The Magical Power of the Copper/Gold Ratio. Is Copper the New Oil as the World transitions to Clean Energy?

Estimated Reading Time – 14 minutes

In our last post, we covered the BT Market Risk Indicator to help track the OECD Composite Leading Indicator (CLI), which is a significant input in our BT G20 Models from a cyclical perspective.

The Copper/Gold Ratio plays a significant role within the BT Market Risk Indicator and gives us a read on the day-by-day cyclical economic activity implied by markets.  

We will cover the importance of copper to the physical economy and the role of gold as a safe-haven financial investment in a fiat currency system. We have split the discussion into a two-part series, we will cover Part I in this post and Part II will be provided in a few days.

We will cover the following sections:  

Part I:

1. How Does the Copper/Gold Ratio work?
2. What is the ratio currently telling us?
3. Demand and Supply of Copper
4. Overview of BT Copper Model

Part II:

1. History of Gold Usage in the Financial System
2. Demand and Supply of Gold
3. The Golden Rule!
4. Have Cryptocurrencies replaced Gold as a Store of Value?
5. Overview of BT Gold Model

1. How Does the Copper-to-Gold Ratio work?

1. How Does the Copper/Gold Ratio work?

The Copper/Gold ratio measures the risk appetite of risk assets relative to sovereign bonds (US Treasuries). The absolute number is not as important as the direction/momentum of the ratio.  

In Chart 1, we review the uses of copper and gold and how each metal reacts to different parts of the economic cycle. An increasing copper/gold ratio typically is correlated with an upswing in cyclical economic activity and a reduction in the copper/gold ratio usually signals a deceleration of cyclical economic activity. Jeffrey Gundlach, CEO of DoubleLine Capital LP has noted that the copper/gold ratio was a “fantastic” indicator of interest rates – specifically the yield on the benchmark U.S. 10-year U.S. Treasury. We believe the ratio is helpful across both bond and equity markets.

Chart 1 – Summary of Copper/Gold Ratio

	Copper	Gold
Uses	Used in manufacturing and construction and used as a proxy for economic growth   Known as “Dr. Copper” given the ability to assess overall economic conditions through the price of copper because of the metal’s wide-ranging application (industrial production/electrical equipment/building materials).	Perceived Safe Haven in response to Fiat Currency System (debasement through increasing money supply) and Geopolitical Risk as the anti-currency.   Gold is universally accepted and therefore serves as valuable collateral during times of crisis (trust and confidence) as it carries no credit or counterparty risk.   Historical Store of Wealth and maintaining purchasing power and tracked M2 money supply over time   Negative or lack of price correlation to the US dollar, commodities, and many financial assets
Cyclical Economic Activity	Risk-on, Higher GDP on higher demand /growth accelerating/higher inflation – copper prices higher     Risk-off, growth is decelerating, GDP is declining/lower inflation – copper prices decline	Risk-on, Higher GDP on higher demand for manufacturing, construction, and consumer goods,  growth accelerating/higher inflation – risk assets offer better return relative to gold Risk-off, growth is decelerating, GDP is declining/lower inflation – capital preservation, gold should outperform risk assets
Interest Rates	U.S. Treasury 10 year (UST10Y) yield up, Central Bank overnight rate up when copper prices accelerate/going up	UST 10Y yield down, Central Banks reduce rates when copper prices are decelerating/going down
Copper-to-Gold Ratio	Rises as the economy grows, the ratio falls as economic demand slows. Tracks UST10Y yield well.	Ratio declines as capital preservation bid up the gold price in recession

2. What is the Copper/Gold ratio currently telling us now?

The current Copper/Gold ratio has largely been range-bound since the middle of 2021 and has not shown strong momentum to the upside, despite the market narrative of a cyclical upswing emerging from COVID-19. The Copper/Gold ratio also tracks the OECD CLI well at almost a 0.80 correlation since 2002 (see Chart 2 below).

As a reminder we highlighted in our last post, the OECD Composite Leading Indicator (CLI) is a key factor in all country models and appears to pick up turning points in stock markets well in advance of major drawdowns, as well as, economic turning points.

