China remains a key driver of demand for copper. This is why copper prices plummeted after the country allowed a relatively small solar firm to default on its corporate debt. Previously, the government reacted to similar situations and bailed out companies. This default could be a first sign that it could be changing its ways, causing various firms from different industries to fail without governmental support. This is worrying news for Freeport-McMoRan Copper & Gold (NYSE:FCX), which is heavily dependent on the revenues from its copper production.
Drop in copper prices poses threat to debt reduction program
The news sent copper prices trading closer to $3 per pound and put pressure on another copper producer, Rio Tinto (NYSE:RIO). Although the copper-producing segment is not the biggest in Rio Tinto's portfolio, it did still bring in 10.8% of its total revenue in 2013. Rio Tinto already experienced headwinds from the low iron ore prices, and the decline in copper prices adds to investors' worries.
Freeport-McMoRan's fourth quarter average realized price was $3.32 per pound of copper, way above recent levels. If the drop in copper prices is sustained, it will significantly affect the company's profits and make it more difficult to achieve its ambitious target to reduce its debt to $12 billion by year-end 2016.
Freeport-McMoRan significantly increased its debt level in 2013, when it acquired Plains Exploration & Production and McMoRan Exploration. As a result, Freeport-McMoRan's long-term debt stood at $20.4 billion at the end of the fourth quarter. The ability to reduce debt will depend on the magnitude at which operating cash flows exceed the company's capital spending.
Freeport-McMoRan targeted $9 billion of operating cash flows in 2014, assuming a price of $3.25 per pound of copper. For clarity's sake, the company stated that for every 10 cent decrease in the copper price will lead to a $370 million decrease in the cash flows. So, a 20 cent decline in the copper price from the projected $3.25 will lead to a $740 million decrease in cash flows, cutting the total yearly operating cash flow to $8.36 billion. This number still exceeds the projected $7.1 billion in capital spending, but leaves just $1.26 billion to the debt reduction program.
Troubles in Indonesia are not solved yet
What's more, Freeport-McMoRan can have troubles in achieving its copper sales target of 4.4 billion pounds if it does not solve the problems with the concentrate export tax imposed by the government of Indonesia. Indonesia, which wants producers to build smelters in the country, imposed a progressive tax on exports, which started from 25% in 2014. Freeport-McMoRan and Newmont Mining (NYSE:NEM), which also produces copper in the country, halted their exports and started negotiations with the government.
Thankfully, there have been positive developments on this front, as Indonesian government indicated that it could ease the tax if miners prove that they are serious about building smelters in the country. However, it's too early to say whether this matter will be resolved soon, which further clouds Freeport-McMoRan and Newmont Mining outlooks.
The sustained decline in copper prices will lead to negative consequences for Freeport-McMoRan debt reduction program. Problems in Indonesia question the company's sales outlook and pose threats to the targeted operating cash flow. On the positive side, the recent decline in the Freeport-McMoRan's shares has lifted its yield to 3.88%, which could attract income investors.
Chinese demand dictates the success of more than just copper
Vladimir Zernov has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.