Want To Bet On A Crude Or Iron Ore Rebound? Look Outside The USA

by: Paulo Santos


Many commodities are now trading at levels which ensure the exit of many producers from the field.

The impending removal of capacity as well as widespread losses and bankruptcies is a hallmark of a cyclical bottom.

It's thus natural to be looking for investment oportunities in the sector, for the coming, if delayed, cyclical upturn.

This time, though, the easier answer might be somewhat outside of the U.S. markets.

This is more of a general case to my article titled "The Best Way To Play Crude Is To Buy Russia," which was geared just towards investing in crude via Russia and the Ruble.

There's an interesting thing happening. The exporting countries of most imploding commodities like crude (NYSEARCA:USD), natural gas (NYSEARCA:UNG) or iron ore, all have naturally seen their currencies become extremely weak.

Imploding Commodities

For instance:

  • Natural gas, sourced from Russia and at Germany's border, went from $10.99/mmBTU in early 2014 to $5.09/mmBTU at the end of January.
  • Brent crude went from $110/barrel in early 2014 to $31.80/barrel a couple of days ago.
  • Iron ore, 62% Fe bound to China CFR, went from $134.20/ton in early 2014 to $47/ton last week.

These were all massive moves. Natural gas fell 53.7%, Brent crude fell 71.1% and iron ore fell 65%.

Any producer exposed to these moves was bound to quickly get into trouble, as these are very capital-intensive industries. But something else made some producers more exposed than others.

All the prices above, which represent revenue, are expressed in dollars. For a producer receiving revenues in dollars, the question then becomes "in what currency does it (mostly) pay its costs"?

U.S./EU Producers

For US producers, for instance shale producers like Chesapeake Energy (NYSE:CHK) or Ultra Petroleum (NYSE:UPL), those costs were paid in dollars. Sure, there was a drop in demand for oil services which led to those services (mining, drilling, fracking, etc) becoming cheaper. And they became more efficient as well. But still, by and large the costs had no way of following the price crashes. The same applied to an iron ore producer like Cliffs Natural Resources (NYSE:CLF). As a result, U.S.-based, or even Europe-based producers of these commodities were slaughtered, with many still running straight into bankruptcy.

Producers Elsewhere

But what about producers elsewhere? Say in Australia, Brazil or Russia? A very different dynamic took place:

The currencies of those countries took a large plunge to reflect the exposure of those economies to the commodities crash. For instance, in the same time frame as above (early 2014 to present):

  • The Australian Dollar lost 20% of its value against the USD.
  • The Brazilian Real lost 40% of its value against the USD.
  • The Russian Ruble lost 57% of its value against the USD.

Now remember, the producers in those countries (Australia, Brazil, Russia) are mostly exposed to costs denominated in local currency for the production of those commodities denominated in dollars. So, as an example:

For natural gas

A company like Gazprom (OTCPK:OGZPY) would have seen the price of what it sells to Europe drop by around 53%. If we allow for constant quantities, it would have lost more than half its revenues in dollars. But as it were, its costs, denominated in Rubles, fell even faster (the RUB lost 57% against the USD in the same period)!

So, such a company was very likely to remain profitable and viable. And it did. Its stock dropped, its worth in dollars dropped, but the company itself remains as healthy as it was before. For instance, in the 9 months to September 2015, Gazprom had growth both in revenues (+4.9%) and operating profits (+4.4%).

Contrast that with the shale E&P companies in the U.S., which will be falling off like flies.

For crude

The same effect took place. If you look at Lukoil in the Moscow exchange, its share price is actually up ~20% since the start of 2014. This is so, again, because what crude fell (71.1%) was mitigated by the drop in the Russian Ruble (57%). In Rubles, the impact was much mitigated.

For iron ore

For iron ore, there is something similar happening with a lesser-known producer, Fortescue Metals. Fortescue Metals was a late entrant into the cost-advantaged mining of iron ore in Australia. With its mining projects being recent, it was naturally saddled with heavy debt and was thus a prime candidate to not survive the present downward cycle in iron ore.

However, with the current drop in the AUD and crude, plus other cost-mitigation measures, Fortescue now seems entirely sustainable, with >$2.5 billion in EBITDA sustaining ~$6.2 billion in net debt. For our sadness, however, the company trades at a not so cheap ~10.6x EV/EBITDA.

A Counterpoint And Conclusion

While in local currency the local companies (in Brazil, Russia, Australia) end up looking healthy, they're still worth less for U.S. investors due to the translation effect (translating from local currencies to USD), which makes their revenues, profits, etc., be worth less than in the past.

Still, due to this same effect, the foreign companies are much healthier than their US counterparts - because although they had to contend with lower USD pricing for their products, at least they got to pay for the cost of production in locally depreciated currency as well.

The end result is that it might be much easier to find cheaper and healthier investment alternatives in those deeply punished countries and sectors, than in the U.S. market.

Disclosure: I am/we are long OGZPY.

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.

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