Chart 2: Copper/Gold Ratio, US Treasury (UST) 10Y, China Government Bond (CGB) 10Y Yield, OECD CLI  

1. Custom China index based on all freight (20%), bank loans (20%), electricity consumption (20%), yield curve spread (10%), M2 Money Supply(10%), Purchasing Manager Index(10%), Copper(5%), and China OECD CLI(5%)

A few other interesting observations from Chart 2 when looking at the Copper/Gold ratio and various 10-year yields: 

• Despite very supportive monetary policy since the Great Financial Crisis through quantitative easing (QE) which was intended to reduce yields at the long end of the yield curve, cyclical changes as measured by the copper/gold ratio have been strongly correlated with changes in 10-year U.S. Treasury yields.  When quantitative easing is implemented, long-term interest rates tend to decline. When the Fed enters the market as a major buyer, supply and demand should push interest rates lower. This encourages individuals and businesses increase their risk appetite and take on loans at new, lower rates. Additionally, when interest rates are low, investors turn to riskier investments, like equities, to bolster their returns. As additional capital enters equity markets and the incentives for businesses to borrow funds for expansion or share buybacks , quantitative easing can lead to larger stock market gains. There is a psychological effect of quantitative easing for investors as there is the perception is that the Fed is taking an active role in bolstering the economy. This perception can lead to more confidence in the stability of the underlying securities and stimulated economic performance.  A future post will dive deeper into the yield curve and attempt to bifurcate between cyclical and structural impacts.

• Despite strong copper demand from China, one may expect that CGB 10-year bond yields would rise with strong copper demand, and CGB yields would fall with lower copper demand over the economic cycle. However, this is not the case as changes in 10-year CGB yields are not significantly correlated with changes in the copper/gold ratio and are very close to 0.50 over multiple periods (see Chart 2), which may suggest that China is managing its bond market against the gold market (more on this in the next post).  

• Famed macro researcher, Louis-Vincent Gave (GaveKal) has proposed that if China is executing this strategy, the objective may be aligned with a long-term policy strengthening of the Renminbi as a creditable store of value to be used in trade agreements/potential path of de-dollarization. We go into this idea further in Key Trade Flows and Supporting Agreements section (link). In Part II, we will review the gold holdings of China and test this idea further.  Further internationalization of the Renminbi, would further diversify China’s economy from production/manufacturing of goods to a focus on domestic markets consumption. This has been a typical path as economies have matured over time.     

• One factor that we are watching which we do not believe has been fully integrated into market pricing/economic data yet is the current monetary policy divergence between central banks (U.S. and China) with the recent loosening of monetary policy by China, while the Federal Reserve and other countries that provided significant fiscal and monetary stimulus in response to COVID-19, look poised to tighten in 2022. The combination of these moves may extend the global growth cycle further and reduce tail risk in China’s property sector. We note that the current OECD CLI and OECD Diffusion Index as of December 2021 (subject of a future post), showed a decelerated growth, even before considering any hiking of monetary policy rates, so the recent moves by China may further extend the global growth cycle. This remains to be seen.

To further understand the direction/momentum in the Copper/Gold ratio, we took a deeper dive into the Demand, Supply, and Reserves Global before attempting to model the price of copper.

3. Demand, Supply, and Reserves of Copper

Chart 3: Summary Facts on Copper and Supply Chain

Before we started to build our model from our BT G20 dataset we reviewed in the last post, we reviewed the demand and supply of the underlying copper market to determine the feature sets that may be used in estimating the drivers of copper prices currently and potentially in the future as well. Given thermal and electrical conductivity, copper is used mainly in electronic and industrial applications.

Copper plays an important role in modern human life (powering and protecting our homes, cars, cellphones, and computers). Currently, China plays a major role as a producer, processor, consumer, and trade flow of copper (see Chart 3) – consuming 50% of the world’s copper. China is expected to continue to strengthen its hold in the market through the clean energy transition.

Chart 4: Identified Copper Resources and Top 20 Copper Mine Production

Roughly 40% of global output is mined in South America (Chile and Peru) – see Chart 4. China, the Democratic Republic of Congo (DRC), the United States, and Australia are the other major producing countries.

