HEDGING OPINION ON NOBLE GROUP FY15
The collapse is unfolding before our eyes.
Following an annual loss of $US 1.67 billion both S&P and Moody’s have cut Noble Group Ltd. further in the junk territory, (respectively from BB+ to BB- and Ba1 to Ba3 ).
This wasn’t brought about by depressed commodity prices.
The annual loss is rather attributable to a downward adjustment of Noble’s stratospheric pricing assumptions for its thermal and met coal.
These led to the non-realization of a portion of the mark-to-market gains on long-term commodity contracts and derivatives previously booked by Noble Group Ltd in Q42014.
The removal of Noble Group Ltd as a component of the Straits Times Index (STI), the SGX’s main benchmark is also vindicating Iceberg research.
Banks should be leery of “Noble exceptionalism”, from the economics to deal capture, valuation assumptions and default risk.
At the end the MtM realized loss in Q415 finally coped with up:
I) considerable negative free cash-flows from the core operating units,
II) the low-level of profitability
III) the poor financial reporting visibility inherent of this business.
Prior to 2015, Noble Group Ltd has been given the opportunity as a sponsor to enter several project finance agreements to sponsor the construction of coal mine assets.
Noble’s president and mastermind of the hardcore assets strategy – William Randall – from the half-witted off-take trade deals and poorly constructed investments into junior coal companies (such Aspire Mining, Pan Asia, Xanadu Mines, Gloucester coal, PT Sangha Coal, Sundance Resources, Guilford Coal, Blackwood, Cockatoo, Resgen, Xanadu, Jamalco the failed alumina producer) has a lot to answer for investments decisions that had initially very low probability to be recouped for its sponsor given their level of project risk and future cash flows.
An analyst asked to summarize the bank’s credit exposure to all counterparties related to Noble Group Ltd. should consider its many different counterparties (Noble Americas Corp, Yancoal Australia limited, X2 Resources Limited, Harbour Energy, Africa Commodities Group, Noble Resources Ltd, Noble Americas South Bend Ethanol LLC, Ekhgoviin Chullu, etc). They both operate under the same umbrella with different credit arrangements, including different levels of pledged credit exposures from the parent company.
Nonetheless, it mission impossible to ascertain this highly complex counterparty exposure (default risk) given the level of disclosure of the parent company.
Noble Group is the off-taker in several Take-or-Pay agreements (T-o-p), obligating the trader to either take physical delivery of Q amount of a commodity or pay a pre-determined price (swap rate) with commodity producers, whether this amount is taken or not.
The Mark-to-Market value of these contracts positive (negative) should reflect the difference between the Present value (PV) of the swap rate and the new swap rate times the size of the future off-take contract obligations.
When an off-take contract is signed the fair value (or MTM) is recorded in income statement and shows on the balance sheet as asset.
Q = size of the future contractual obligation.
Swap rate= should be more or less equal to the commodity curve be for longer maturities its level is set arbitrarily by the trader.
The PV of fair value gains can also change because depending of the T-o-P terms, under-takes (over-takes) may be taken as make-up (carry-forward) into the next contract period.
The long-term nature of these commodity contracts increases the risk that the off-taker will fail to pay due to an adverse change of its financial situation or a change in the supply and demand fundamentals.
Although it goes unreported, the suppliers of these commodity contracts have now a sizable positive counterparty exposure to Noble Group Ltd.
Interestingly and as reported by FT, the CEO of Noble Group tantalized the analysts during a conference call by recycling this idea that the impairment loss is due to “hedge performance”.
“The company had tried to hedge its exposure by taking large bets against short-term coal prices in a strategy known as “stack and roll”. However, this had not worked, because of a global agreement to limit carbon emissions, resulting in longer term coal prices falling faster than those for delivery in the next few years and this has had a knock-effect on consensus estimates for future coal prices…”
– Yusuf Alizera, CEO of Noble Group Ltd. available here Passcode: “Noble Group”
“Large bets” to hedge should particularly raise eyebrows.
Figure 1- Coal API2 cif ARA Argus/McCloskey Swaps
The whole curve is now backwardated (the nearby contract is higher the next month contract by $0.75 per t).
At first sight, they might have a scapegoat with the collapse in API2. The stack and roll position generates negative cash-flows under these conditions.
However, given the magnitude of the collapse in the API2 shown in figure 1 (by more than $35/t), the impairment loss hedging performance explanation doesn’t add up.
As a more plausible explanation, hedge instruments (API2 swaps) are marked-to-market daily with the brokers but the long-term commodity contracts that have to await settlement for their G/Ls to be realized rely upon pricing assumptions and the swap rate used the trader.
Opinion: the FY2015 hedging loss is rather because of a mismatch between the level of profits booked on these contracts and their underlying expected cash-flows.
THE RISK OF HIGH LEVERAGE AND A PLUNGING ASSET VALUE
Figure 5- Consolidated Balance Sheet
The default risk of the trader is not limited to the renewal to renewal of it trade facilities.
Potential suitors or lenders to the trader must consider:
IV) the risk that a plunging asset value could create insolvency and ii) the risk that the asset value stated by Noble Group Ltd. may be inaccurate or uncertain even before a fall in value.
