If Commodity Prices Don't Recover, These Investors Lose

Hunter Hillcoat, a commodity analyst at Investec, commented in a note on Monday that mining companies have "gorged themselves" with "cheap debt" over the past few years in response to the Chinese stimulus that occurred following the global financial crisis. However, the consequences of these actions are "only now coming home to roost."

Hillcoat continued that debt has now become the most important consideration for mining companies and their stakeholders. The analyst added that he expects the commodity markets to "remain subdued" for "several years to come," which should worry investors.

"As a result, equity investors are increasingly focused on the slice of the value pie that is left for them," Hillcoat wrote. "It is not just the cost of debt service that matters; the repayment schedule should also be of concern. If confidence wanes in the ability of highly indebted companies to refinance principal payments, a major crisis can suddenly be precipitated."

Hillcoat went on to point out mining companies enjoy a low net debt to equity ratio of 8 percent in fiscal 2005 and 2006. However, if spot commodity prices persist, net debt to equity levels for both Rio Tinto plc (ADR) RIO and BHP Billiton Limited (ADR) BHP could increase to over 40 percent – implying net debt would constitute close to half of the hypothetical equity value.

Related Link: Oil Price Impact On Mining Industry: Literated Market Research

Individual Company Analysis

BHP Billiton's equity as a proportion of total value has grown steadily since 2000 with a "noticeable lift" in debt in fiscal 2012. If current commodity prices prevail, there will be no increase in value for shareholders with net debt "holding steady" at around one third of the total value. In addition, the company will likely re-examine its dividend policy.

Glencore International has a lower-margin asset base (relative to BHP Billiton and Rio Tinto), which could result in "considerably greater" downside to earnings forecasts. The analyst noted that despite the "drastic" action that management has taken to improve its prospects, the company still faces an "almost complete collapse" in forward earnings to the point where "no meaningful estimate of shareholder value" can be derived. In effect, debt could become 100 percent of the total enterprise value and the company is solely working to repay its debt obligations.

Anglo American's shareholder value is expected to reach a low in fiscal 2016, coinciding with net debt levels at its peak. At that point, net debt would constitute more than half of the entire enterprise value. However, increasing earnings could lower its net debt to 15 percent of total value by the end of the decade.