/ 25 January 2013

Undisclosed agreement with Glencore sets Eskom at ease

Glencore-Xstrata may have increased export capacity at the Richards Bay coal terminal.
Glencore-Xstrata may have increased export capacity at the Richards Bay coal terminal.

Eskom has pressing concerns about merged Glencore-Xstrata's ability to influence domestic coal prices and take advantage of the utility's supply shortfalls, according to Eskom's confidential last-minute submission to intervene in the merger, of which the Mail & Guardian has a copy.

But on Friday last week Eskom withdrew its objection to the competititon authorities after coming to an undisclosed agreement with Glencore. The withdrawal of Eskom's objection saw the Competition Tribunal agree that the merger could go ahead, which was announced on Tuesday.

The submission to intervene, submitted in November last year, details Eskom's concerns that the merged parties could have an increased ability to manipulate prices. It raises the fear that it will give Glencore greater influence over coal pricing and, over time, could mean that Eskom will have to pay export prices for coal.

A key concern is that the new group could take advantage of a much larger export allocation at the Richards Bay coal terminal by utilising spare capacity at its mines to wash coal normally supplied to Eskom in order to upgrade it to export quality.

Although Glencore and Xstrata are relatively small Eskom suppliers compared with the likes of Exxaro and Anglo American, Glencore poses a particular threat because it has an in-depth understanding of the market, which allows it to cater for shortfalls in supply when others cannot.

These unforeseen costs related to short-term supply afford Eskom little room to negotiate and cannot be passed on to consumers, the parastatal states in its submission. But industry critics have asked whether all the fuss was a smokescreen for Eskom to justify its ever-increasing electricity tariffs.

Anti-competitive behaviour
Following an investigation of the merger, the Competition Commission concluded the transaction was not likely to result in substantial anti-competitive behaviour and recommended it be approved.

But in its submission, Eskom says the commission may have overestimated the utility's negotiating power and feared the merger would reduce its ability to negotiate prices for long-term and short-term contracts as the companies in the ever-expanding Glencore group would share information.

But an industry expert who asked not to be named said: "Although Glenstrata will be big, by itself it cannot increase prices as Eskom seems to believe."

In its submission to the commission, Eskom reports that supplies related to the merging parties is little more than 19-million tonnes per annum (Mtpa). But, according to the analyst, Glencore, as a coal trader, also buys supplies from small mines, which it could sell to Eskom. In 2011, the small mines supplied 6.2-million tonnes, which was not much compared with bigger suppliers to Eskom, such as Anglo (supplying 34.8Mtpa in 2011), Exxaro (32.5Mtpa in 2011) and BHP Billiton (20.6Mtpa in 2011). Both Exxaro and Anglo are also expected to increase supplies to Eskom soon.

But it's in the short-term contracts that Glencore has the competitive edge. According to estimates from Ted Blom, a partner at Mining and Energy Advisers International, Eskom's long-term contract price is an average of R135 per tonne compared with a R300 to R400 per tonne price for short-term suppliers.

In its submission, Eskom states the commission might misconstrue the relative importance of short-term supply contracts to its ability to maintain its operations. Hence "Eskom has no bargaining power in regard to this element of its procurement … Eskom is essentially a price taker in this regard".

The utility states it believes Glencore's objective is to ensure that short-term contracts are subject to export parity pricing, which would cause the parastatal's cost of production to increase.

Price determination
The financial effects of this are exacerbated by the fact that the multiyear price determination to which Eskom is subject "makes it impossible to pass on short-term price fluctuations".

And it's in situations such as these that Glencore shines, given its extensive insight into the market because of its activities in logistics as well as finance, Glencore says in a 2011 prospectus.

At the time of Glencore's listing in London and Hong Kong, the M&G reported how the company could benefit from opportunities brought about by good or bad weather. "For instance, it is able to exploit arbitrage opportunities, including arbitraging its own commodities, which may arise from a train derailment, because of its ubiquity and detailed knowledge of markets," the M&G reported.

Eskom believes Glencore's trading philosophy is based on buying up medium-term production and selling it on the spot market and Glencore's end game is the introduction of an export market-related price for coal.

"In order to generate maximum short-term profits for shareholders, Glencore needs to export increased volumes of lower grade coal (previously earmarked for Eskom) or achieve higher prices in South Africa based on export parity pricing."

