Noble’s HEDGING exceptionalism

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.

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 

and 

III) the poor financial reporting visibility inherent of this business.

A TUMOR

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.Sans titre666

MTM coal1.1

Where;

= 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.

HEDGING PERFORMANCE

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.

coal curve api 2 .

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.

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