The scarce arena of “pure play” tier-one copper mining stocks looks set to dwindle further. First Quantum Minerals Ltd. (OTCPK:FQVLF), which operates the Kansanshi and Sentinel copper mines in Zambia, surged 22% since last Wednesday after people with knowledge of the matter indicated that the company has been drawing preliminary takeover interest from global miners. Jiangxi Copper Co., China’s top producer of the base metal, reportedly built up a stake of less than 10% in First Quantum in recent months, and First Quantum is now working with defense advisors to examine its options. We believe that the acquisition of First Quantum would trigger an imminent scramble to acquire scarce world class copper assets and that Freeport-McMoRan (FCX) is either concurrently being targeted or will be targeted next.

The timing of an M&A boom in the copper market may seem perplexing to market participants with the red metal trading near 30-month lows, but prices have been artificially depressed by an almost record net short position in non-commercial futures contracts. Physical supply is tightening in spite of the global slowdown. According to a recent report from the International Copper Study Group (ICSG), the global copper supply deficit came in at 190,000 tons for the first five months of this year. Copper exchange inventories have also plunged in recent weeks. Warehouse inventory levels on the LME declined 14% from the beginning of September to 290,800 tons, near the low end of their historical 20-year range, and copper stocks across Shanghai bonded areas have been consistently declining since May. Amazingly, this global supply tightness has occurred in spite of a decline in Chinese copper imports by about 280,000 tons over the first seven months of 2019 from the same period a year earlier. Global production has consistently fallen short of expectations as a result of mine disruptions and closures. We believe that Glencore’s recent shuttering of its Mutanda mine in the Democratic Republic of Congo and Oyu Tolgoi’s operational issues, in conjunction with a pickup in demand from increased Chinese infrastructure spending, could widen the deficit further than analysts anticipate.

Jiangxi Copper’s reported interest in First Quantum indicates that China may be preparing for a growing copper supply shortage by scrambling to acquire resources while they are still cheap. We believe that a dearth of compelling acquisition candidates could result in a series of hostile or friendly takeover attempts with First Quantum as the initial victim. China’s investment in its power grid, the single biggest driver of copper demand in the country, has risen by a paltry 0.4% so far this year. Analysts, however, expect State Grid Corp of China, whose budget comprises an estimated 50% of the country’s annual copper demand, to fulfill its promise to increase investment on the nation’s electronic grid by 5% this year, implying 14 billion yuan ($2 billion) of additional spending. State Grid’s accelerated infrastructure investment activity, in conjunction with sluggish supply growth, low exchange inventories, and a massive net short position in non-commercial futures contracts could result in copper prices squeezing materially higher into year-end irrespective of the trade war outcome. If this were to occur, copper miners’ shares would move sharply higher, making cash acquisitions less accretive.

We believe that the secular trend towards electrification of energy, in conjunction with muted copper supply growth, could result in significant multiple expansion for producers over the coming years. Extensive quantities of copper are required for electric vehicles (EV’s), charging stations and supporting infrastructure because of the base metal’s durability, high conductivity and efficiency. EV’s contain more complicated wiring harnesses, extra motor windings and copper anode foil for batteries. While conventional cars comprise 18-49 pounds of copper, hybrid electric vehicles (HEV) contain approximately 85 lb’s, plug-in hybrid electric vehicles (PHEV) contain 132 lb’s, battery electric vehicles (BEVs) contain 183 lb’s, hybrid electric buses contain 196 lb’s, and battery electric buses contain 814 lb’s, most of which is used in the battery. Copper consumption from EV’s, estimated to comprise just 0.9% of global demand in 2017, is expected to rise to 8.2% of total consumption in 2030. Renewable energy growth is also expected to accelerate copper demand, as it requires more copper than conventional power generation. Based on International Energy Agency’s (IEA) forecasts of global average annual net capacity additions for solar photovoltaic, wind and other renewables between 2017-2040, 635,000 tons of copper demand, or approximately 3% of global copper consumption in 2017, is expected be generated every year on average until 2040.

Meanwhile, economic copper resources are being depleted, and the equivalent of 3 world-class copper mines are being consumed annually. World discoveries of new copper deposits peaked in 1996. Production costs are rising for existing mines as ore grades decline and resources deplete. Net cash cost at mines globally in 2017, for example, were about 3 times those in 2000, while copper ore grades at mines in Chile, the world’s largest producer, declined to 0.65% in 2016 from 1.41% in 1999. Of the 20 biggest copper mines globally, only 4 began production in the 21st century.

China consumes approximately half of the world’s copper and is the largest EV market in the world. The Ministry of Industry and Information Technology expects one-fifth of all vehicles sold in the country to be EV’s by 2025. China’s unprecedented focus on EV development is largely in response to the country’s struggles with urban air pollution over the past several decades. Also, the multi-billion dollar Belt and Road Initiative (BRI), which encompasses major projects in 71 countries, is expected to have a huge impact on global copper demand. The BRI, according to research commissioned by the International Copper Association (ICA), is likely to increase demand for copper in over 60 Eurasian countries, to 6.5 million tons by 2027, a 22% increase from 2017 levels.

With the prospect of a looming copper shortage derailing China’s ambitions for the electrification of energy and infrastructure development, it’s no surprise that Jiangxi Copper may be seeking to acquire First Quantum. Unfortunately for Jiangxi Copper, however, the company will likely face significant competition in acquiring major producers like First Quantum or FCX. In our previous note titled “Freeport-McMoRan: A Sitting Duck With More Than 200% Upside“, we reported that “it has been evident that Rio Tinto is hard at work trying to close a large copper acquisition. In June 2018, for example, a Reuters article titled “Rio Tinto ready to splash out on copper” indicated that “The global miner would be willing to fork out a large premium over market value to secure a prime asset as it tries to reduce its reliance on iron ore, company and banking sources told Reuters”.

