Commodities indebted to the past

An oil tanker passes near DCOR LLC's Edith offshore oil and gas platform in the Beta Field off the coast of Long Beach, California, U.S., on Tuesday, May 18, 2010. Senators from California, Oregon and Washington introduced legislation last week to ban offshore oil drilling off the West Coast amid mounting concern about the BP Deepwater Horizon rig spill spreading in the Gulf of Mexico. Photographer: Tim Rue/Bloomberg©Bloomberg

Commodity prices have been on a tear of late. Last year’s dogs, such as oil and iron ore, have soared. With oil approaching $50 a barrel this week, Goldman Sachs has turned more bullish on its prospects, and Chinese speculators have pushed up the price of iron ore by as much as 50 per cent.

This rebound has led to strong gains in related stock market sectors. Energy and mining share indices have risen fastest, after trailing the entire market in 2015.

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What has lured in the buyers? For one thing, some very depressed valuations made the decision to dive back into commodity stocks a lot easier.

One measure on which the two sectors look historically cheap is the price-to-book ratio. Some investors prefer this to other price ratios as the net asset (or book) value of companies tends not to change dramatically every year. In the case of the metals and mining sector, the PB ratio in February touched lows not seen since 1979.

Of course, there’s a reason for that. Return on equity (profits as a percentage of book value) has also tumbled to historic lows, below zero. Understandably, the market will not pay up for companies apparently destroying value. Also, an ultra low PB ratio may simply indicate investor distrust of the value of that equity.

But this measure does not capture the rising amount of debt in these companies. Nor does it take account of cash flow, which can be a useful indicator given the volatility of earnings at these companies, due to their occasional asset impairment charges.

Looking at enterprise value (which includes net debt) together with a proxy of cash flow can give a better read of cheapness. And among energy and mining groups, EV as a multiple of earnings before interest, tax, depreciation and amortisation has risen. For oil stocks, this ratio is near its high for this millennium. That makes sense: oil and gas producers carry a lot more debt than in previous cycles. Net debt to ebitda has soared.

Of course, cyclicals usually look expensive at the bottom of the cycle and higher commodity prices would boost cash flows. What’s really needed, though, is years of balance sheet repair.

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