According to the International Energy Association (IEA), in a scenario that meets the Paris Agreement goals, clean energy technologies’ share of total demand rises significantly over the next two decades to over 40% for copper and rare earth elements, 60- 70% for nickel and cobalt, and almost 90% for lithium.

EVs and battery storage have already displaced consumer electronics to become the largest consumer of lithium and are set to take over from stainless steel as the largest end-user of nickel by 2040. With the move towards clean energy technologies, transition minerals are more geographically concentrated than oil or natural gas, with China playing a major role in both extraction, processing, and consumption (see Chart 5).

Chart 5: Mining and Processing of Fossil Fuels and Minerals

Copper has long played an important role in China’s economy. Currently, China is the world’s biggest importer of copper by some margin, accounting for 43% of global copper ore imports – more than three times the level of Japan in second place.

While copper usage in China is primarily driven by the fact that it is an important component in manufacturing and construction several ongoing government initiatives are expected to increase demand further – See Energy Transition and Key Challenges section below.

While there is expected higher demand for copper due to the clean energy transition, do we have enough to meet the increased demand? According to the United States Geological Survey (USGS), since 1960 there has been roughly 38 years of production in reserve –see Chart 6.  Copper can be recycled and used again, so primary copper used today may be reused at a later date without a loss in performance. If the IEA’s estimates of 40% more copper is required annually are proven correct, this would reduce reserves to ~31 years of production.   

Chart 6: Reserves and Annual Production

In 1960, predominately most consumption of copper came from North America and Europe at 87% of total global consumption which is consistent with post World War II redevelopment. Since 1980 most of the growth in global copper has come from Asia (74% of global consumption), most notably China (represents 50% of global consumption) given the vast amount of industrialization and construction (see Chart 7).

Copper’s use is pervasive across all aspects of life from transforming energy and minerals to power our homes, computers, iPhones, and cars/boats. So increases in consumption during economic upswings would be expected to raise copper prices and decreases in consumption during an economic recession would lead to fewer homes being built/renovations occurring and cars/computers bought.

Hence, this is why the global growth cycle may be inferred from tracking copper prices given the wide-ranging applications across modern human life. Major uses by the major application are provided in Chart 8.

Chart 7: Refined Copper Consumption

Chart 8: Major Uses and Applications of Copper

Uses	Major Applications
Electrical	Safest Residential and Commercial Building Wiring
Electronics and Communications	Local area networks, Transformer, Switches  Mobile phone, computers, semiconductors/circuitry in silicon chips/remove heat from transistors to drive Data and Artificial Intelligence
Construction	Plumbing and construction materials for its durability, machinability, corrosion resistance, and ability to be cast with high precision (does not burn or release toxic fumes in case of fire and resistance to extreme weather events)
Industrial Machinery and Equipment	Gears, Turbine Blades, Pipes exposed to seawater for oil platforms and coast power stations depend on copper given corrosion resistance for protection
Consumer	Electrical appliances, cookware, brassware
Transportation	Cars, Trains, boats including Electric Vehicles

China continues to be the world’s largest consumer and importer of Copper. The price of copper has historically been influenced by economic activity/cycles in China. It has long been rumored that official GDP statistics of China are man-made and to get a sense of the level of activity one can follow the Li Keqiang Index¹ or other custom index made up of high-frequency indicators – see Chart 9 below.

Chart 9: China’s Demand for Copper Driven by Strong Economic Activity

1. Li Keqiang Index based on growth in electricity consumption (20%), rail freight (40%), and bank loans (40%).
2. BT Custom China index based on all freight (20%), bank loans (20%), electricity consumption (20%), yield curve spread (10%), M2 Money Supply(10%), Purchasing Manager Index(10%), Copper(5%), and China OECD CLI(5%).

Energy Transition to Clean Energy and Key Challenges

The current electricity generation mix (see Chart 10 below) continues to be heavily weighted towards fossil fuels (Coal, Oil, Natural gas) in some countries (China, Australia, Indonesia) and the switch to renewable energy systems is likely to be a key demand driver for copper moving forward. Carbon Dioxide or CO2 emissions are expected to decline as electricity generation from coal switches over to renewable energy over the next 10-15 years.