Long-term contracts
Eskom was concerned the commission would not take into account that mining companies could avoid long-term supply agreements in favour of shorter ones. And it was also concerned that co-ordination between major players, brought about by the merger, would erode Eskom's bargaining power even in long-term contracts.

If post-merger production is dictated by global pricing, Eskom believes it could see month-to-month shortfalls.

"If the development of mines is scheduled according to the availability of exporter capacity at RBCT [Richards Bay coal terminal], this may not align in time with Eskom's requirements."

Eskom's concerns were further fuelled because, at the time of its submission to intervene, Xstrata was "at large" to engage about the viability of new long-term projects geared to support Eskom.

The utility's proposed conditions included that the ratio of coal supplied to Eskom versus the amount exported will be maintained after the merger, that new supply contracts could be entered into if it was required to keep the ratio intact, and that export parity pricing would not be applied to domestic supply contracts.

The Competition Tribunal approved the multibillion dollar merger between Glencore and Xstrata on Tuesday after the sudden turn of events that saw Eskom withdrawing its intervention following a memorandum of understanding drawn up by the parties.

Merger probe exposes gaps in industrial policy

In its investigation into the Glencore-Xstrata merger, the Competition Commission acknow-ledged difficulties in the market but concluded these were not merger-specific as the industry was already facing challenges such as competition from countries that use the same grade of coal as Eskom.

The commission said these concerns could be addressed by state-driven industrial policy, referring to instruments in the mining rights regime and suggestions in the national development plan to place conditions in mining licences and export permits for particular grades of coal.

But this did not satisfy Eskom, which, in its submission, accused the commission of trying to "pass the buck" to other bodies and ignoring its mandate to investigate and address these issues fully.

Eskom's Hilary Joffe said the power utility has been liaising with the relevant government departments and hopes that its long-term concerns will be addressed in consultation with state, industry and other stakeholders, including the Competition Commission.

Critics, however, accuse Eskom of not being active in securing supply.

Despite indicating in 2009 that it needed at least 40 new coal mines to ensure supply and keep prices down, to date only one contract has been secured for a small or medium-sized supplier.

At the tribunal, the council of the merging parties also argued that Eskom had made no moves to secure long-term contracts with them, particularly for one power station whose agreement is due to expire within the next two years.

Another aspect of Eskom's relationship with the merging parties that is largely a mystery is Xstrata's participation in Eskom's power buy-back programme, under which the parastatal pays the miner an undisclosed sum not to run its energy-intensive operations while Eskom's systems are at reduced capacity to allow the utility to do maintenance. The Xstrata-Merafe Chrome Venture agreed to temporarily shut five of its 20 furnaces from December to the end of March and in return, Eskom will buy back the energy not consumed by these furnaces. The ferrochrome production loss is an estimated 100 000 tonnes.

This is the second round of Eskom's buy-back programme. This year's budget allocation for all demand response and buy-back programmes is just over R2.5-billion and has no implications for tariffs.

Utility is 'happy' with Glencore agreement

The agreement between Eskom and Glencore may be confidential but the power utility has said it is pleased with the arrangement, which goes some way towards addressing the merger-specific concerns raised with the competition authorities.

"The agreement establishes a framework within which we can co-operate with each other," said Eskom spokesperson Hilary Joffe.

"Eskom expects that the spirit of the agreement will ensure that its concerns relating to the potential effect of the merger will be addressed."

Joffe said the parastatal was pleased with the outcome in that there was recognition that its concerns are valid both from the competition authorities and from the merging parties. However, she said, Eskom was concerned more broadly about the developing dynamics in the domestic coal supply market and the effect this may have on future coal supply and electricity generation.

Other details of the deal are confidential, said Joffe.

The National Union of Metal Workers of South Africa (Numsa) had also intervened in the matter but dropped its case a few hours after the deal was struck.

Steve Nhlapo, Numsa's sector co-ordinator for basic metals and energy, said its intervention was withdrawn because the submission ran parallel to Eskom's, but the union had no more details about the agreement.

"They have not necessarily informed us, but our understanding is that it was not concluded but that there is a principal agreement to negotiate."

Nhlapo said the union would approach Glencore and Eskom in order to participate in negotiations.