The Terrible Tale of Two Commodity Catch-22s

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The Terrible Tale of Two Commodity Catch-22s

By Tim Maverick, Senior Correspondent

How the mighty have fallen! Last week, one of the world’s commodities giants, Glencore plc (GLNCY), experienced a major blow.

On September 28, its stock collapsed by 30%. The reason? The company’s very heavy debt load in the face of still falling commodity prices.

The former commodities trading giant went public in a $60-billion stock market flotation four years ago. At the time, its traders transacted 60% of the world’s zinc, 50% of the copper, and 45% of the lead.

It became a physical commodities powerhouse when its head, Ivan Glasenberg, forced a merger with one of the world’s biggest miners, Xstrata, in 2013.

But now, its shares are down more than 80% from the issue price. And worries persist in the market that Glencore may be the next Lehman Brothers.

A Back-Breaking Debt Load

That particular fear may be overblown.

You see, Lehman Brothers may have had up to a trillion dollars in derivatives exposure.

Glencore does have about $100 billion in liabilities including $30 billion in net debt. Not good when your market capitalization is down to less than $20 billion. And the debt is 2.7 times annual earnings.

However, Glencore’s derivatives exposure is more limited than Lehman Brothers’. It’s believed to have a bit over $10 billion in derivative assets and close to $12 billion in derivative liabilities. Scary, but not Lehman. It may have had up to a trillion dollars in gross over-the-counter derivatives trades.

Its real problem is how to service that $30 billion in debt while commodities tumble. In effect, with each slide in commodities, Glencore’s leverage grows as its assets shrink, sinking the company further into quicksand.

Glencore is in a quagmire of its own doing. Most in the industry point to the $60-billion (including debt) acquisition of Xstrata as the turning point. Glencore took on a lot of debt for assets that weren’t all that great. Most of Glencore’s other mining assets are in the high-cost, low-quality variety.

In the two years following the deal, two of the key components – copper and coal – fell sharply in price. They were down 30% and 41%, respectively.

Trying to Dig Out

So now, Glencore is trying to dig out from under that huge debt pile.

It has taken the easy steps, like eliminating its dividend and issuing new shares for a total of $5 billion. Now the company faces the tough part. It’s going to have to try to sell some assets into a very depressed commodities market.

Unfortunately for Glencore, it may have to sell a stake in one of its remaining jewels – the agricultural division. This division was beefed up by the 2012 acquisition of Viterra, a grain handler based in Canada.

Overall, its agricultural arm contributed $856 million in earnings last year. That was about a third of the company’s marketing division profits.

It’s also likely Glencore will do a streaming deal for its gold and silver properties. This involves getting cash upfront in exchange for royalties on future sales of its gold and silver.

The Effect on Physical Commodities

But here’s where things get interesting. Its trading division is sitting on vast inventories of physical commodities.

Glencore itself admits it’s holding about $17-billion worth. It says about two-thirds of that is oil-related. The remainder is in various metals. And it’s likely that zinc was among the metals. Glencore is one of the largest miners and traders of zinc in the world. Zinc had been a strong outperformer, based on mine closures and dwindling supplies.

But then zinc collapsed to a five-year low in September as massive supplies began showing up at London Metal Exchange warehouses in New Orleans. Glencore’s warehouse business, Pacorini Metals, dominates the storage market in New Orleans.

But on October 9 we saw the biggest one-day intraday jump (up 12%) in zinc since 1989!

The reason is Glencore is cutting one-third of its global zinc production, which is about 500,000 metric tons. But any rally cannot be sustained without further cuts by other miners.

But don’t think for a moment Glencore is done liquidating commodities inventories, such as copper. It’s desperate to stay afloat. But this maneuver will only push commodity prices even lower – a real catch-22.

A Coppery Future

Speaking of copper, the company’s whole future may rest on it. Mining copper accounts for about a third of its core earnings. But that hasn’t been a good business, as prices have fallen to a six-year low on excess supplies.

Glencore has suspended operations at copper mines in Zambia, which will take 400,000 metric tons out of the market. And another troubled miner, Freeport McMoRan (FCX), is cutting about 75,000 tons worth of production.

But much more is needed to balance supply and demand. Perhaps another 500,000 tons. That will only happen if copper continues to fall. Another catch-22 for Glencore.

It looks as if Emperor Glasenberg has no clothes.

Good investing,

Tim Maverick

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By Tim Maverick