The Effects of the Commodity Crash

Glencore Plc (GLEN 1.34%) is known as a giant in the commodities sector, but its recent bout of bond needs has left investors fearing the worst outcome for the company.

Meanwhile, Petrobras (PBR 0.26%) is trying to save face as the Brazilian currency takes a dive, and Tyler has a favorite stock, Enterprise Products Partners (EPD 0.21%) -- but there's a fun fact behind this company that might have you jumping on the investment train as well. All this and more, on this energy edition of Industry Focus.

A full transcript follows the video.

Sean O'Reilly: We're talking about the effects of the commodity crash, on this energy edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly, here at Fool headquarters in Alexandria, Virginia. It is Thursday, Oct. 22, 2015. Joining me are the coolest cats in town; Tyler Crowe and Taylor Muckerman. How's it going, guys?

Tyler Crowe: Pretty good, man.

Taylor Muckerman: Not too bad. I don't know how I like being called a cat, but at least it says cool.

O'Reilly: You're the coolest cat, man.

Crowe: I like how you threw out "Oct. 22." We should let everybody know that we're pre-recording this.

O'Reilly: You just had to go full disclosure on us.

Crowe: Come on. Full disclosure. Let's be fair to everybody.

Muckerman: We're the Fools.

Crowe: Who knows what may happen next week?

O'Reilly: It is Oct. 22 to them.

Crowe: To them, yes. Sean and I will be in Houston next week doing some interviews with company executives.

Muckerman: Or are you currently in Houston?

Crowe: Or are we doing it right now?

O'Reilly: We've got to go back... to the future!

Crowe: Pre-recording. So if anything happens between last Thursday and what you're hearing today, sorry.

O'Reilly: That is why.

Crowe: You'll hear about it next week.

O'Reilly: Guys, we talk a lot about how oil prices have crashed over the last year, but the carnage really in the commodity sector hasn't been limited to the black gold. The S&P GSCI Commodity Index is down 18% over the past year; copper is down 24%; iron ore has been in a perennial bear market for five years and is down 30% over the last 12 months. Needless to say, it's been kind of rough if you deal in commodities.

This leads us to our first story. Analysis put up by Bank of America says that global financial firms have over $100 billion of exposure to commodities giant Glencore Plc. Bank stress tests aside: Do Foolish investors need to worry about the very solvency of any commodity-based stocks in their portfolios, or is this just part of the mega-skewed cycle that we're witnessing and part of being a producer?

Muckerman: That's a tough call, man.

Crowe: That's a really loaded question.

Muckerman: From a bank's perspective: I don't know. Yeah, there's probably going to be a bank or two that's in trouble. I think that some of the banks apparently made the right move within the last couple years. I know Goldman Sachs got rid of a lot of its commodity arms where they physically own mines.

O'Reilly: They stopped that years ago, right?

Muckerman: Yeah. Other banks have followed suit. I don't know the exact names; I just remember reading headlines over the last couple years.

Crowe: Yeah, there was also some weird thing where they own businesses that traded commodities, but at the same time they owned the commodities. There was that conflict.

O'Reilly: "We're short the commodities" -- they put out negative notes.

Crowe: It's like, "It's going to be undersupplied," but it happens to be that they have a very large buildup of inventory in their companies.

Muckerman: And they're holding on to it to drive the price up. I think, from that perspective, we're kind of safe, but I don't know about the loan exposure that these banks have.

O'Reilly: That's not to say that it's going to be like a 2008-2009 financial crisis or anything.

Muckerman: No, not at all.

O'Reilly: The commodities industry is not nearly as big as housing in America -- $100 billion in Glencore alone. They've got to roll over all this debt.

Muckerman: When you consider the size of Glencore compared to anyone else, you're not going to see anyone even close to that kind of market dominance in this sector. We talked about the companies that produce mining equipment -- Caterpillar, seems like they lay off thousands to tens of thousands of people almost on a quarterly basis over the last couple of years.

Crowe: Yeah, and a couple weeks ago they revised down their guidance again.

Muckerman: Again, yeah. That's been happening for a couple years.  That stock has been cratering even before they saw a lot of these commodities slides take place. it was almost like a predecessor to the slide, and it's continuing right along with it. Then Joy Global is another big name, and in Stock Advisor Canada we recommend a company called Finning, which is a retailer of Caterpillar equipment in Canada.

It hasn't been hit quite as hard, but we've been keeping a close eye.

