Here’s why ‘lower for longer’ is hurting commodity stocks

Commodity stocks are mostly down again Wednesday. There has been much discussion about how stocks like Freeport McMoran could continue to drop. It’s down another 8 percent mid-morning after dropping 4 percent on Tuesday.

The simple answer is they may have great assets but they also have huge amounts of debt. Traders and analysts are now making worst-case assumptions, in this case that “lower for longer” prices in oil and copper will make it increasingly difficult to pay the debt and leave any residual value for shareholders.

In Freeport’s case, the company has about $20.7 billion in debt, cash flow (EBIDTA) of about $4.1 billion for 2015, and interest expenses of about $600 million.

For the moment, the cash flow can cover the interest expense, but as oil prices keep dropping it gets tougher.

However, they are burning a lot of cash due to very high capital requirements, so even if prices stay where they are, it’s still going to be tough. Bottom line: They need a recovery in commodity prices!

But it’s not clear that is going to happen. A few weeks ago Morningstar ran some numbers assuming the “lower for longer” scenario. The firm assumed copper would stay at roughly $1.79 a pound, and oil would only recover to $54 by mid-2018.

Morningstar concluded that with those prices, “we see little remaining value for shareholders as a result of a heavy debt burden.”

If you change those numbers — go to $2.68 per pound for copper, and $74 a barrel by 2018—you can create shareholder value. Morningstar estimates that under this scenario Freeport could be worth $11 a share.

But nobody’s doing that. Most traders are making the most bearish assumptions.

And that’s how you get these amazing drops. And very high open interest in put options.

Naturally, their bonds have been under pressure too, and that is an additional problem: it’s harder to access the credit markets to cover a shortfall in free cash flow.

I’m not picking on Freeport. You can make similar assumptions about a lot of commodity companies and the difficulty servicing their debt levels if you keep commodity prices really low for a long time.

Remember, this is what did in the coal companies, many of which have already filed for bankruptcy. In the case of Arch Coal, the company had EBIDTA of $161 million, but when you take out $362 million in interest payments, you have negative cash flow.

Coal is a different business than Freeport’s business, which is leveraged to oil and copper, but the point is the Street is making “lower for longer” assumptions about other commodity prices as well.

Until that mentality changes, these stocks will remain under pressure. – Here’s why ‘lower for longer’ is hurting commodity stocks