Chart 10: Current Electricity Mix

Current Key Challenges – Copper

• Performance: Challenging to substitute due to its superior performance in electrical applications
• Ore Quality: Mines currently in operation are nearing their peak due to declining ore quality and reserves exhaustion. Declining ore quality exerts upward pressure on production costs, emissions, and waste volumes
• Climate Change Impacts: Mines in South America and Australia are exposed to high levels of climate and water stress

Source: IEA

Over the coming decades, the demand for copper is expected to be robust through the development of clean energy technologies – see Chart 11 below comparing the current state with the future state.

Chart 11: Clean Technologies Expected to increase demand for Copper

While the West (European Union, United States, UK, and Canada) have begun the transition with a greater proportion of renewables driving electricity production, China’s switch to renewable energy systems is likely to be a key demand driver for copper going forward. Copper is a key material in energy-efficient generators and renewable energy systems, with solar and wind energy installations using larger volumes of copper as compared with thermal power generators.

Electric vehicle production is also expected to drive China’s copper consumption. Copper is an important component in electric vehicles, used in the batteries, windings, and copper rotors of electric motors, as well as in the wiring and charging infrastructure. At an average of 83kg of copper, the typical electric vehicle uses nearly four times as much of the metal as a conventional car (see Chart 11).

China has ambitions to be a leading electric vehicle manufacturing center by 2025, as part of its Made in China 2025 initiative.

Chart 12: New Energy Sources Introduce New Trade Patterns and Geopolitical Concerns

China has emerged as a major force in global supply chains for critical minerals and clean energy technologies over recent decades. Despite its current reliance on coal to power electricity, the country’s rise to becoming the leader of clean energy supply chains has largely been underpinned by its long-term industrial policies, such as five-year plans for economic development, the Made in China initiative, and the Belt and Road Initiatives. This has not been an accident, but part of a 25-year plan to secure strategic minerals and natural resources…more on this later.

The shift to a clean energy system is set to drive a huge increase in the requirements for these minerals, meaning that the energy sector is emerging as a major force in mineral markets. Until the mid-2010s, the energy sector represented a small part of total demand for most minerals. However, many of the minerals are controlled the by 3 largest category producers (>75% of the market) geographically concentrated, suffering from the reduced resource, quality, and water-stressed stressed areas. This may introduce new geopolitical concerns and new trade patterns – see Chart 12 above.

With the new energy sources and shift away from oil, there could be a threat to the petrodollar system that the current U.S. dollar financial system has been built upon given that much of the global production and consumption of copper and other minerals required for clean energy transition may reside outside of the U.S. going forward – see Trade Flows section below. For background, Investopedia provides a good summary of the U.S. petrodollar system:

• Petrodollars are U.S. dollars paid to an oil-exporting country for the sale of oil, or simply, an exchange of oil for U.S. dollars.
• Petrodollars are the primary source of revenue for many OPEC members and other oil exporters.
• Because they are denominated in U.S. dollars, the purchasing power of petrodollars relies on the value of the U.S. dollar. When the greenback falls, petrodollars do, too.
• The Petrodollar came to prominence during the oil crisis of the 1970s and regained traction in the early part of the 2000s.
• The petrodollar system creates surpluses, which lead to large U.S. dollar reserves for oil exporters, which need to be recycled, meaning they can be channeled into domestic consumption and investment, used to lend to other countries, or be invested back in the United States.

Many of the conflicts in the Middle East since the 1970s have been related to protecting the petrodollar system and maintaining status quo given that many of the countries with significant oil reserves are in the Middle East (Iran/Iraq/Saudia Arabia/Qatar). However, with the world moving towards renewable energy, trade flows, supply chains and geopolitical focus may move away from the Middle East towards Latin America and Africa.

Key Trade Flows and Supporting Agreements – Copper

China’s expansive, multi-billion-dollar Belt and Road Initiative (BRI) traverses several continents – Southeast Asia to Eastern Europe, Latin America, and Africa – and encompasses major projects in 71 countries – see Chart 13 below. The BRI focuses on infrastructure investment, education, construction materials, railway and highway, automobile, real estate, power grid, and iron and steel and improves trade across the infrastructure built. Linking up road and rail connections with global ports is essential for the functioning of the maritime road aspects of BRI. China’s motivations for food and energy security and regional development intersect and are mutually beneficial for trade partners. In response to COVID-19, China has also seized the opportunity to improve relations further via vaccine diplomacy, in particular in hard hit countries in Latin America.