O'Reilly: Have their inventory numbers been creeping up at all?

Muckerman: No, actually. They've been controlling that. They got ahead of it, I think. They've been doing a good job, but there is some backlash in terms of equipment producers that we can speak of.

O'Reilly: Assuming that human civilization doesn't collapse, isn't this the time to be looking at some of these names?

Muckerman: Well, you definitely want to take a look...

O'Reilly: We're at the bottom of the cycle... Maybe it's not the bottom, though.

Muckerman: Ninety-five percent of the time I'm against miners.

O'Reilly: OK. It's a commodity and you can't have any advantage.

Muckerman: I don't own any oil producers, I don't own any natural gas producers, I don't own any miners. I don't study the individual commodities enough to know what's going to happen with the prices. Yes, I own energy companies, which are tied to commodities prices, but they're not 100% directly linked to the price of oil and natural gas.

O'Reilly: Got it. Tyler, why do you own commodity stocks?

Crowe: I have no thoughts that I'm a Nostradamus when it comes to commodity prices in any way...

O'Reilly: I know you have a hidden crystal ball.

Crowe: ...in terms of where they're going to go, and what's going to happen. The thing that matters to me when buying a producer is, I'm looking for the companies that can sustainably generate cash over the long term throughout the cycle. If you look at somebody like ExxonMobil, or Royal Dutch Shell, or someone like that, yes, they are tied to production directly through their production, but they also have other assets that help to offset that.

If you look at some of those assets to offset it like refining and stuff, those are very cash-heavy investments that, once you build up the facility your maintenance capital is not a huge deal. It will generate a lot of cash for you over the long term. Having those things to offset that production is something very valuable to me to have. Just like any other space, you can look at retail, tech; there are companies that do well throughout the cycle, or throughout the entire business, because they're a better-run company.

If you could look for the best-run companies within commodities, the same thing happens. They're able to weather these storms. I might see some large declines in my portfolio because of what's happening as of late, but I'm OK with that as long as the business is still intact and doing what it has done for many years.

O'Reilly: Cool. Before we move on, I wanted to point our listeners to a newly redesigned focus.fool.com. There you'll discover a special offer to join The Motley Fool's Stock Advisor newsletter for all Industry Focus listeners. All loyal IF listeners have access to a special discount on Stock Advisor that works out to $129 for a full two-year subscription. Just go to focus.fool.com to take advantage of this offer. Once again, that's focus.fool.com.

I'm here with Tyler Crowe and Taylor Muckerman. Our second story is Petrobras, which was forced to cancel a $750 million bond issue because of lack of interest. That's not even that much money, is it?

Crowe: For Petrobras, not really.

O'Reilly: If the company can't find enough appetite for $750 million, that does not bode well for a company that needs to refinance $35 billion in the coming years. Is this a harbinger of things to come?

Muckerman: I would say so. It's been happening. For the first time in company history, we saw that they didn't bid on an offshore oil block off the coast of Brazil.

O'Reilly: Who else was there to bid?

Crowe: Petrobras.

Muckerman: There were some big names, but they weren't there and they've got the currency crisis in Brazil with the real, there's been government scandals left and right, they're still not even sure if the current leader there will remain for much longer due to citizen unrest, and it goes back to when you see a company in a state-owned country that doesn't really know how to run a company...

O'Reilly: Tyler, you were talking earlier about how Petrobras was set up to fail, almost from the beginning. What do you mean by that?

Crowe: Not exactly from the beginning. They IPO'd a little more than a decade ago. The idea was that they found this massive oil field off the offshore.

O'Reilly: Was it as big as the guar fields in Saudi Arabia?

Crowe: It was... what was it?

Muckerman: I'm not sure of the exact size.

Crowe: Multiple billions of barrels, in the tens of billions of barrels.

O'Reilly: Boatload of oil; that's what we'll call it.

Crowe: Boatload of oil.

Muckerman: An ocean-load of oil.

Crowe: They needed to finance the development of that, and it needed a lot of capital. One of the ways they did that was one of the largest IPOs of all time. Trying to bridge the difference between a government, state-owned, and being a private-invested, publicly traded company. The problem was that there were so many regulations and stipulations built into how the company is structured that it makes it very difficult for them to be successful in the long run.

O'Reilly: Was it just that the government wanted their cut?

Muckerman: They wanted the money to stay in Brazil.

O'Reilly: OK.

