Leverage Is Lethal For Commodity Producers

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Includes: DBC
by: Christopher Mahoney

Summary

Negative free cashflow will force these companies to borrow.

Credit market appetite for their debt is dwindling, and ratings are pressured.

Bankruptcies loom.

Most big companies seek the highest possible credit rating for many reasons, one of which is ready access to the debt markets. Life is easier when you can borrow large sums at low interest rates at short notice. Some managements believe that highly rated companies can take on debt because they have market access. Unfortunately, this theory can be a fatal trap.

A large debt load is only sustainable as long as market access is assured, and it is never assured for anyone (recall 1932, 2002 and 2008). Any company can lose market access at any time. I could make a long list of investment grade companies that have lost market access without much warning.

Today we have two industries at risk of financial disruption: energy and mining (E&M). Of course, the minor players face problems, but that is not news. It is not a black swan. The names to worry about are those companies with two characteristics: (1) investment grade ratings and (2) negative free cash flow.

Given the expense structure and the operating leverage of E&M companies, the income statement is meaningless, as is EPS. Debts are not paid with profits, they are paid with cash. Positive free cash flow and net income are unrelated.

When I look at the big E&M companies, I see falling or negative operating cashflow, large capital expenditures and dividends. The dividends and negative free cash flow are being financed by the issuance of long-term debt. The dividends can (and must!) be stopped, but unfortunately a lot of the capex can't be because resource development projects take years. Exploration and new projects can be suspended, but those in development generally can't be.

When we look at these companies' 2016 cash flow statements a year from now, we will not see a substantial reduction in capex, despite negative operating cash flow. That means that these companies must raise cash in 2016, either via asset sales or more debt or, theoretically, more equity. Given current commodity prices, equity and asset sales will be difficult, which suggests that the crucial survival factor will be credit market access.

Creditors know all of this. They know that many E&M companies' breakevens are above current prices, free cash flow is negative and they will need to borrow. Knowing that, creditors will generally seek to reduce exposure to E&M, making borrowing difficult.

To determine the stress horizon for E&M companies, the investor should assume loss of market access and calculate how long the company can burn through its cash and committed bank lines, while repaying maturing debt. They should closely monitor credit ratings because the loss of investment grade status can result in a loss of market access. Rating changes are not always predictable with respect to either timing or severity.

Here is what Moody's said last week about the major oil companies:

"The integrated oil and gas companies (IOCs) will experience stressed cash flow metrics in 2016-17. The lower-for-longer price scenario that we expect will result in weaker-for-longer financial profiles, straining the IOCs' ratings and outlooks in 2016, despite their generally resilient credit profiles. Lower oil and natural gas prices will keep the IOCs' earnings flat or lower in 2016, aggravating the industry's negative free cash flow, which we estimate at about $60 billion for 2016, and heightening its funding needs."

Many E&M companies have big cash piles and staggered debt maturities. That will allow them to stay afloat a while longer while hoping for higher prices. But absent a burst of commodity inflation, some of these companies could go bust.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long stocks and bonds.