 trillion Infrastructure Investment and Jobs Act.  The law boosts infrastructure spending by approximately $550 billion beyond what had been previously allocated.  Included in the legislation are $73 billion in funding for improvements to the U.S. power infrastructure and $15 billion in subsidies for electric vehicles.  These two provisions alone imply a substantial boost to copper demand.  Additionally, the law also provides for $110 billion in funding for roads and bridges, $66 billion for passenger and freight rail, and $105 billion in improvements to drinking water and water storage systems.  These provisions may provide a more limited boost in demand for copper.  Overall, the legislation’s funding amounts to nearly 5% of a single year of GDP, although the additional spending will be spread out over several years.  The nations of the European Union have also been boosting their spending on infrastructure and various green-energy initiatives, particularly in the wake of sharply reduced coal and natural gas imports from Russia. 

Upside Risk 2: Supply and Inventory Constraints

Copper’s push higher has also come amid low levels of inventory and relatively slow growth in mining supply.  When it comes to stockpiles of copper, COMEX inventories are at their lowest levels since early 2015 (Figure 4).  Meanwhile, copper-mining supply has grown more slowly than that of other industrial metals (Figure 5).  

Figure 4: COMEX copper inventories are the lowest in eight years

Figure 5: Copper production has risen much less than other industrial metals since 1994

Once Bearish Risk Factors Potentially Turning Positive: Chinse Growth and U.S. Equities

Copper’s recent rally came after a 37% sell off between March and July 2022 and despite what might have been considered a bearish environment.  For starters, China’s economy grew at its slowest pace in decades in 2022 as a result of COVID-19 lockdowns and a sharp decline in the country’s property sector.  In 2023, however, China could pivot from being a bearish to bullish factor for copper.  In the past two months, China has lifted almost all its pandemic restrictions and has injected money into property developers while also liberalizing lending standards.  These policy changes have the potential to produce a strong rebound in Chinese demand for copper. 

How potentially faster growth in China filters through to the copper market, however, is unclear.  Over the past two decades, copper prices have tended to follow the pace of growth in China with a lag of around one year, on average (Figures 6 and 7).  As such, copper prices may not fully reflect any improvements in the pace of Chinese growth in 2023 until 2024.  

Figure 6: Copper tends to track China’s growth but sometimes with a lag of a year or more

Figure 7: Copper’s correlation with the Li Keqiang Index peaks with a lag of around four quarters

Lastly, had it not been for low levels of copper inventory and the boost to U.S. infrastructure spending, the U.S. stock market might also have been a drag on the price of copper.  For decades, the S&P 500 and copper have been positively correlated.  If 2022 wasn’t great for China, it was worse for the U.S. equity market, which showed its steepest annual decline since 2008.  What’s interesting though is that the U.S. stock market is more a measure of the state of the white-collar economy, which underwent some retrenchment in late 2022 after booming in 2020 and 2021. Tech stocks came down as inflation and interest rates soared.  By contrast, the U.S. and much of the developed world is experiencing a boom in the blue-collar economy, with manufacturing growing and investments in green infrastructure on the rise.  “Doctor Copper” is better at indicating the health of the blue-collar economy than the while-collar one (Figure 8 and 9). 

Figure 8: Copper is usually positively correlated with U.S. equities

Major Downside Risks: Higher Interest Rates and Their Impact on the Global Construction Industry

This isn’t to say that all is rosy for the blue-collar economy, or for copper.  Higher interest rates have crimped demand for new homes in the U.S.  Housing starts and building permits have fallen by over 25% during the past year (Figure 10) as mortgage rates soared from a 2021 low of 3% to over 6%. This is potentially bad news for copper as the average American home contains 440 lbs – or about 200kg — of copper.  

Figure 10: Rising Interest Rates are Weighing on the Housing Sector

Additionally, interest rates have soared in many other places as well, including Europe, Australia, Canada and Latin America, with presumably similar consequences for the construction business.  Moreover, commercial and office construction may also find itself under pressure not only from higher interest rates but from post-pandemic shifts in commuting and consumer behavior. 

While the decline in housing demand has the potential to reverse copper’s rally, for the moment, options traders appear to see a preponderance of upside risks stemming from the boom in infrastructure spending, a potentially strong recovery in China and the low copper inventories. 

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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