While the Equity booked value gyrated at a 85% over its traded value per share, figure 5 shows that a drop of just -19% in the $17 billion assets value would render the commodity trader insolvent.
The later assumptions are not only possible and probable, they have been proven recently.
In Q42015 Noble Group Ltd. has sold its remaining 49% stake Noble Agri to Cofco corp, a -44% discount to the $1.34 billion that Noble Group Ltd. was valuing the agricultural unit on its FY2014 balance sheet.
“The company has significant long-dated contracts that are not fully hedgeable and the value of which relies on input assumptions that are not market-observable
We cannot rule out further asset impairment, given the depressed commodity prices.”
– Standard and Poor’s 2016-02-26
By all accounts, the physical oil or coal volume traded by Noble Group Ltd. would place them in the world’s largest charterers of ocean-going vessels.
Figure 2- Segments Results
Can the commodity trader seriously trade over 3 Million barrel equivalent per day ?
“Don’t kid yourself, with Noble you can easily cut the apple in 4 or 5 “.
– Legendary oil trader
150 Millions metric tonnes of Oil liquids is a volume greater THAN the SUM of:
ST SHIPPING, Shipping arm of Glencore.
CLEARLAKE, Shipping arm of Gunvor.
CSSA, Shipping arm of Total S.A
and the Shipping arm of BP all combined…
Figure 4- Full year financial statements
- Evidently, when Noble renews its trade finance credit lines, has to demonstrate that at least one commodity segment is traded at least a gross profit per ton (on a CIF-Spot basis).
- The consolidated performance of the business lines remains asymmetrically negative and for us, the frontier between Operations, Corporate Activity and Capitalized Assets is undefined.
- The Corporate Activity in figure 4 is just mind-bogging, so is the Coal Energy ( $M 646 million in figure 2 vs $US -243 million in figure 4).
- From Figure 4, the Corporate Segment erases Gas & Power Segment y-t-y. Possible trail: the Gas & Power is subsidizing or acts as a sort of cash-flow hedge for the Corporate Segment.
- In nominal terms, Noble Group Limited’s Net Income FY2015 (IFRS) comes to the tune of US$ -1,676 billion with an “adjusted net profit” of US$224 million.The Energy segment is operating with a gross margins ceiling of 1.60% and the trader has already lost its funding cost comparative advantage.
“Should the banks renew the revolving credit facilities they will bleed noble. Equity holders don’t realize that noble’s staff will work for the banks going forward”.
-Credit Analyst, Hong Kong
The new Noble has a volume/margin mix with a very low-ceiling.
As they renew the credit lines at higher rates, they will not beat their real working capital marginal cost unless taking more units of risk.
P&L IN REAL TERMS
You’d expect to have the P&L stated by US$ 100,000 of capital used.
Figure-4 Noble Group Profitability per $US 100,000 of capital
Figure 4 tells us that if Noble Group was a commodity units of a bank, they’d be cut out, the profit is too low / expansive in real terms.
The commodity trading unit is at least 3 times less profitable than the threshold that JP Morgan Commodities or Citigroup would set PER $100,000 for its proprietary capital.
Banks who are arguably experts in risk, do not trade a very-low profitable book. They lend money to a cash-addicted company instead of trading directly.
Noble Group doesn’t make it.
You would also expect to have the P&L PER US$ 100,000 of capital stated in relative terms:
Figure-5 Noble Group Profitability per $US 100,000 of capital vs Cargill
In relative terms, Noble Group Ltd. is on its own scale.
“CONSIDERABLE NEGATIVE FREE CASH FLOWS”
The net income, alone, isn’t a robust metric to assess the real financial position and performance of a complex company like Noble Group Ltd.
Figure 6-Free Cash Flows from the Operations
Figure 6 shows that Noble’s operations are burning cash, losing in real-termS since at least one decade. When THE sales figures came down, the balance sheet was caged (circa 2014), no longer allowING NOBLE to expand in size.
“The company’s credit standing and banking relationships have weakened, in our view. Recent negative developments weaken the company’s position in its discussion with banks and could affect financing terms”
– Standard & Poor’s 2016-02-26
During 15′, illiquidity has become a solvency problem as the debtor sold Noble Agri, assets at distressed prices, to meet its debt obligations.
The CDS curve is hovering at the levels of the default.
Figure 4.2-Noble Group Ltd. CDS curve
As shown above, the front end has slid lower but the back end in.
In probabilistic terms, the 6M , 1YR, 2YR and 10YR credit spreads, at a recovery rate of 40%, would translate into 100, 66, 66 and 100% probabilities of default.
“Can they be trusted ? the market is proving decisively that no they can’t.”
– A First-Class Trader
Sell-side analysts have commented that Noble might find a buyer for its associates and/or commodity contracts, but an
With respect to the potential private equity or institutions approached by the trader, there is a fair warning at all times- to inform investment expectations that subsequent changes in the Net positive fair value gains on commodity contracts booked by Noble Group Ltd. are possible and, indeed, likely.
Simon Jacques is a certified Energy Risk Professional, as distinguished by the prestigious Global Association of Risk Professionals.