Glencore, Commodities Traders, and Systemic Risk

Glencore, the second largest commodity trader in the world and one of the swasbhucking progeny of the old Marc Rich trading empire, has gone in recent months from looking wobbly to being on the verge of a death spiral.

Glencore, became an awkward hybrid trader/producer particularly exposed to industrial metals by virtue acquiring Xtrata, a miner, in 2012. That gave it a big debt load. In the face of dim prospects for commodities and 29% fall in six-month earnings, Standard & Poors cut its ratings outlook for Glencore to negative at the beginning of September. A few days later, CEO Ivan Glasenberg issued a plan to lower debt levels by $10 billion and strengthen its balance sheet. But with talk not yet matched by enough in the way of concrete action, the pressure on Glencore has only increased as bad economic news out of China continues.

Even though Glencore’s stock price rebounded 16.9% on Tuesday after a 29% plunge on Monday due to a bearish analyst report from Investec, its bonds fell by a stunning “Lehman moment” 20% and did not recover. And it has already been the worst performer in the FTSE 100 over the past year before its recent swoon. I’m told that regulators and bankers are concerned about the systemic risks of a Glencore meltdown, since they don’t have a good picture of the size and concentration of its counterparty exposures. In fact, experts were expecting to see trouble among commodity traders before this, given the severity of the commodities bear market and continuing pressures from deflationary policies in Europe and weakness in China.

In other words, Glencore, along with other heavyweight commodity traders like Noble Group and Trafigura, are now the focus of concern about their viability. Note that commodities traders all make heavy use of borrowed money to secure positions, both in physical commodities and in derivatives, so access to credit at competitive prices is key to survival.

The crisis showed how quickly leveraged guarantors and trading operations like the monolines, AIG, and investment banks can go into a meltdown. As bond ratings fall, counterparties demand higher haircuts on secured loans and derivative positions. Rating agencies tend to be slow to downgrade, particularly for weak credits, since they don’t want to be accused of pushing arguably viable businesses over the brink. So if credit default swap and bond prices signal the high odds of more downgrades, particularly to below an investment grade rating, it can feed into a cycle of selling: bond investors sell, particularly ones that have restrictions on holding non-investment grade exposures (they’ll bail out to avoid a forced sale at a lower price upon a downgrade to junk); equity investors see credit spreads rising and worry about the implications for profits and even survival, so the stock price decays. The fears of equity investors shuts off one of the escape routes, that of selling more stock to shore up equity levels. And more decay in stock prices reaffirms lender concerns about a lack of rescue options, feeding further declines in bond prices and rises in CDS spreads.

Now in more normal times, this process would be limited by speculators. For instance, a downgrade to junk isn’t necessarily fatal if the junk bond market is in good shape and investors like the opportunity. And in the early days of the crisis, sovereign wealth funds swooped in to buy big stakes in US and European banks, perceiving them to be bargains (as we know, those bets turned out much less well than Saudi prince AlWaaled’s rescue of Citigroup in the early 1990s).

Glencore has announced its intent to raise $2.5 billion of equity by the end of 2016, as well as cut dividends and restructure the company. The sketchiness of the plans may not have helped soothe rattled investors nerves. From the Financial Times on September 8, the day after the program was announced:

Glencore’s apparent caution about embarking on a rights issue — where new stock is offered to existing shareholders in proportion to their stakes — may be rooted in how they are seen by some as time-consuming and bureaucratic..

“There’s no pressure on the company to do a particular structure,” said one person familiar with the company’s thinking. “There’s a very open dialogue with the shareholders about what they would like Glencore to do and when they should do it.”

Rather than a rights issue, Glencore could opt for an equity placing with a limited group of institutional investors, or issue a form of convertible debt, according to bankers…

Analysts at Investec Securities said Glencore’s proposal to raise new equity “could be construed as a masterpiece of spin” designed to spook short selling funds that have bet against the company’s stock in recent months.

Glencore also plans to offload assets, and observers expect the size of the sales to further depress prices. From Reuters in mid-September:

Substantial amounts of base metal zinc could be released onto world markets, weighing further on fast falling prices, as major producer Glencore implements a plan to liquidate some of its commodity inventories to help pay off debt…

Zinc, mainly used to galvanize steel to protect against rust in autos and construction, has slumped from being one of the best performing industrial metals earlier in the year to one of the worst due to the inventory change.

“It’s been a big shock to the market, this massive flood into the LME warehouses,” said Stephen Briggs, metals strategist at BNP Paribas.

But mining and trading company Glencore may add further to a plentiful supply situation after announcing a raft of measures to slash its net debt of $30 billion.

Glencore is also trying to sell some of its copper production in Chile and Peru, into another weak market.

As an aside, Bloomberg reported yesterday that official pressure saved Goldman from a self-destructive case of Glencore envy:

In October 2011, things were looking bleak at Goldman Sachs Group Inc.’s commodities business. Revenue was down, competition was up, employee attrition was at an all-time high and new regulations were on the horizon.

Beyond the usual rivalries with Morgan Stanley and JPMorgan Chase & Co., Goldman Sachs executives saw an upstart doing deals they couldn’t do and throwing lots of cash at traders: Glencore Plc. The commodities company wasn’t tied down by rules that applied to banks and had become even more of a presence since a $10 billion initial public offering earlier that year. It boasted strong growth and higher stock multiples than Goldman Sachs was receiving for its commodities unit.

“Glencore competes with GS Commodities but has a broader business mix, including significant production, refining, storing and transport activities,” Goldman Sachs executives said in a presentation that month to the bank’s board later made public by the Senate Permanent Subcommittee on Investigations. “May be model for evolution of commodities trading.”…

Goldman Sachs and other banks have the U.S. Congress and the Federal Reserve to thank. While you won’t hear many bankers praising regulation that limits their activities, the Fed’s scrutiny of banks’ physical commodities units came at a fortuitous time for the largest Wall Street firms.

The story describes how the dim view of the officialdom led major banks to curtail their physical commodities businesses in anticipation of a regulatory crackdown.

But the big question remains: will the tsuris at Glencore, and its troubled kindred Noble Group and Trafigura morph into a full bore crisis?

The disconcerting bit is that the regulators seems to know much less about interconnections in the commodities markets than it did in the credit default swaps and CDO markets in 2007 and 2008, and we know they were flying with bad maps back then. The fact that three major players are all looking fragile is also dangerous. While the failure of any one of them might be more a MF Global-level event rather than an LTCM, given how opaque all three of them are, that if one does go into a death spiral, it’s almost certain that investors would bail out of the other two wobbly biggies, as well as smaller players deemed to be risky. Remember, the financial crisis just past looked like individual players falling over, but it could just as well be seen as large institutional chunks calving off a glacier of overly-risky subprime exposures.

So we can expect both analysts and regulators to continue to scramble to get a handle on not just how fragile these commodity giants are, but who is next in line if they go down. And the risk is yet again that the cost of letting leveraged speculators operate with too little supervision is that the unwinding is bigger and nastier than anyone anticipated.