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Should You Buy Vedanta Resources plc, Anglo American plc & Glencore plc As Commodity Prices Extend Declines?

Mining stocks extended losses today, as weak trade data from China led to further weakness in commodity prices. Over the past year, shares in Vedanta Resources (LSE: VED), Anglo American (LSE: AAL) and Glencore (LSE: GLEN) have fallen by 51.7%, 49.5%, and 44.7% respectively.

Vedanta Resources

Of the three mining companies mentioned here today, Vedanta seems to be in the worst shape. Its Indian oil and gas assets took a $6.6 billion writedown back in May, as the fall in oil prices meant Vedanta had massively overpaid for its energy assets. The company is now saddled with gross debt of $16.7 billion, and net debt of $8.5 billion. This gives it a net debt to EBITDA ratio of 2.3x, which is much higher than many of its peers.

However, cash flow generation remained strong at the end of last year, with the company generating free cash flow of $1.0 billion. Thus, free cash flow covered its dividend more than 5 times. But as commodity prices have fallen significantly further in recent months, free cash flow could very likely be wiped out for 2015/6.

Vedanta Resources is attractive on its sizeable exposure to zinc, which is widely considered to be the metal with the most attractive outlook. Unlike most other metals, zinc benefits from a likely transition towards a supply deficit by 2016/7, which means zinc prices are likely to bounce back in the medium term. 37% of its EBITDA comes from zinc, and unlike many of its competitors, zinc production is steadily growing.

Today, Vedanta announced that it was likely to restart production from its biggest iron ore mine at Codli in Sanguem taluka, Goa. News of this sent shares in Vedanta 9.7% higher, to 490 pence, by early afternoon trading.

But, even with the recommencement of its iron ore operations in Goa, Vedanta’s profitability is unlikely to improve significantly. Low ore grades and high export taxes mean many iron ore mines in Goa and much of India are relatively uncompetitive with iron ore prices at a six year low.

Anglo American

Diversified miner Anglo American saw its underlying earnings fall 30% in the first half of 2015. Free cash flow after interest payments fell into negative territory, meaning its dividend had to be entirely financed through an increase in debt. This situation can only get worse in the medium term, as iron ore prices have continued to plummet.

Anglo American is fighting back by announcing plans to lower annual operating costs by $1.5bn and cutting as many as 6,000 jobs. But, with the deficit in free cash flow affecting the company now, Anglo American could very possibly be forced to cut its dividend soon.

Glencore

Glencore is in a stronger position, as it has a sizeable commodities trading business. Trading profits are generally less correlated to commodity prices, and this means it reduces the volatility of the group’s profitability. In fact, the higher volatility in commodity prices this year should mean that earnings from its trading operations are likely to be much stronger in 2015. Its oil trading division should particularly benefit the contango in the futures market, which makes it profitable to store oil to sell at a higher price in the future.

Glencore is set to release its 2015 first half production report on Thursday, 13 August 2015.

Dividends not fully covered by free cash flow

As all three mining companies are unlikely to generate sufficient cash flows to cover their dividend payment in the medium term, a cut in the dividend is a real possibility. Unless there is more certainty with their dividend sustainability, it seems to early to invest in any of these three shares.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.