The Heartbreak of Commodities
Lanchner, David, Global Finance
For commodity producers, earnings for the December quarter are looking terribleand in more than a few cases have turned into outright losses. The main reason: Commodity prices have sunk to unusual depths. In Decemher the Bridge Commodity Research Bureau's widely followed commodity index hit a 21-year low.
To economists, the price plunge is strong evidence that inflation is dead-and may even augur an era of global deflation. For multinational resource companies (mostly oil, gold, or base metals rather than agricultural producers), the collapse of their pricing structure is forcing them into a major round of mergers, cost cuts, shutdowns of older or costly mines and oilfields, and layoffs.
Most desperate appear to be independent oil companies,which aren't cushioned by downstream operations. Though less damaged so far, the big integrated oil producers have embarked on a critical round of mergers that's transforming the industry. Among miners, Phelps Dodge is reeling from the fall in copper prices, nickel giant Inco is shutting some production, and zinc producer Cominco is struggling. Viag and Al Group began to discuss merging aluminum operations-and decided to merge everything.
Gold miners may be in the best shape, partly because central banks' practice of lending gold at low interest rates provides an effective hedging market that other commodity companies don't have.
The oil industry is particularly scrambling. West Texas Intermediate, the industry's premium crude, sank to nearly $11 a barrel in December, while lesser-quality crudes fell closer to $8. Adjusted for inflation, that put prices back to where they were before the Organization of Petroleum Exporting Countries (OPEC) tripled prices in the summer of 1973.
The decline has not been as brutal as in 1986, when Saudi Arabia knocked world prices down sharply to undermine Iran's war effort against Iraq. North Sea Brent plunged 44%, as opposed to only 25% over the past year, and West Texas Intermediate fell as low as $10.40. But prices rebounded quickly. Today's downturn is due to a real falloff in demand. Few people see prices recovering until Asian economies get back on their feet.
One result of the 1986 collapse was that it pushed oil companies into a long period of technological improvements, which have contributed to today's glut by spurring production but have also cut costs by twothirds, from $15 to about $5 a barrel. Today's companies expect further improvements with such techniques as horizontal drilling and three-D imaging. They've got to whittle down breakeven levels, which range from around $8 for the best integrateds to $16 for smaller, less efficient exploration and production companies.
Oil producers must also worry about their returns on capital. At big integrated companies, whose profits are somewhat insulated by their large volume and highmargin refining, average return on capital employed is beginning to slip dangerously below their cost of debt and equity capital, which averages around 8.5%.
For the smaller pure producers, whose cost of capital averages lOro, trouble is already at hand. US and Canadian exploration and production companies, though still profitable, have already seen returns on capital employed sink below 10%. And producers elsewhere in the world, where extraction costs are higher and the quality of crude (and thus the price) is lower, face potential calamity
Strategic mergers are one response. Last August British Petroleum, the industry's third-largest producer and most avid cost-cutter, announced a $48.2 billion merger with Amoco.The deal will so improve BP's numbers that it's putting the heat on everybody else. Secondlargest Exxon rushed into a $75 billion stock swap with Mobil in Decemberall the while denying that falling oil prices or BP's deal had anything to do with it. The same day, France's Total agreed to buy Belgian refiner Petrofina for $12.9 billion in stock. …