Freeport-McMoRan (NYSE:FCX) oversaw the destruction of billions in shareholder wealth through speculation in the production of commodities. Investors familiar with the operations may assume that I'm talking about their decision to purchase oil exploration assets near the top of the oil market. That would be a reasonable interpretation, but that isn't the area I want to focus on. Like most shareholders in Freeport-McMoRan, I now hold a very small position. Like most shareholders, it started out as a large position but the rampant destruction of wealth shrank the position substantially.
When I entered into a position, it was based on a fairly complicated model used to predict future earnings. The model worked great, except it took far too much time to keep it up to date and I opted to issue warnings to readers before following my own conclusion about deteriorating fundamentals. By the time I was ready to follow my own conclusion, the market had reacted and shares fell substantially. After having a few months to contemplate the decision, I kept coming back to the idea of futures contracts. I want to expand on that idea today to demonstrate precisely what is wrong with the industry and how to fix it.
Futures and Share Prices
I've discussed futures contracts for Freeport-McMoRan occasionally. Back on September 19th, I made the argument that I'd like to see management hedging future production with futures contracts. One concern readers had at the time was that it would've been vastly superior for management to hedge the costs when prices were substantially higher. It was a legitimate concern, and I would expect that management of FCX had a similar opinion. Unfortunately, since then prices on copper continued to fall and oil has plummeted substantially further. Since Freeport-McMoRan is trapped by a weak balance sheet that forced them to issue dilutive equity to sustain their operations, their share price has cratered in a way that makes the commodity movements look tame.
September 19th the markets were closed; on September 21st, 2015, shares closed at $10.51. That is fairly weak, but it is still materially better than being below $4. Spot prices for commodities had a very strong correlation with futures prices, and Nasdaq has some nice tools for tracking the futures prices for commodities:
Under my suggested strategy, FCX would've been locking in copper prices around $2.30 to $2.45 and crude oil prices around $47 to $49. Compared to copper at a hair under $2.00 and crude oil at $32.19, those futures contracts sound like they would have been great.
On the other hand, if futures markets moved in the opposite direction the suggestion would've been forgotten as FCX would have rallied dramatically on higher commodity prices.
The Old Dynamic
I want to suggest an entirely different economic model for the production of raw materials. After discussion with a few colleagues about what industries might be ripe for "Uberization", I keep coming back to the mining economy. The current mining economy is a high risk, high loss (supposed to be high reward, but…) industry. The natural argument in defense of this system is simply "That's just how it is". I believe the result is a terrible inefficient industry that serves neither shareholders nor the world's economy to the best of its ability.
For investors that are not familiar with uberization, it is the concept of being able to rapidly adjust supply and demand in real time to reflect the market situations. While this concept was initially applied in regards to modifying prices to equalize the quantity supplied and the quantity demanded in real time, it can also be used to establish more efficient capital allocation planning over the span of several years.
When Freeport-McMoRan wants to develop an asset, they must buy that asset for hundreds of millions (sometimes less, sometimes more, depending on the size of the asset and bull/bear nature of the market). They must then pour in an enormous amount of resources as they develop the asset to extract the raw materials. This is an absolutely terrible system. If you remember "Porter's 5 Forces", you'll know that these huge fixed costs and barriers to exit are problems because they create more intense competition. If you've studied Modern Portfolio Theory, you'll recognize that the volatility of this operation results in a much higher cost of equity. If you've read "Security Analysis", you'll know the importance of having a solid business plan. By any of these measures, the current industry is a complete failure.
A New Dynamic
I want to suggest an entirely different model of planning that I believe would result in the entire industry seeing vastly superior returns over the next several decades. However, those great returns would not merely be the result of gouging customers and bleeding the rest of the world economy. The returns would come from a business model that I believe is inherently superior. I want investors to consider the triple net lease REIT business model for a moment. These REITs buy property and lease it to customers with the customer paying most of the operating costs. The leases usually cover several years, often more than a decade. Specifically, I want to highlight STORE Capital (NYSE:STOR), National Retail Properties (NYSE:NNN), and Realty Income Corp. (NYSE:O). These are three simple net lease REITs. NNN and O have decades of history while STOR is a much newer entrant to the sector, though their management has several decades of experience in managing real estate. When STORE Capital released their last earnings presentation, they included the following slide:
I put the green box around the area I want to talk about. STORE Capital's weighted average lease term remaining is a staggering 15 years. NNN has 12 years, and O has 10 years. These are experts in running the triple net lease REIT business model. These REITs all trade at substantial premiums to the REIT industry and the triple net lease REIT sector. Investors are drawn to these companies because they offer the exact opposite of the Freeport-McMoRan experience. They have extremely reliable earnings (when measured by AFFO and FFO) and they use those earnings to pay out an increasing stream of dividends. Realty Income Corporation has increased their dividend over 80 times. Assuming no new acquisitions, these companies could create fairly solid estimates of their revenues, AFFO, and FFO 5 to 10 years in advance. Because of the way they finance new acquisitions, those estimates for revenue, AFFO, and FFO should establish the baseline for what investors should expect.
