Five weeks into 2011, and investors are looking at their first bona fide bubble of 2011. All that money sloshing around global markets, led by the Federal Reserve’s massive easing policy, was bound to start igniting various speculative asset classes. Gold surely looked frothy in 2010, and in 2011, it’s copper that’s looking bubble-icious.

 
 

You have to take a 15-year look at copper prices to understand just how crazy the current market looks. For a decade up until 2005, copper usually traded for $75 to $100 a pound. That price reflected a nice equilibrium between supply and demand. It was also a period of steadily declining output of copper, as second-tier and third-tier mines were hard-pressed to make money.

China changed the whole dynamic. As its economy started to take off during the past decade, demand for copper, which is used in many industrial and construction applications, soared, pushing prices up above the $300 mark in 2006, 2007 and 2008.

Although copper prices eventually cooled, China learned its lesson. The next time copper prices took off, China would have ample supplies on hand to draw upon if necessary. And that’s precisely what’s happening now. China’s stockpiles of copper rose from 150,000 metric tons last July to more than 300,000 by the end of 2010, according to Scotia Capital. That’s just the officially cited figure of the Shanghai Futures exchange, which doesn’t account for copper that is warehoused outside of government-regulated sites. At some point, perhaps very soon, China’s stockpiles will be sufficient, and this key segment that drove demand in 2010 will fall off.

Demand destruction and supply stimulation
Make no mistake: $400 copper has a real impact on construction costs. When prices spiked back in 2007, many copper consumers looked for ways to replace the metal when possible. For example, plastics-based plumbing can be swapped for copper-based plumbing in certain applications. In other areas, aluminum can be swapped, and aluminum has not enjoyed the remarkable price run that copper has. Copper is also heavily used in air-conditioners, and manufacturers are now boosting prices to offset the spike. That may blunt some of the strong demand for air-conditioning units we’ve seen in China the past few years.

In addition to the China wildcard, $400 copper also alters the supply dynamic. As noted earlier, a number of mines were economically infeasible when the red metal was cheaper, but they would now be wildly profitable. As a result, plans for roughly a dozen new copper mines have been announced in the past six months. It will take several years for those mines to come online, so industry output may not materially rise for a few more years, but investors look well down the road in an industry like this.

The future market helps tell the story. Contracts to buy 1,000 pounds of copper for deliveries in the next nine months appear stable at around $460, but then steadily drop by about 15% during the next four years. As plans for re-started copper mines are announced in coming months, I suspect the futures prices could drop yet lower. Most analysts seem to avoid the topic, but Morningstar concisely sums up the looming problem for high-flying copper prices: “Major mining firms, prompted by today’s heady mix of record copper prices and incredibly cheap capital, will undertake dramatically more growth projects than previously expected,” wrote their analysts in a February 3 report.

What it means
For Freeport-McMoran (NYSE: FCX) and Southern Copper (Nasdaq: SCCO), the industry’s two largest publicly-traded players, this math implies that these companies are approaching the peak of their cycles.

Using Freeport as an example, both sales and EBITDA are expected to hit a cyclical peak in 2012 and then fall about 10% in 2013, according to Citigroup. Yet the company’s ever-soaring stock seems to be ignoring that drop-off. Shares trade for about nine times projected 2012 earnings. Yet in past cycles, the stock has traded for around seven times peak earnings (and fell as low as 3.5 projected times earnings in 2008).

Looked at another way, Freeport just earned $2.32 a share in 2010, the first time the company has ever earned more than $2 a share in its history (split-adjusted). Strip out the strong 2010 and the dismal 2008, and Freeport has earned an average of $0.91 a share during a seven-year stretch. (Shares trade for more than 60 times “normalized” earnings.) Analysts think earnings will be an eye-popping $6.50 a share this year. But to use the $6.50 forecast as a “new normal” completely ignores the supply and demand dynamics of this industry. Copper is in a bubble, and so are shares of Freeport.

Shares of Southern Copper also look extremely pricey. Morningstar, which generally had a positive review of the company, believes it should trade at seven times EBITDA, or $25 — well below the current $46 share price. UBS sees shares falling to $33, predicting that copper prices will fall back to $2.50 a pound by 2015.

Action to Take –> Copper is scorching hot, and momentum investors are marking solid gains as the metal’s price continues to surge. But if you hold either of these stocks, I wouldn’t risk holding these shares any longer.

A deeper look at the supply-and-demand dynamics should be of real concern. The bubble could keep going for a while longer — a key concern for shorts, but if you’ve got a 12-18 month time horizon, you should short this bubble.

P.S. — There’s an interesting way to make money that’s getting a lot of attention lately. In short, a Texas man has figured out how to collect an extra $3,000 to $6,600 each and every month by simply owning shares of some of the safest stocks on the planet. If this sounds like something you’re interested in, keep reading…