Don’t let the rally fool you: Commodity companies are headed for a massive debt cliff

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

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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 increase within the fourth quarter and it is more than double year-earlier levels.

While recycleables have rebounded in the past month, they are still well below amounts of even 2 yrs ago – 28 percent in the case of copper and 64 per cent for crude. To finish the gluts that sank prices, companies needs to be cutting more output, however, many continue to be so deeply in debt that they must keep churning out cash to stay above water.

“I refer to it as the commodity conundrum,” said Jessica Fung, a commodities analyst with BMO Nesbitt Burns Inc. in Toronto. “Cutting production is completely the last resort for just about any company because you’re basically closing your revenue generation. And then what?”

More Defaults

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

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With crude crashing from more than US$100 a barrel in mid-2014 to as little as US$26 recently, your debt ratios are becoming worse for many drillers, even the investment-grade companies like Anadarko Petroleum Corp. which have been cutting output and costs.

A surprise rally in metals because the start of year has helped ease the burden for many gold producers, including Newmont Mining Corp. and Barrick Gold Corp., and mining stocks in February had their biggest one-month tear since 2009. Iron ore prices that had plunged for 3 straight years are up 46 per cent this year, though they’re still half what they were two years ago.

Burden Grows

But on a single 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 in the annual conference of the Prospectors & Developers Association of Canada, the world’s largest mining convention. “The issue is debt.” Bianchini estimates $50 billion to $60 billion in capital is needed for that mining industry to stabilize itself after the commodity rout.

Freeport-McMoRan Inc., the largest publicly owned copper producer, has witnessed its ratio of debt to adjusted earnings before interest, taxes, depreciation and amortization a lot more than be used as of Dec. 31, to 5.6 from 2.1 a year earlier, data published by Bloomberg show. The company on Jan. 26 said it is looking to chop its $20 billion debt by $5 billion to $10 billion through multiple transactions.

Debt for oil and gas producer Anadarko was at 3.Five times adjusted EBITDA after 2015, compared with 0.9 a year earlier, the data show.

“That is a serious problem,” Bianchini said. “I was taught in early stages that debt kills. It’s likely to kill several companies now, or at best take a few appendages.”

John Thornton, Barrick’s non-executive chairman, said there are only 3 ways for extraction companies to pull from the spiral: produce more money, issue more equity or sell assets.

Restructuring Industry

“Probably if prices stay as they are then we’ll see next year lots of restructuring from the mining industry,” said Diego Hernandez, ceo of Antofagasta Plc, 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 in the right price.

For now, miners selling assets are charging an excessive amount of because they haven’t accepted the reality that prices might be lower for a long time, said Oscar Landerretche, non-executive chairman of Codelco, the world’s largest copper producer.

Oil Producers

The oil market is faring a whole lot worse.

Since the beginning of 2015, 48 North American oil and gas producers have declared bankruptcy using more than $17 billion indebted, according to law practice Haynes and Boone. Recently, Chaparral Energy Inc. and SandRidge Energy Inc. missed interest payments on their own debt. Both companies have drawn down their full line of credit and hired legal and financial advisers, moving viewed as a prelude to bankruptcy.

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

Interest Expenses

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

Yet many producers had continued to enhance output until late last year. Area of the reason is the fact that cash-strapped companies need to keep growing to keep their line of credit from shrinking. The total amount banks are willing to lend to borrowers with riskier credit is dependant on how big a company’s reserves and also the cost of crude. The loans are typically readjusted twice a year, around April and October. If your 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 appear to be as near towards the bankruptcy cliff, partly because many negotiated longer-term debt after the last commodities downturn in 2008. The cost of shuttering a mine is enormous, meaning that creditors might be lured to let companies still produce baffled while still trying to shed their weakest assets.

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

“I’ve covered this industry since the late ’70s and I would need to say I haven’t seen a scenario like this, of the magnitude,” said Carol Cowan, a Moody’s senior analyst. “We’ve figured this isn’t an ordinary cyclical downturn.”

Bloomberg.com