The biggest risk for gold and commodity investors
With commodity prices falling and mining project costs adding up, is this the time for investors to cash out?
A few years after the global economy emerged from the economic crisis of 2008, commodity prices began to surge, thanks to ongoing robust demand from China. Chief financial officers at mining firms quickly realized that firm commodity prices implied robust future profit streams, and a broad range of new mining projects were put into motion.
To pay for those projects, billions of dollars were borrowed, and investors began to anticipate impressive cash flow returns from all of that borrowing. Just a few years later, that optimism has evaporated.
Slumping commodity prices have hurt potential returns from these expansion plans. Of greater concern, some mining firms are now carrying too much debt, and unless commodity prices rebound, they could be looking at a cash crisis in the next year or two. The Reuters/Jefferies CRB Index, which tracks a basket of commodity prices, has posted some mini-rallies in the context of a broader downtrend over the past few years.
How big of a debt hangover are we talking about? A basket of 55 leading miners held a collective $2 billion in debt 10 years ago, according to BMO Capital Markets. That figure has now risen above $20 billion.
Indeed, much of the debt has been accumulated in just the past few years, as bonds were sold to embark on major new mining projects. Trouble is, once these projects get underway they start to soak up huge amounts of capital spending, and often need to receive many more cash injections to see them to fruition.
For example, take Newmont Mining (NEM). In 2012, the company spent $3.2 billion on mine development, which was roughly twice the company's 10-year average. To pay for that, total debt swelled from $4.3 billion to $6.3 billion. (And debt has risen yet further to $6.8 billion in the middle of 2013.) And just to finish up the mining development work that began a year or two ago, Newmont will be spending more than $2 billion this year as well.
Meanwhile, the recent plunge in gold and copper prices led Newmont to write off more than $2 billion from its stated asset value when quarterly results were released last week. If commodity prices slump further and stay down for several years, Newmont's debt load may start to force the company to unload assets at fire-sale prices.
Selling off assets at a time of depressed commodity prices brings its own pain. To start to meet a massive 12- to 18-month funding gap, Barrick Gold (ABX) recently sold its energy division for roughly $450 million. Barrick had been carrying that asset on its books for $900 million and now needs to take a big write-down. The move leads to concerns that as other mining firms look to sell assets, investors may sense that their current balance sheets represent a far too optimistic valuation of their asset base.
Many other firms focused on mining, commodities processing and finished goods production (such as steel makers) need to make sure that there is enough cash on hand to meet the next few years' worth of debt obligations. Here's a quick look at firms that currently lack the cash to meet their debt obligations that will come due over the next two to three years.
For smaller firms, known as junior miners, the situation could become even more dire -- as their total debt is often expected to be repaid in less time than the big miners. Some mining firms have seen their share prices plunge more than 50% this year. Such a sharp downward move often suggests looming financial distress. That's not always the case, so it pays to do more research to identify potential balance sheet risk, but some of these big plungers include:
Allied Nevada Gold (ANV)
Golden Star Resources (GSS)
Detour Gold (DRGDF)
Perseus Mining (PMNXF)
Hochschild Mining (HCHDF)
Risks to Consider: As an upside risk, any sign that China's slowdown has been mitigated by government stimulus programs could give a quick boost to commodity prices.
Action to Take: The mining industry is suffering from both a slowing in China and an overly ambitious expansion program over the past few years that is bringing too much supply to a depressed market. We probably haven't seen the last of this industry's woes, and before you decide to invest in miners, you should assess their balance sheet and cash flow statements with a great deal of scrutiny.
Also, today's tougher pricing environment, and the cash crunch it is causing, is leading to a sharp slowdown in any new project development. That could lead to a phase of weak growth down the road, as The Wall Street Journal recently noted.
So it's unwise to anticipate a sharp snap-back in industry share prices back to levels seen a year or two ago, even when commodity prices finally rebound.
David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.
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