The BRI is expected to drive copper demand higher.  The BRI includes Peru and Chile (40% of global annual copper production) and China has signed Free Trade Agreements with both countries, as they have been keen to secure and diversify their supply of copper, as the globe enters the new era of de-carbonization and electrification moving ahead. The BRI also fulfills a secondary objective of de-dollarization by settling trade in the Renminbi (RMB) instead of U.S. dollars. 

Chart 13 – Copper Trade Flows and China’s Belt and Road Initiative

Given that the world’s two consumers (China and the U.S.) are net importers and with much of the current reserves and production capacity in Latin America (Chile and Peru), and the importance of copper to the energy transition, does the focus of energy resource security shift from the Middle East (Oil and Gas) to Latin America (Minerals for Clean Energy)?

With decarbonization Is Copper the New Oil? How Do Central Bank Bilateral Swap Lines Play into Trade?  

In Chart 14, we have attempted to map relevant bilateral central bank liquidity swap arrangements with the U.S. Federal Reserve and People’s Bank of China (PBOC) and Copper/Oil production. These swap agreements stabilize markets when markets become stressed so that cross-border trade can continue. Swap lines keep plenty of currency available during times of stress so that countries can continue to trade and secure important raw materials for manufacturing and production. In a fiat currency system, liquidity is necessary to keep financial markets functioning smoothly during crises.

Currently, China’s net import reliance is at ~60% of domestic consumption compared with ~40% net import reliance in the US (See Chart 14).

We observe that while these swap arrangements are typically reserved for trading partners that are exporting key goods/services into either US or China, we note, that the China-only swap line countries skew heavily towards having a larger proportion of copper production (with generally larger trading relationships) on an annual scale which may help bolster domestic production in periods of liquidity stress going forward.

We note that the existing split between the US and China is much more balanced when looking at Oil Production and Bilateral Liquidity Swap Arrangements (BLSWAPs) (29%/31%) relative to Copper Production/Reserves (40%/23%) in Chart 14. China and BLSWAPs have a significant foothold in the world’s refining annual capacity at ~60% (mostly within China). The European Union also has a high annual net import reliance at 82% with little mine capacity. Allocation of energy resources has typically been the source of geopolitical conflicts in the past given they are limited and mining/extraction has been energy-intensive.  

Note that Chart 14 does not include significant production from African nations such as Zambia, the Democratic Republic of Congo, or Peru, which on a combined basis have copper reserves of 28 years’ worth of annual production and represent ~24% of annual world production or 15% of the world’s copper reserves. However, despite not having a bilateral swap arrangement with the PBOC, all three countries are members of China’s Belt and Road Initiative and Free Trade Agreements exist (Peru) which may secure the supply of copper from these countries for China in exchange for infrastructure/further economic development. As an recent example, Shanghai-based China Cosco Shipping is building a new $3 billion port at Chancay in Peru, while there are ambitious proposals for a transcontinental railway linking South America’s Atlantic and Pacific coasts from Brazil to Chile.

However, despite not having Free Trade Agreements in place with Chile and Peru, the U.S. has had strong diplomatic and economic ties with Latin America for many years and currently imports copper from the region. Latin America has historically been the part of the world with the highest approval rating for the U.S., rooted in foreign assistance, law-enforcement cooperation, education, and cultural ties.

The question remains if existing agreements and supply chains will be enough to meet the increased demand for copper and other relevant minerals as the global transition to clean energy moves ahead, without severe geopolitical conflicts over resources.

Chart 14: Bilateral Swap Lines (US Fed /PBOC), Copper/Oil Production, Copper Net Import Reliance US and China

4. Overview of BT Copper Model – Another Shield for the Armory

Now that we have reviewed the supply and demand dynamics of copper, we will start to integrate the BT G20 dataset, along with further data gathered based on our review of the global copper market.  

As Chile plays a significant role in the global copper market, we have included monthly statistics including the Chilean Peso/USD exchange rate, Chilean electricity production, and total copper production/exports.