Applying the triple net REIT model to Freeport-McMoRan
It wouldn't be possible for Freeport-McMoRan to price in their costs of production in the same way that a triple net lease REIT passes on costs to customers. However, it would be entirely possible for them to plan their future production and acquisitions by estimating the production volume for future years and then selling 80% to 90% of that volume in the futures market. They would want to treat the futures positions as hedges and match them up to physical production. The relevant metrics for shareholders would be looking at their earnings (or adjusted earnings) for future periods while treating the gain or loss on the futures contract at expiration as a direct change to gross revenue. Since the expiration of the contract would occur in the same quarter as the shipment of physical goods (sold at the market price), their cash flows would be almost identical to a scenario where they were simply selling for the futures price rather than the market price.
Isn't That Speculation?
Investors may be prone to think of trading futures contracts as speculating. For the normal retail investor, I would agree with that classification. However, think about how these triple net lease REITs are doing so well. They own physical assets in the form of real estate. That real estate will produce something of value in each future period. Specifically, it will produce the opportunity for a tenant to run a business in the location. If a store was vacant, it would represent a waste of that opportunity, but the opportunity still would have existed. Does anyone think these companies are speculating by signing leases that will last a decade? I don't think they are speculating at all. They are creating revenue certainty.
In this context, a mine that can be used to produce copper and gold is also a physical asset. Because Freeport-McMoRan will produce the raw materials that it wants to sell in future periods, using futures contracts to effectively lock in the price a decade in advance would create revenue certainty. To avoid posting enormous margins when commodity prices fluctuated, FCX might need a third party involved to cover the margins. That party would handle putting cash up for margin when commodity prices moved much higher and holding the cash when commodity prices moved lower. If FCX could provide shareholders with a fairly solid estimate of their revenues, earnings per share, and operating cash flows 5 and 10 years in advance, would shareholders feel that their investment was more speculative or less speculative?
Because the investment would be less speculative in nature, the returns demanded by shareholders would also be lower. Lower risk justifies lower expected returns. That means more capital readily available for developing any profitable mining operations. It doesn't just lower the cost of equity capital though; it also lowers the cost of debt capital because the bond holders care a great deal about the certainty of getting their cash back. Any mining company, or off shore drilling company, using this strategy should expect credit rating upgrades and the ability to issue bonds at materially lower rates.
By locking in their revenues, earnings, and cash flows years in advance, the mining industry should see a much lower weighted average cost of capital. Other sectors have already demonstrated the value of establishing long term contracts to create revenue certainty. By establishing revenue certainty, the management of the company can focus simply on driving down their cost of production and acquiring assets that will generate a respectable yield based on selling the production several years in advance. Some investors may be concerned that this technique would result in overloading the futures market, but I think the market would adapt rapidly. If the companies could not sell their commodities years in advance, they would refuse to make capital expenditures which would result in declining estimates of supply. The expectation for weaker supply would make buying the futures contracts more appealing and bring in new customers.
The best scenario for Freeport-McMoRan would be if other mining giants such as BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) decided to commit to the same strategy. Initially this might create an exceptional amount of demand for futures contracts to sell their production, but over time it should reduce the amount of excess capacity being developed. Rather than guessing at the market price for copper and oil over the next few years (where FCX failed spectacularly), they would be making decisions based on reliable estimates of the revenue that would be earned over the next decade.
I feel compelled to point out that if FCX opted to use this kind of strategy, they would need to be very mindful about structuring contracts regarding assets where the government has excessive ability to interfere. For instance, in Indonesia this strategy would be problematic because FCX is unable to be certain that they would successfully produce the physical assets to settle their contracts.
Disclosure: I am/we are long FCX, NNN, STOR.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.