China, Petrobras and the Circling Sharks
Image Source: Leszek LeszczynskiÂ
A key gauge of manufacturing activity in China plummets to Financial Crisis lows, Brazilâs Petrobras may be the first major casualty of the countryâs deepening recession, and lenders are beginning to tighten the noose on overleveraged commodity producers in America.Â
The Federal Reserve meeting last week came and went, and now the markets are back to focusing on fundamentals, as they should. The problem for equity investors, however, is that the fundamentals arenât great, and it is becoming increasingly more difficult for even the most bullish investors to find reasons for optimism, at least in the near term.
The economic environment in China continues to worsen. We outlined our grave concerns regarding the implications of its collapsing stock market on the health of the countryâs property market, and the resulting consequences on Chinaâs largest banks. Commodity-linked entities in China continue to feel pain, and the preliminary reading on the Caixin China manufacturing purchasing managersâ (PMI) index fell to Financial Crisis lows of 47 in September, below last monthâs measure, analystsâ forecasts, and signaling economic contraction. The reading hasnât been this low since the panic bottom of March 2009, and we maintain the view that conditions in China may be even worse than feared.
Weakness in Asia has already spread. Export-dependent countries, including Brazil and Canada, are already in recession, and the former may be in a world of trouble. Political scandals and corruption, asset flight and resulting currency weakness are only exacerbating the hazards related to the countryâs financial health. S&P recently downgraded Brazilâs sovereign debt to junk status, and there may be little the country can do to pull itself out of a recession, absent a recovery in commodity prices, which may not happen anytime soon without a sustainable bounce in China export demand, clearly out of reach at the moment.
Brazil state-run oil giant Petrobras may be the first major casualty of the countryâs deepening recession as a result of a triumvirate of corruption, weak earnings from collapsing crude oil prices, and exorbitant levels of US dollar-denominated debt in the face of an ever-weakening real. Net income at the company dropped 90% in the second quarter on an operating income decline of nearly 30%. Free cash flow of R$4.5 billion during the first half of 2015 is practically negligible compared to the firmâs total indebtedness of R$415.5 billion. Net debt on a US dollar basis stands at over $104 billion, and itâs difficult to envision a positive scenario for Petrobras investors without help from improving crude oil prices.
In an uncharacteristic two-notch move, S&P cut Petrobras from an investment-grade rating of BBB- to BB, junk status, earlier this month. The Brazilian oil giant is now the largest non-investment-grade corporate issuer, and prices for its bonds keep falling. Confidence has been shattered, and reports indicate that credit default spreads on the firmâs debt are âexploding.â As member nations of OPEC continue to produce to put US domestics out of business, Petrobras has been caught in the crossfire. The company may very well be forced to restructure its ballooning $90+ billion in dollar-denominated debt soon, and ironically, it may be the Fed that will eventually push Petrobras over the edge. Asset flight out of Brazil into US assets in the event of a rate hike in the US could weaken the real to a point where Petrobrasâ debt becomes too expensive to service, even if crude oil rebounds.
All is not well with US producers of oil either. Line Energy sounded the alarm bell when it announced that it would suspend its distribution on account of concerns that its borrowing capacity would be cut once banks reassess their crude oil price decks, a twice-yearly occurrence. Bloomberg reported today that almost 80% of oil drillers will âsee their borrowing base cut,â according to a survey by Haynes and Boone LLP, marking the beginning of the end of this debt-infused stock bubble, in our view. Weâve long stated that even the dividends of energy bellwethers, Chevron and ConocoPhillips may not be safe. The sharks are circling.
The size of credit lines in the energy arena have been for some time completely detached from fundamental credit quality, in our view, so even an average credit-line cut of ~40%, according to the report, may only be the beginning, if credit markets continue to tighten. We would expect the probability of dividend cuts on the weakest upstream entities to increase, and many in the midstream space may eventually become victims of contracting credit, especially those that point to their revolver as a means to manage the dividend with minimal cash on the books. We continue to believe the master limited partnership model will be challenged during this cycle as credit dries up, and it is not surprising to see Energy Capital Partners looking to dump MLP assets, its interest in Summit Midstream.
Stock market bulls continue to point to the view that because stocks only make up 15%-20% of Chinese household wealth that there is no need to worry about the growing risks of a global economic calamity. Those same bulls, however, may not know that only 16% of households were invested in US stocks right before the Crash of 1929. Though a Great Depression is simply not a possibility this day and age, in our view, we donât think the global selling in equities is over, and it may not be for a while. Indexers could be in for more pain, as the Fed may hike not once but twice this year in failed attempts to counter-intuitively reestablish market confidence by communicating through the rate hikes that all is well. Bad news, however, is bad news again, and the Fed put is no longer in place.
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About the Author: Brian Nelson is the president of equity research and ETF analysis at Valuentum Securities. Before founding Valuentum in early 2011, Mr. Nelson worked as a director at Morningstar, where he was responsible for training and methodology development within the firmâs equity and credit research department. Prior to that position, he served as a senior industrials securities analyst covering aerospace, airlines, construction, and environmental services companies. Before joining Morningstar in February 2006, Mr. Nelson worked for a small capitalization fund covering a variety of sectors for an aggressive growth investment management firm in Chicago. He holds a Bachelorâs degree in finance and a minor in mathematics, magna cum laude, from Benedictine University. Mr. Nelson has an MBA from the University of Chicago Booth School of Business and also holds the Chartered Financial Analyst (CFA) designation.
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