Don’t let commodities rally fool you

If you think commodity producers are out of the woods as markets rally, here’s a reality check: many are still grappling to contain debt.

Toronto - If you think commodity producers are out of the woods as markets rally, here’s a reality check: many are still grappling to contain debt.

Another year of belt-tightening hasn’t kept pace with an earnings slump after prices collapsed. One gauge of leverage among mining, energy and agriculture companies continued to rise in the fourth quarter and is more than double year-earlier levels.

While raw materials have rebounded in the past month, they are still well below levels of even two years ago - 28 percent in the case of copper and 64 percent for crude. To end the gluts that sank prices, companies ought to be cutting more output, but many are still so deeply in debt that they need to keep churning out cash to stay above water.

“I call it the commodity conundrum,” said Jessica Fung, a commodities analyst with BMO Nesbitt Burns Inc. in Toronto. “Cutting production is absolutely the last resort for any company because you’re basically shutting down your revenue generation. And then what?”

More defaults

Unless commodity prices extend gains, the conundrum holds grim consequences for 2016 for some producers. The debt burden is growing for many miners and drillers no matter how hard they pump and dig. Corporate defaults will reach a six-year high this year, led by commodity companies, according to Moody’s Investors Service, which in January put 55 mining companies and 120 oil and gas drillers on watch for possible downgrade.

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With crude crashing from more than $100 a barrel in mid-2014 to as low as $26 last month, the debt ratios are getting worse for many drillers, even the investment-grade companies like Anadarko Petroleum Corp. that have been cutting output and costs.

A surprise rally in metals since the start of the year has helped ease the burden for some gold producers, including Newmont Mining Corp. and Barrick Gold, and mining stocks in February had their biggest one-month tear since 2009. Iron ore prices that had plunged for three straight years are up 46 percent this year, though they’re still half what they were two years ago.

Burden grows

But on one key metric - leverage - most commodity producers are struggling.

“There’s still some decent cash flow,” Egizio Bianchini, co-head of global metals and mining group at the Bank of Montreal, said Tuesday in Toronto at the annual conference of the Prospectors & Developers Association of Canada, the world’s largest mining convention. “The problem is debt.” Bianchini estimates $50 billion to $60 billion in capital is needed for the mining industry to stabilise itself after the commodity rout.

Freeport-McMoRan, the largest publicly traded copper producer, has seen its ratio of debt to adjusted earnings before interest, taxes, depreciation and amortisation more than double as of Dec. 31, to 5.6 from 2.1 a year earlier, data compiled by Bloomberg show. The company on January 26 said it is looking to cut its $20 billion debt by $5 billion to $10 billion through multiple transactions.

Debt for oil and gas producer Anadarko was at 3.5 times adjusted EBITDA at the end of 2015, compared with 0.9 a year earlier, the data show.

“That is a big problem,” Bianchini said. “I was taught early on that debt kills. It’s probably going to kill a few companies this time around, or at least take a few appendages.”

John Thornton, Barrick’s non-executive chairman, said there are only three ways for extraction companies to pull out of the spiral: produce more cash, issue more equity or sell assets.

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Restructuring industry

“Probably if prices stay as they are then we’ll see next year a lot of restructuring of the mining industry,” said Diego Hernandez, chief executive officer of Antofagasta, the mine owner controlled by Chile’s richest family. His company’s cash and liquid assets exceed debt, and Hernandez said it may look to buy more assets at the right price.

For now, miners selling assets are charging too much because they haven’t accepted the reality that prices could be lower for years, said Oscar Landerretche, non-executive chairman of Codelco, the world’s largest copper producer.

Oil producers

The oil industry is faring even worse.

Since the start of 2015, 48 North American oil and gas producers have declared bankruptcy with more than $17 billion in debt, according to law firm Haynes and Boone. Last month, Chaparral Energy Inc. and SandRidge Energy Inc. missed interest payments on their debt. Both companies have drawn down their full credit line and hired legal and financial advisers, a move viewed as a prelude to bankruptcy.

Drillers’ debt ballooned to $237 billion at the end of the third quarter, a 12 percent increase from the previous year, according to the most recent data available that is compiled by Bloomberg on 61 drillers in the Bloomberg Intelligence index of North American independent oil and gas producers.

Interest expenses

Keeping up with debt has gotten tougher, too. In the third quarter of 2015, interest expense exceeded 10 percent of revenue for 28 of the drillers in the index. A year earlier, only 13 companies had debt payments that high.

Yet many producers had continued to boost output until late last year. Part of the reason is that cash-strapped companies need to keep growing to keep their credit line from shrinking. The amount banks are willing to lend to borrowers with riskier credit is based on the size of a company’s reserves and the price of crude. The loans are typically readjusted twice a year, around April and October. If a company doesn’t add new wells, then its reserves fall as the oil is pumped out of the ground and sold, causing its credit line to shrink just when the company needs money most.

Miners don’t seem to be as close to the bankruptcy cliff, in part because many negotiated longer-term debt after the last commodities downturn in 2008. The cost of shuttering a mine is enormous, meaning that creditors may be tempted to let companies continue to produce at a loss while still trying to shed their weakest assets.

And nobody knows how long the downturn is going to last.

“I’ve covered this industry since the late 70s and I would have to say I haven’t seen a situation like this, of this magnitude,” said Carol Cowan, a Moody’s senior analyst. “We’ve concluded that this is not a normal cyclical downturn.”

--With assistance from Asjylyn Loder and Scott Deveau.

BLOOMBERG