Why Weak Oil Prices Will Negatively Impact Freeport McMoran

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Crude oil prices have recently witnessed a significant decline from their peak values this year. Brent crude oil spot prices currently stand at levels of around $81 per barrel, around 23.5% lower year-over-year and roughly 30% lower as compared to their values in June of this year. [1] This weakness in oil prices is significant for Freeport McMoran Inc. (NYSE:FCX), which became a diversified natural resources company with the acquisition of oil and gas assets in 2013. Though copper mining is the mainstay of Freeport’s business, the Oil and Gas division is an important segment for the company, generating around 22% of the company’s revenues in the first nine months of 2014. [2] In this article, we will take a look at the impact of weakness in oil prices upon Freeport’s Oil and Gas division and the implications for the company’s debt reduction efforts.

See our complete analysis for Freeport McMoran Inc. here

Oil Prices

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Crude oil prices have declined recently due to an oversupply situation. Global oil supply has been boosted by rising oil and gas production from the U.S., where hydraulic fracturing techniques have helped boost output. In addition, major oil producers of the Organization of the Petroleum Exporting Countries (OPEC) have not lowered output in response to falling prices, in order to preserve their market shares. [3] Demand for oil remains weak in the midst of economic weakness in Europe and slowing Chinese growth. China, the world’s largest importer of oil, is expected to witness a slowdown in GDP growth to 7.3% and 7.1% in 2014 and 2015 respectively, from 7.7% in 2013. [4] With a weak demand situation compounding a supply glut, oil prices will remain subdued in the near term. This will negatively impact price realizations and margins for the Oil and Gas division.

Impact Upon the Oil and Gas Division

The fall in oil prices has corresponded to an 11% sequential and 15% year-over-year decline in realized revenues for the Oil and Gas division to $69.08 per barrel of oil equivalent (BOE) in Q3 2014. [5]((Freeport McMoran’s Q3 2014 10-Q, SEC)) The cash operating margin, which represents profitability after taking into account cash production costs, has declined 17%  sequentially and 25% year-over-year to $48.15 per BOE in Q3 2014. [5]((Freeport McMoran’s Q3 2014 10-Q, SEC))

One of the reasons for Freeport’s diversification into oil and gas was to counter the impact of weak copper prices upon its copper mining business. With strong long-term energy demand, driven by emerging economies, Freeport’s foray into oil and gas looked like a sound investment at the time. However, the acquisition of oil and gas assets was funded by debt. With the company looking to sharply lower its debt burden over the next couple of years, the decline in oil prices has come at a bad time for the company.

Debt Reduction

Freeport’s total debt stood at $20.7 billion at the end of 2013. This is a steep rise from the figure of $3.5 billion that the company reported as debt at the end of 2012. [6] The company raised $10.5 billion in debt in 2013 to fund the acquisition of Plains Exploration And Production Company (PXP) and McMoran Exploration Company (MMR). [6] Freeport further assumed $6.7 billion in debt from PXP. [6] In comparison to the $20.7 billion in debt, the company reported a paltry $2 billion in cash and equivalents at the end of 2013. [6]

The company’s senior unsecured debt was rated ‘BBB’ with a negative outlook by Standard and Poor’s at the end of 2013. While the company’s debt is currently investment grade, Freeport is looking to shore up its balance sheet to maintain such a rating and keep its borrowing costs low. The company is looking to reduce its total debt to $12 billion by the end of 2016. [6]

The weakness in oil prices will take its toll on the company’s operating cash flows. This will compound the problems of a weak copper pricing environment upon the company’s mining operations. Copper prices have fallen this year due to concerns over Chinese economic growth. China is the world’s largest consumer of copper, accounting for nearly 40% of the world’s demand of copper. ((Copper Ends at 5-Month Low on China Worries, Wall Street Journal)) Freeport’s average realized price for copper stood at $3.12 per pound in Q3 2014, as compared to $3.28 per pound in the corresponding period last year. [7] Freeport’s total debt stood at $19.7 billion at the end of Q3 2014, with $658 million in cash and cash equivalents. [7] As indicated in its Q3 earnings conference call, the company could resort to asset sales in addition to rationalizing its capital expenditure, in order to reduce its debt burden. [8]

Net asset sales from the Oil and Gas division this year have translated into after-tax cash proceeds of $1.3 billion. [9] In addition, the company recently sold off its interests in the Candelaria and Ojos del Salado copper mines in Chile. This sale is expected to result in after-tax net proceeds of approximately $1.5 billion. ((Freeport-McMoRan Announces Agreement to Sell Its Interests in Candelaria/Ojos for $1.8 Billion in Cash Plus up to $0.2 Billion in Contingent Consideration, Freeport McMoran News Release)) The focus of these transactions was to use the proceeds to pare down the company’s heavy debt burden. If oil prices remain subdued for an extended period of time, there  may be more asset sales on the horizon for Freeport.

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Notes:
  1. Brent Crude Oil Spot Prices, Y Charts []
  2. Freeport McMoran’s Q3 2014 10-Q, SEC []
  3. Global Oil Glut Sends Prices Plunging, Wall Street Journal []
  4. Goldman Sachs cuts China growth forecast sharply, Market Watch []
  5. Freeport McMoran’s Q2 2014 10-Q, SEC [] []
  6. Freeport’s 2013 10-K, SEC [] [] [] [] []
  7. Freeport McMoran’s Q3 2014 Earnings Release, SEC [] []
  8. Freeport McMoran’s Q3 2014 Earnings Call Transcript, Seeking Alpha []
  9. Freeport-McMoRan Announces Agreement to Acquire Deepwater GOM Interests for $1.4 Billion, Freeport News Release []