Crowe: So they have to sell gasoline at a government-subsidized rate, basically. They're trying to control inflation so they can only sell gasoline/diesel at a certain rate. When oil prices are high, that can really cut into you, especially when the fact that you're selling gasoline in Brazilian reals and having to buy it on open market in U.S. dollars when you have a deflation, devaluation of currency in the real, that's a huge deal.

They were forced to take outside stakes in a lot of these projects on those auction blocks that we were just talking about. It had to be the operator. They had to bid on anything that anybody wanted to bid on and take the operator stakes. They had an extreme exposure to that singular area.

Muckerman: They were the majority partner.

O'Reilly: Yeah.

Crowe: Yeah. I think it was almost a 40% stake in all of these. That's a ton of capital that you have to raise.

O'Reilly: Did it occur to anybody to be like, "Hey, maybe we should let Exxon take the lead on this, but we'll take 40% of the profits?"

Muckerman: Then Petrobras gets to mandate where their hiring comes from, where their machinery comes from, because they even have to buy all their machinery from Brazilian...

Crowe: There's a local content depending on where it is. I think onshore it's really high. I think it's 60%-70%, but the further offshore with more technology, they say only 40%.

Muckerman: So they're having to buy higher-priced, underperforming equipment.

O'Reilly: Did either of you see these criticisms of Petrobras five years ago? There was a time when the stock was kind of a high-flyer. Correct me if I'm wrong. Is it just that we're talking about these problems now that oil prices are crashing?

Muckerman: It was a high-flyer when offshore oil was the new kid on the block, throwing money around like it's no big deal because they did have so much exposure to it. Now that offshore oil is pretty much on the back burner in terms of oil development around the world -- it is more expensive, it takes more time to develop -- they're in a world of hurt because of that.

Crowe: I think a lot of people kind of got dollar signs in their eyes. Remember in Looney Tunes where the wolf's eyes would pop out of his head?

O'Reilly: Was Wall Street Wile E. Coyote...

Crowe: Giant dollar signs came out, and what they saw is they overestimated production growth that they were going to see. They were estimating tripling and quadrupling production to blow every supermajor out of the water in terms of the total production, and underestimated how much it was going to cost.

O'Reilly: Was these their estimates, or Wall Street's?

Crowe: I think it was a little bit of both.

Muckerman: A bit of a mix. A lot of the people thought Brazil was going to be the next big thing when it came to...

O'Reilly: Well yeah, even Buffett...

Crowe: It was the BRIC. It was supposed to be one of the great developing nations.

O'Reilly: You were talking about the real. There was a year in the mid-2000s that Buffett actually took up currency, a 4x stake in the Brazilian real. He talked about how they had a trade surplus and everything. Relative to the dollar it looked good.

Muckerman: The last couple years, since we've been handing money out to the banks, our currency is...

O'Reilly: Oops.

Muckerman: Once everyone else started to quantitatively ease their economies, too, they devalued their currency and people still have more faith in the dollar.

Crowe: One of the things for Brazil, and why the devaluations have been such a big deal with them is because so much of their economy has been exports of natural resources. Not just oil, we're also talking about ...

Muckerman: Iron ore.

O'Reilly: That's their big one.

Muckerman: The other's partially stayed around.

Crowe: Extremely levered to exporting natural resources to China. If you look across what's been going on in nations that have done that -- Indonesia, Brazil, anyone who has been very highly tied to exporting natural resources to China -- have seen...

O'Reilly: Taken it on the chin.

Crowe: Yeah. Quite hard, lately.

O'Reilly: Very good. Moving on, a more positive note -- America's rise to dominance in petrochemical manufacturing in the face of oil lows. This usually translates to robust chemical product profits with oil prices falling through the roof. In contrast, the Saudi Kayan Petrochemical just reported a net loss. We're making gobs of money, Dow Chemical (DOW) is doing great. Guys, why are we so awesome?

Muckerman: American ingenuity and dumb luck of settling in the right country.

Crowe: Yeah. You could say it.

O'Reilly: Wait, we're awesome because of dumb luck?

Muckerman: Yeah. We pioneered the right country. This was the last country available for pioneering. We found it, and we just decided that we could produce commodities better than anybody.

Crowe: It just happens to be sitting on natural gas reserves that are absolutely immense. One of the things...

O'Reilly: Tyler Crowe: "We're the Saudi Arabia of natural gas."