As copper plays heavily into international trade and the a significant proportion of trade is moved via maritime transport. Therefore, we have also included the Baltic Dry Index as a proxy for shipping costs that may factor into copper market pricing.    

Each country’s dataset was tested against the 12-month change in the price of copper and the top 10 features at each country level were selected and combined with the Chilean data set. See Chart 15 for the feature set used.

The training monthly dataset period began in October 2002 until January 2018. The out-of-sample testing period ran from February 2018 to November 2021.

Chart 15: BT Select G20 Model Feature Set and Features with High Model Value (in Green)

The rate of 12-month change in Copper prices appears to be strongly correlated with the rate of change with an R-squared of 0.89 (goodness-of-fit) in the out-of-sample period 2018-2021 (Chart 16):

• Canadian dollar/US dollar exchange rate
• Mexico’s OECD CLI/Mexico exports to the U.S.
• U.S. dollar liquidity (Money  Supply)
• U.S. Treasury 10-Year Yield
• Oil Price
• Chilean Peso/US dollar exchange rate
• New Orders in European Union
• Motor Vehicle Sales in China
• China Economic Activity represented by BT Custom Index

Chart 16: Summary BT Copper Model an Example Feature Set (Extra Trees Regressor) Sensitivity

Summary Observations on the BT Copper Model:

• Despite being a top 5 producer, the U.S. is a net importer of copper and relies on trade partners such as Canada, Chile, and Mexico to supply copper and other value-added processing/smelting. As a result, cyclical changes in demand/supply may have a significant impact on the world price of copper. Canada also attracts major foreign investment flows from aboard as well (see Chart 17 below) given unparalleled access to capital markets (TSX and TSX Venture Exchange), innovation, and expertise across the clean technology and mining services and supply chains.

• Changes in Maritime Shipping rates were not significantly correlated with changes in copper prices

• South Korea’s Industrial Production and exchange rate relative to USD were significantly correlated. South Korea is a net exporter of copper (11^th largest exporter) and 55% of exports go to China. South Korea produces copper for cars, vehicle parts, and marine applications.  Also, Samsung and SK Hynix are South Korea’s biggest chipmakers and two of the world’s biggest producers of memory chips (which include copper) used in everything from smartphones to automobiles and aerospace equipment. All of the microchips used in Apple iPhones are made by Samsung.

• The price of Copper and U.S. Trade-weighted dollar appear to be negatively correlated – see Chart 18. This is common across most commodities priced/settled in USD. The Trade-weighted dollar index strengthens as the U.S. Fed raises short-term rates slowing the pace of copper price growth (and the economy including slowing the consumption of imported goods and building homes which rely on copper), and tends to decline with large U.S. budget/trade deficits/lower Fed Funds rate, supporting higher copper prices (improving the growth in the economy including higher consumption of imported goods and housing starts which rely on copper) – see Chart 19.

• China’s EV car market share is only at about 6% of total sales, yet changes in copper prices, are strongly correlated with changes in Motor Vehicle sales. Given the relative size of the Chines economy on a global scale, change in demand for cars (conventional and EV) may impact copper prices.

• Commodity Driven Economies: Countries that have significant activity related to mining resources have a significant correlation to changes in industrial metals such as Copper (Canada, Russia, Australia, Brazil, Chile). The Copper/Gold Ratio also tends to track the G20 OECD CLI well over time and could be a significant cyclical indicator that you can monitor daily.

• China’s role as a top consumer and net importer of copper appears to have an impact on the price of copper via changes in industrial activity as measured by the BT China Custom Index.

Chart 17 – Global Mineral Investments in Exploration

Chart 18 – Copper Price vs U.S. trade-weighted Exchange Rate

Chart 19 – U.S. Twin-Deficits, U.S Trade-weighted Exchange Rate, Fed Funds Rate

1. Includes Fiscal Balance and Trade Balance as % of GDP.

Join us for Part II in which we review our Gold model and Gold market dynamics (we plan to post in a few days). Thanks for reading. Appreciate any questions or feedback you have or other research topics you may suggest.

Please contact us at beowulftreasury@gmail.com.

BT