We believe that an intense competitive landscape for tier-one copper acquisitions coupled with the scarcity of compelling takeover targets will result in a series of bidding wars that will propel the valuations of potential acquirees to in excess of the replacement cost of their copper capacity, implying meaningful upside to current share prices. Assuming a replacement cost of $9.65 per lb for FCX’s capacity (which we believe is conservative given FCX’s superior copper asset portfolio), for example, the implied valuation of the stock would be a minimum of $40.5 billion, or $23 per share net of its debt.

Potential Acquisition Targets

The following table lists the world’s top copper mines in 2018:

Note that FCX operates 3 of the top 10 producing mines in the world. Of the remaining mines on the list, most are controlled by companies that are not conceivable acquisition targets. BHP, for example, is a diversified miner with a market capitalization of well over $100 billion, Codelco is the Chilean state- owned copper mining company, and only 30% of Glencore’s (OTCPK:GLCNF) EBITDA is derived from copper. Of the top ten global copper mining companies, we believe that only FCX and First Quantum are realistic acquisition candidates.

In November 2018, RFC Ambrian, a leading independent advisor and investor in the natural resources market, published a note titled “Copper M&A – The Cupboard is Nearly Bare” in which it indicated:

We have taken a look at the copper acquisition opportunities, including existing operations and potential development projects. We have focused on the Tier 1 copper development projects, with more than 3Mt of contained copper. It often appears that everyone claims to be looking for a Tier 1 copper asset, but the interesting thing is that there are only a handful of projects out there that tick the boxes of availability and attractiveness. We expect M&A to hot up in these concentrated areas of interest.

RFC Ambrian believes that First Quantum and FCX are the only two potential takeover targets among tier-one copper companies, since many of the top 30 primary copper companies are unlikely to be acquired as a result of complexities associated with their ownership structures (i.e. government shareholding or family holding).

Why First Quantum & FCX?

We believe that of all the attributes that make First Quantum and FCX particularly compelling takeover candidates, their rising production profiles are paramount. Both First Quantum and FCX have long remaining mine lives and rising production growth in the context of stagnant global copper supply. First Quantum’s Cobre Panama project is expected to drive the company’s aggregate copper production from 606,000 tons in 2018 to 840,000 – 870,000 tons in 2020, before contracting slightly in 2021. First Quantum’s geographic exposure will also improve, as Zambia declines from 79% of its total production to 60% in 2020, while Panama increases from 0% to 35% of production over the two-year period.

FCX is expected to increase copper production by 30% from 2019 to 2021, while cash costs decline approximately 25% over this period. The primary driver of FCX’s rising production is the completion of its underground transition at Grasberg from the depleting open pit. To put the magnitude of Grasberg Underground into perspective, the open pit mine, which has been one of the most prolific resources in the world, yielded a total of 36 billion lb’s of copper and 54 million oz’s of gold over its lifetime. Grasberg underground is expected to yield an additional 36 billion lb’s of copper and 30 million oz’s of gold over its remaining life.

The most exciting source of production upside for FCX, however, that investors seem to have dismissed is the company’s wholly owned Lone Star project located near the Safford operation in eastern Arizona. Lone Star’s low capital requirements stem from the utilization of existing infrastructure at the Safford operation. The development phase for the Lone Star oxide ores commenced in first quarter of 2018, and first production is expected by the end of 2020. FCX has been conducting additional drilling as it evaluates longer-term opportunities available from the significant sulfide potential in the Safford/Lone Star minerals district.

As indicated in FCX’s 2018 annual report, “Copper production from Lone Star is expected to average approximately 200 million pounds per year”. On September 12, however, FCX’s CFO Kathleen Quirk presented at the Morgan Stanley 7th Annual Laguna Conference and indicated that drilling results at Lone Star continue to exceed expectations, leading FCX to believe that the project could evolve to be as big as its Morenci mine, North America’s largest copper mine. Morenci has 4.6 billion tons of proven and probable ore reserves comprising 15.6 billion lb’s of copper. Its production totaled 1 billion pounds of copper and 9 million pounds of molybdenum in 2018, five times FCX’s current copper production guidance for Lone Star. If Lone Star does in fact evolve into another Morenci, we believe that it could add ~$8 billion or ~$5.50 per share to FCX’s fair value (which we previously estimated was $34 per share in our last Seeking Alpha note). In May 2016, FCX sold a 13% undivided interest in its Morenci unincorporated joint venture to SMM Morenci, Inc., an affiliate of Sumitomo Metal Mining Co, Ltd., for $1 billion in cash. Since Lone Star is currently 100% owned by FCX, extrapolating upon the value of the Sumitomo transaction yields $8 billion in value for 100% of Morenci. Hence Lone Star could potentially grow to comprise more than half of FCX’s current market capitalization despite its not producing any current revenue. We believe that the potential size of the Lone Star resource will make it easier for an acquirer of FCX to justify paying a significant premium.

In conclusion, we believe that the reported takeover interest in First Quantum from global miners, including Jiangxi Copper, will kick off a repricing of world class copper resources and a scramble to acquire tier-one miners, including FCX, at significant premiums. The copper market seems to be nearing an inflection spurred by scant supply growth and Chinese infrastructure spending, and the secular supply/demand dynamics of the red metal over the next decade are arguably better than those of any other commodity. We believe that other than First Quantum, there are no takeover premiums embedded in the valuations of publicly traded copper miners, which all nonsensically trade at meaningful discounts to the replacement value of their production capacity.

Disclosure: I am/we are long FCX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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