Crowe: Basically. That's actually one of the things that's been so important here. A lot of petrochemical manufacturing that happens outside of the United States -- places like Saudi Arabia, the Saudi Kayan -- one of their basic feed stocks is called naphtha.

O'Reilly: Gesundheit.

Crowe: Thanks. It's a feed stock that's based from oil, versus in the United States we use ethane, which is based on natural gas. If you look at the crack spreads, or...

O'Reilly: Are we arbitraging with natural gas?

Crowe: Yes! We are. The cost for natural gas in the United States is less than $3 for 1,000 cubic feet right now. Ethane is a reject product from that, and it's dirt cheap right now in the United States compared to the derivatives that you would use for oil to make those same products. You have that going for us. You have the fact that investment is much easier here because you don't have those state-run issues you may get in other areas.

O'Reilly: We get stuff done.

Crowe: Yeah. Within the next two to three years we're going to have 8.2 million tons per year of new chemical manufacturing, based solely on this cheap feedstock that we have coming online. You add that and also, one of the reasons we've been able to undercut is, we can export a lot of that cheap petrochemical manufactured feed stock. Enterprise Products Partners alone -- this is one of the companies that's...

O'Reilly: Here we go. He's plugging Enterprise. I'm just kidding.

Crowe: This is actually just to state a fact.

Muckerman: He does have a little fun fact.

O'Reilly: I know.

Crowe: Enterprise Products Partners is a major exporter of ethane, as well as propane. Today, it exports more of those from the United States, just as that one company alone, than the largest country out there. I believe the second largest is Qatar. Enterprise alone exports more than the entire country of Qatar. I believe the U.S. is more than the next five nations combined in terms of total exports.

O'Reilly: So we get stuff done and we're enormous.

Muckerman: We don't only have the largest military in the world by leaps and bounds; we also export natural gas liquids.

O'Reilly: 'Murica.

Muckerman: 'Murica. Invest in us.

O'Reilly: Is that like a... oh, man.

Crowe: It's a great tag line.

O'Reilly: Yeah, it is. Do we say it at the U.N.? Where would we say that?

Muckerman: I don't know, but we're saying it on Industry Focus.

O'Reilly: Before we head out of here, are there any petrochemical stocks besides Enterprise Products that you guys like right now?

Muckerman: There's a lot of competition out there. I think you look at the pipelines that are shipping it to the Gulf, to all these refiners, and then somebody mentioned Dow Chemical.

O'Reilly: I did.

Muckerman: Yeah. Between them and DuPont (DD), those two companies are producing things that are used in pretty much every reach of every industry around the world. If you pick something up in a supermarket, chances are, one of those companies used some of those for packaging. I think cheap, natural feedstocks will benefit them.

DuPont is in a bit of a different place right now because the CEO just left, activist investors want to split the company up, but Dow Chemical would certainly be a company that I would look at if you want to take advantage of scale and cheap natural gas liquids.

Crowe: I think one that's going to come up pretty fast in the next couple years, because of some large investments, is one that's called CPChem. You can't invest directly in it, which sounds kind of bad.

O'Reilly: Why are we talking about it?

Crowe: CPChem is... Phillips 66 and Chevron have built a joint venture where they've taken...

O'Reilly: They're totally going to spin this off.

Crowe: They've taken their entire chemical manufacturing facilities, pooled their resources on those two ends and said, "This is our chemical manufacturing arm." Those two companies combined have been pouring a lot of money into new facilities. Like we said, 8.2 million tons per year; a lot of that is going to be coming through CPChem and there is a lot of potential there for some big growth that could actually move the needle a bit for companies like Philips66 and Chevron. That's not an easy thing to do.

Muckerman: Maybe a possible deep-value play: Huntsman Corporation just took a huge hit in the market early last week. It bounced back a little, but they were down over 20% in a day.

O'Reilly: Were the earnings that bad?

Muckerman: I can't remember exactly what it was. I think it was just a forecast. I'm not saying I'm going to buy it, or you should buy it, but if you want to do a little research...

O'Reilly: Do you want to add the disclaimer?

Muckerman: If you want to do a little research, they sold off heavily and they're right along the same path -- not nearly as big -- as Dow Chemical. They make a lot of what you use.

O'Reilly: Cool. Thanks for your thoughts, guys. Have a good one.

Muckerman: Yep.

O'Reilly: If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Tyler Crowe and Taylor Muckerman, I'm Sean O'Reilly. Thanks for listening, and Fool on!