Glencore rout puzzles analysts

On Monday, a bearish note from Investec analysts in the United Kingdom was widely blamed for causing an unprecedented rout that wiped out 30% of resource giant Glencore’s market value in one day.

But Hunter Hillcoat, the lead author of the note and a mining analyst, is not convinced his opinion had all that much sway. Instead, he suggests, it was Volkswagen’s fault.

Last week, the vehicle manufacturer announced it would recall as many as 11-million cars that contained software that the US Environmental Protection Agency claim helped the carmaker to cheat emissions standards tests. For its transgressions, VW now faces a penalty of up to $18-billion.

The news has seen its share price weaken 38% since the middle of September. On Monday, the Financial Times reported VW’s cost of borrowing, for example, its 2020 issue, had climbed by almost one percentage point since the scandal blew up. Volkswagen has a very high level of corporate debt in the form of bonds rather than bank debt, said Hillcoat. When the scandal unfolded, liquidity had dried up in the corporate debt markets.

“The markets were already on the edge over this,” he said. The note about Glencore “just caused it to slip over”, he said.

Jean Pierre Verster, an analyst at 36One Asset Management, said the spread on credit default swaps (the cost of insuring against a debt default) blew out slightly before the share price dropped – “an indication that debt investors, rather than equity investors, were the first to take fright”.

Reuters reported that Glencore’s eurobonds, due in 2016 and beyond, were under pressure for the past month. Glencore still has an investment grade rating, but since Monday’s unprecedented fall there is pressure on it from keeping its bonds from reaching junk status. On Wednesday Bloomberg reported that credit markets have begun to view Glencore’s bonds as if they are already junk and derivatives traders were even demanding upfront payments for the first time since 2009.

In the comprehensive Investec note titled Bermuda Triangle – The Shrinking Slice of Equity Pie, analysts spoke about how mining companies “gorged themselves on cheap debt” to grow production and meet Chinese demand and now the consequences are “coming home to roost”.

And none more so than Glencore, which is feeling the combined brunt of being both highly geared and a commodity trader at a time when resource prices remain depressed and growth slows in China.

The note said Glencore’s gearing ratio (equity as a percentage of borrowed funds) is at 300%. Anglo American’s ratio is also high at 70%, and competitors Rio Tinto and BHP Billiton have ratios of 18% and 25% respectively.

The gearing means that, if commodity prices do not recover but remain weak for a sustained period, the resources company will end up spending any money it makes on repaying debt, the report said. This would dissolve its equity value – if not wipe it out entirely – given that gearing levels would “literally be off the chart”. The same applied to Anglo America, and BHP and Rio would be in a less extreme but still very difficult position.

A few months ago, Glencore seemed invincible. Even at the end of the resources’ supercycle, it had a clear drive to cut costs and promised shareholders it would pay the same, if not more, in dividends. Based on his 8% shareholding in the company, chief executive Ivan Glasenberg was worth $2-billion and number 301 on the Forbes list of the wealthiest people in the world.

But it has lost 68% of market value in the past year – even after a 16% rebound from Monday’s fall – and Glasenburg lost $500-million of personal wealth on the day. Earlier this month, the company announced it would do away with dividends and instead sell stock to raise equity and cut debt.

“In our view, the recent restructuring by Glencore may prove to be just the start,” the Investec note said.

Achilles heel
Glencore is more vertically integrated than other resources companies – it is active in upstream mining and resource extraction as well as downstream marketing. Its marketing and logistics activities mean the company has the advantage of strategic intelligence and the ability to understand the cycle and underlying supply and demand issues.

Its access to real-time information on the ground means, some believe, it can respond to changes in the market faster than other mining companies.

But, in the commodity price downturn, it is its vertical integration that could prove to be its Achilles heel.

Although all resource companies are feeling the downturn, none feels the effect as much as traders – and this is a differentiating factor, said Wayne McCurrie, of Momentum Wealth. “If your volumes dip and prices halve, your cash flows dry up.”

The hope is that commodity prices will not remain this low for much longer.

Glencore, and all resource shares, are a proxy for China, McCurrie said.

Fears abounded a few weeks ago when China’s equity market experienced a correction and the yuan was devalued the People’s Bank of China three times. But no further poor economic news has come out of the world power, which has assured a slower but steady growth of 7% for the foreseeable future.

But resources have continued to tumble. “This is the great conundrum,” said McCurrie. “Resource prices and resource shares are behaving as if China is in recession.”

Glencore is not invested in iron ore – a key component for steel, which has experienced a significant tumble in response to slowing demand in China – but it is invested in copper, which has become a bellwether for the performance of the global health of commodities prices, Hillcoat said.

The Chinese economy consumes 40% of the world’s copper supply.

Resource downcycles have come and gone and are hardly unusual, but this is the first time McCurrie had seen such a collapse without a corresponding collapse in demand, he said. This time it’s an oversupply that is causing the price collapse. Supply growth outstripping demand is also not new, but the extent of it is, McCurrie said.

Glasenburg has been vocal in reprimanding competitors for not cutting supply as the global commodities glut grows larger. Glencore itself cut thermal coal production and recently announced its plan to cut its copper output.

“If Glencore could afford it, by their balance sheet being strong, they would have been producing as much as anyone else,” said McCurrie. “But they can’t because of the debt, and can’t afford negative cash flows as long as the other guys. Their resource deposits are also not as low on the cost curve.”

“The market has clearly been dramatic. I have never seen a company of that size have such a big swing in one day,” said McCurrie. “Someone is panicking here – either panicking to get in or panicking to get out. But it is highly unusual.”

Hedge funds that have viewed Glencore as a proxy for China have profited handsomely from short-selling, the Financial Times reported this week. Short-selling is where investors bet on a share losing value.

“The JSE and London Stock Exchange do not track short interest but, according to Bloomberg, the total public filings of short positions in Glencore shares only comes to 1.55% of the shares outstanding. As a comparison with other London listings, WM Morrison is at 13% and Sainsbury is at 10.9%,” Verster said.

“Pundits are always quick to blame short sellers because they are the ones who benefit from a drop in price, but by far the largest participants in almost all share price drops are long-only managers, who have a lot more shares to sell (those that they already own) versus the few shares that a short seller can borrow in order to sell.”

On Wednesday Glencore issued a statement saying it has taken proactive steps to withstand current commodity market conditions, and its business remains operationally and financially robust, with positive cash flow, good liquidity and “absolutely no solvency issues”.

“We are getting on and delivering a suite of measures to reduce our debt levels by up to $10.2-billion. Glencore has no debt covenants and continues to retain strong lines of credit and secure access to funding, thanks to long-term relationships we have with the banks,” the company said.

McCurrie said it is unclear how long the excess in the market will last, but what is certain is that the market will have to come back up to the correct clearing price at some point.

“Glencore is not exactly on the brink of catastrophe – they don’t have to refinance their debt tomorrow,” he said.

“The company is not worth nothing – there is still value in the company because they physically own deposits and mines and infrastructure and assets, which, at a higher resource price, is still valuable.”

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