2015-01-15

Piercing The Vale on Dollar Debt

Pater Tenebrarum finds Trouble in Iron Ore Land
Vale is the world’s largest producer of iron ore. The price of iron ore has recently hit a 5 year low, as China’s mad-cap building of ghost cities and the associated infrastructure has slowed down considerably.

...From the point of view of an iron ore producer based in Brazil, the price decline shouldn’t matter too much, since the Brazilian real has plummeted as well. Thus its dollar revenues translate into higher amounts of reais than previously.

...However, in this particular case, the decline in the real is definitely not an unalloyed boon. Vale’s problem is that its total debt amounts to more than $30 billion – and a very large chunk of it is in fact denominated in US dollars. As a result, the decline in the dollar price of iron ore is more relevant to the company than it would otherwise be. To be fair, it also holds about $7.8 billion in cash and cash equivalents, so net debt amounts to a somewhat less impressive, but still quite large $22.2 billion. Of this, $20.5 billion are denominated in foreign currencies (mainly US dollars and a little bit also in euro, which is only marginally less disconcerting). The more than $7 billion in debt that is denominated in reais has the disadvantage of sporting very high interest rates – it was presumably this interest rate differential that tempted management to accumulate so much dollar-denominated debt.

...However, the biggest problem is that Vale is in the middle of a huge, $20 billion production expansion program that will lift its output by 90 m. tons per year in 2017, just as the price of iron ore has embarked on a precipitous decline – i.e., Vale still need to invest nearly $10 bn., so debt repayments are not the only demands on its cash generation capacity. By 2018, Vale expects to produce 450 m. tons per year. Vale’s competitors were faster in ramping up their production during the good times, but even they are still expanding production. It is therefore astonishing that Vale’s management has kept insisting in the course of the past year that iron ore prices were set to improve. For instance, last May, the company’s CEO predicted higher prices in the second half of 2014 – instead, prices went into free-fall.
Much more over at Acting Man.

How many more Vales are out there, companies attracted by low interest loans in depreciating U.S. dollars? This brings to mind Michael Pettis' book The Volatility Machine: Emerging Economics and the Threat of Financial Collapse,about how emerging markets, and in this case cyclical companies, turn their balance sheets into volatility machines by making pro-cyclical financing and investment decisions. It looks brilliant to finance debt in U.S. dollars when the commodities boom is taking off and is a great move if you counter-cyclically wind down the balance sheet with inflated commodity sales to repay depreciated debt. If instead the balance sheet is leveraged into the peak (maximizing potential earnings), the balance sheet implodes as commodity prices crumble and debt levels soar as the dollar appreciates.

Borrowing in dollars makes sense for companies that price goods in U.S. dollars, but it is even crazier for firms such as Chinese real estate developers who transact completely in Chinese yuan. If Chinese developers get in trouble, onshore creditors are paid first and the dollar bonds will collapse in value, destroying even more U.S. dollars in the process, driving up the value of the remaining greenbacks. Conditions for an incredible deflationary wave are in place and as Tenebrarum notes at the end of his piece, "a great many skeletons will likely come tumbling from assorted closets in coming months.“

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