Glencore; Meltdown or Death Spiral?

While the UK markets attention has been dominated by the Rate Debate and Volkswagen, we have a rather serious problem brewing on our own doorstep. Glencore is in meltdown and with its 5 year CDS trading on Friday either side of 600bps it is a wisp away from a death spiral. That’s the point when, ‘get me out I’m not having this in my portfolio when it goes down,’ PM’s jump ship and their numbers outweigh the bargain hunters. Investors who subscribed to the recent rights issue, and wouldn’t I love to see the crib sheet and FAQ sheet written for the salesmen by corporate finance for that one, will be feeling that maybe ‘cheap,’ wasn’t quite the right word to be banded around at 125p.

Whatever valuations analysts put on Glencore, equity investors may be about to be reminded that equity is at the bottom of the capital structure. Following the announcement earlier this month of the company’s $10bn recapitalisation plan through a rights issue, dividend suspension, asset sales, capex cut and production cut; Moody’s put the company on negative watch on its Baa2 rating, (just above junk). The market is beginning to question if the $10bn recap is sufficient to guarantee the survivability of the company and the whole asset structure is consequently having convulsions.

The problem becomes acute if Glencore is downgraded to junk. At that point we have a potential Lehman / AIG scenario in the commodity space. While Glencore is the biggest listed leveraged bet on the price of copper and the Chinese economy through its mining operations, it is also one of the world’s biggest commodity trading firms. A downgrade to junk could trigger forced selling from PM’s not able to hold junk paper, collateral liquidations and market counter parties slamming the doors shut. The complex daisy chain of OTC derivative contracts have an unquantifiable market risk. At the minimum, fear of a bad thing happening is enough in this fragile environment to unsettle the broader market. Risk managers and regulators must surely have Glencore front and centre on their radar this weekend.

Goldman have suggested in a recent note that it would take only a further 5% drop in commodity prices to tip Glencore over the edge. Bernstein meanwhile apparently think it is cheap.  Sure, the company will announce asset sales, like its agri business, and the shares may enjoy big % temporary spikes. My view however, is investors have no business touching this stock unless they have a near term blue sky view for copper and Chinese growth to which it has a high sensitivity. As neither are likely to be forthcoming investors should take a wide berth. Better to catch the turn in the commodity cycle when it comes with companies who are ahead of the game rather than behind it and examine Glencore only when it recovers its rating and financial health. Better to pay more for something with longevity than to bet at the roulette table in a casino on fire, which is exactly what an investment in the company is now.