Regardless of What Happens to Glencore or Noble, The Commodities River Will Keep on Rolling

It is not outside the realm of possibility that my analysis of whether commodity trading firms are systemically risky-“too big to fail”-will be put to the test not once, but twice, in the coming weeks and months.

One firm that has shipped a lot of water lately is the biggest, by far: Glencore. This spawn of Marc Rich has been hit very hard by the sharp decline in copper and coal prices in particular. It’s CDS spreads have widened dramatically, tripling to 450 bp before tightening some in the last few days. Its stock price is down dramatically. S&P has changed its rating to BBB/Negative, meaning that a downgrade to junk is possible.

In response, the company has announced rather radical measures to slash debt in order to maintain its vital investment grade credit rating. It has announced a cut in its dividend and an issuance of new equity via  a rights issue (about a quarter of which  will be purchased by management). It is also shopping assets, notably the recently acquired grain trading assets acquired with the Swiss firm bought Canada’s Viterra. It has responded to the copper price decline by shutting a mine in Africa.

The market’s initial reaction to these moves has been positive: Glencore’s stock rose when it announced these measures.

Glencore’s distress is a direct result of the sharp declines in copper and coal prices, which in turn are the direct result of the slowdown in China.

Although Glencore’s origins were as a trading firm, and it is still considered a trading firm, it is in many respects the exception that proves the rule, and hence is not a harbinger of doom for other traders. As I documented in my first white paper, The Economics of Commodity Trading Firms, Glencore is the most asset heavy of the firms commonly considered traders. Moreover, its assets are concentrated in the upstream, especially in the aftermath of its acquisition of Xsrata. In its current incarnation, it is more of a mining firm with a trading firm attached, than a trading firm.

Glencore always touted that its trading operation could be an internal hedge for its upstream activities: trading profitability is driven by volumes and margins, and these are less sensitive to commodity supply and demand conditions than prices, because the inelasticities of supply and demand mean that price, rather than volume, bears the brunt of demand and supply shocks. The Glencore argument makes sense, but there is only so much that the trading arm can do to offset an upstream bloodbath. Glencore’s exposure to flat price is so large now that in the grim pricing environment of the present it swamps the ability of the trading arm to bail it out.

Will it escape insolvency? I don’t know, precisely because its fate is out of its control, and dependent on flat prices, which neither I nor its management can predict with any certainty. Events, my boy. Events. Because of its upstream exposure, Glencore is on a ride on the China train. (By the way, those who thought that Glencore was a lower risk than other miners because of some superior ability to predict flat price because it is a trader: what were you thinking?)

If it goes insolvent, will it matter? Well, it’s creditors will mind. But beyond that, the arguments I made in my other white paper, Not Too Big to Fail, imply that the knock-on effects will be minimal. Industrial and mining firms can fail, and go through insolvency/bankruptcy without larger systemic effects.

The possible Viterra sale illustrates another point I made in the paper. Namely, that the financial distress of a commodity trader does not mean that the supply of commodity transformation services will decline. The distressed firm’s assets can continue to operate. One way to ensure that they continue to operate efficiently is to sell them to others. The wheat, canola, and barley that go through Viterra’s elevators don’t really care whose name is on the door. Nor, for the most part, do the farmers upstream or the consumers downstream.

What about other commodity traders? The purer traders they are (i.e., the less upstream asset exposure), the better off they are. Indeed, the lower price environment in oil in particular facilitates the contango trade because contangoes tend to widen when prices decline. BP’s trading arm announced lower profits in Q2 precisely because the contango play was not as profitable: I would expect that to turn around in Q3 and Q4 if prices remain low and the contango remains fat. As another example, Vitol made a well-timed purchase of the remainder of a Dutch oil storage company, presumably to allow it to exploit such plays.

The other firm that could test my arguments is the Hong Kong firm Noble. Nobles issues are somewhat different than Glencore’s. Noble’s accounting has come under sharp questioning, by a rather mysterious outfit called Iceberg (which Noble claims is basically the blog of a disgruntled ex-employee).

The issue is Noble’s aggressive booking of profits on long term deals. Something like 90 percent of the book value of its equity is attributable to these accounting items, whereas for other firms the figure is more on the order of 5-10 percent. Iceberg has also questioned Noble’s reported leverage, alleging that it has engaged in various off-balance sheet repo transactions (a la Lehman repo 105) to conceal debt.

The market has taken these charges seriously.  Noble’s stock has taken a pounding. It rebounded some recently, when Mitsubishi announced the acquisition of a 20 percent share of Olam, another Asian commodity firm whose accounting had been challenged, attracting some aggressive short sellers. But even with the rebound, Noble is flirting with dangerous territory and is at serious risk of insolvency or illiquidity if its bankers get sufficiently concerned (which amounts to insolvency for a commodity trader, which is very dependent on access to credit). Noble’s CDS spread reached 700+ bp in mid-August.

In the event of the worst happening, I again would expect that the pain would be limited to the creditors. Other firms, likely Japanese or Chinese trading firms, would pick up the pieces, and perhaps the whole caboodle. The commodities Noble moves would be moved by somebody else. Banks would eat a loss, but that’s part of their business. Other commodity traders’ accounting would get more scrutiny, from their creditors in particular. And that’s not a bad thing.

Commodity firms have come and gone over the years. (Everybody remembers Enron. Anybody remember Cook Industries? Andre Cie?) But the big commodities river keeps on rolling along.