Gold and Oil Are Facing More Headwinds
Regulators are watching the financial system more carefully and many banks are being pressured to put aside their commodity-trading operations. JPMorgan is already looking to sell a number of commodity-related assets. One of the worries is that big, long-only index investors rollover their futures contracts and commodity prices are pushed upward. With waning bank interest in commodities and the recent gold crash, commodities face a future with less investor interest and lower prices.
The end of the golden goose
For a number of years, buying gold was a sure bet. Under-investment constricted supply, and easy-to-trade gold exchange-traded funds boosted demand.
2013 has been challenging, to say the least. In the past 12 months, the price of gold has fallen from a high close to $1,700 down to $1,232. Based on recent numbers from the third quarter of 2013, investors have reduced their demand for gold tonnes by 56% compared to Q3 2012. The entire supply and demand situation is out of balance. In the recent quarter, total gold demand was only 869 tonnes, while supply reached 1,146 tonnes.
With banks decreasing their activities in the commodities markets, pure commodities funds like SPDR Gold Trust will take a big hit. There is a big spread between the supply and demand for gold, and miners are hesitant to shut down mines until there they are certain that prices will not rebound. Given oversupply in the industry and downward pricing pressure, buying a gold ETF with no productive assets is risky.
Gold miners are not immune from the pain. Barrick Gold is suffering from writedowns, new shareholder diluting equity issues, and lost capital expenditures. As of Q3 2013, it was stuck with approximately $14.6 billion in long-term debt. Even with its recent share offering and $2.6 billion in debt reduction, Barrick still faces falling growth prospects as its big Pascua-Lama growth project has been officially suspended.
Oil prices are supported by strong industrial demand, but less futures trading compresses spot prices and oil producers' margins. Small companies are highly exposed to oil prices, as they can only hedge a limited amount of their production.
In the face of future price instability, companies with large debt loads should be treated carefully. Chesapeake Energy is stuck with a total debt-to-equity ratio of nearly 1.0, even after selling off a number of assets to decrease its debt load. While the company has come back from the grave, it has already sold off a number of valuable assets that could have helped it in the future.
Right now, Chesapeake is hard at work in the Eagle Ford where it is trying to boost its oil and natural-gas-liquids production beyond 27% of its total hydrocarbon production. While a $10 to $20 fall in oil prices is bearable, Chesapeake's profit margin of 7.9% would take a hit. In the long run, falling prices form a big threat. Fewer profits mean more pressure on its dividend and less capex available to boost profitable liquids production.
Kodiak Oil & Gas is a small exploration and production play with a number of assets in the Bakken region. Its production has grown substantially from an average of 1,260 barrels of oil equivalent per day in 2010 to an expected average of around 30,000 BOE/d in 2013. The problem is that Kodiak has driven its debt-to-equity ratio up to 1.9 to fuel this growth. Such a high debt load is dangerous, even if Kodiak does have a non-GAAP cash margin of $71.15 per boe as of Q3 2013.
Falling drilling costs will help Kodiak to bring down its expenditures and reduce its dependence on the capital markets, but it is critical to watch its debt load to make sure that the company is heading in the right direction.
New regulations are decreasing banks' roles in the commodities markets. Less investor demand for commodities will hurt commodity prices. Investors in the SPDR Gold ETF and Barrick Gold have already seen the impact of falling investor demand. The oil market is not as volatile as the gold market, but highly leveraged upstream producers like Chesapeake and Kodiak still need to worry about the impact of falling prices on their ability to service debt.
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The article Gold and Oil Are Facing More Headwinds originally appeared on Fool.com.
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