The Glencore Glitch

World economy has been facing a global slowdown since the start of 2014. Majority of the economies, leaving out a few emerging economies, have so far bottomed out in terms of their GDP growth numbers in the recent quarters. The most significant signs of the global meltdown are the recent fall in global commodity prices amidst subdued global demand and peak volatility in energy prices. The fall in the commodity prices has been beneficial for countries who are net importers of these commodities but have severely dented a few Oil producing nations and oil marketing companies. We witnessed, Saudi, Yemen, Russia, and other OPEC nations selling off oil at prices as low as $44/barrel leading to tensed economic conditions. But there were few companies and countries which were probably ignored because of their strong reputation. One of them is Glencore Plc. In this blog, we will talk about Glencore, its business dynamics and the glitch that might cause a serious threat to the global economy.

Before we proceed, let me brief the readers about the background of the company. Glencore Plc (Glencore), the Global Energy Commodity Resource, a multinational giant in commodity trading and mining. It is probably the largest company in Switzerland and the world’s largest commodity trading company. It facilitates trades of various commodities such as zinc, copper, grains, oil etc.

Picture1

Going back to 2013, we witnessed the global oil prices started tumbling from $110 / barrel to an average price of $50 / barrel. Similarly, the copper prices also started tumbling in the recent year with the fear of weak demand and oversupply amidst Chinese slowdown. The above image show the trading share of Glencore. The image given below give a brief idea on how the revenues share is dependent on these tumbling commodities.

gglencore sector division

Is anything fundamentally wrong with Glencore? Was it considered a debt burdened company before although having the same levels of debt?  The answer is no. It is a levered bet on not only china but on the fate of copper and oil prices in the near future. Lets focus on what has happened in the recent past. With the falling commodity prices since the last 18 months, amidst China slowdown, Glencore has been a counter-party with China in Chinese Copper Financing Deals. The Chinese traders have been using copper as a tool for carry trade by creating artificial demand. The following image will give a brief idea of carry trade on copper.

carry

Precisely, China is creating 70% of the demand artificially by selling off copper and taking positions in futures market to buy it back after 13 months. On paper the demand is definitely existing but it might happen that the same contracts are rolled over. This might make Glencore’s position weak since the contracts are existent but the actual cash flows might be deferred for a longer period. With this fear, two rating agencies namely Moody’s and S&P downgraded Glencore’s rating to BBB with a negative outlook. The BBB rating with a negative outlook is just a notch above the non investment grade rating. The results have dented its share prices in the past few months. As a corrective action on the entire situation, it announced a dramatic recapitalization plan, one which would see it not only scramble to raise $10 billion in capital through an equity offering, asset sale and capex cut, but become the first major copper supplier of scale to cut production and indirectly benefiting its biggest competitors. Apart from the copper, various other commodities and major currencies have witnessed turmoil and it is unlikely that Glencore will be decoupled from the effects of the same.  Here’s a snapshot of Effect on EBIT vs Sensitivity of Various parameters.

Glencore EBIT Sensitivity

To sum up, with the commodity prices heading southwards it seems difficult for Glencore to recover. Although, they are trying to raise fresh capital and reduce their debt with the same, it is unlikely that they can control the external events predominantly related to the Chinese economy. In the midst of the events stated above, questions are being raised about the solvency of Glencore. What if Glencore fails to sustain the further fall in commodity prices? Well, since Glencore is not just a miner but probably the world’s largest commodity trading desk, and a key commodity counter-party, especially in Chinese carry trade deals, the answer is probably simple – Glencore might turn out to be a Lehman Brothers, only this time in the commodity space. 

Thank you. 🙂

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A Lot More Than A Century…

The Reserve Bank of India in its monetary policy review surprised the markets with a 50 bps rate cut. A few expectation stood at status quo based on the technical indicators, whereas a few expressed their views as a 25 bps cut. Dr. Rajan ultimately decided to cut rates by 50 bps taking the advantage of the appropriate levels of room given by the lower inflation. The markets and the corporates have welcomed the rate cut. Although, there has been a certain level of transmission loss so far but RBI is hoping for a complete transmission with time. RBI in 2015, has already scored a century with its total of 125 bps rate cut to boost the economy, but the govt seems to struggle to achieve the same. Apart from the surprise rate cut, there was a lot more in this policy on the reforms side of it. In this article, we will take a look at the reforms other than the 50 bps repo cut and discuss in brief about the probable contribution of rate cuts in boosting equity returns.

ReformsAnyone

With almost no signs of reforms from the fiscal policy stance in the form of GST bill passage, RBI has decided to take the initiative in driving the investment. RBI in its recent policy statement has given certain decision, which are expected to drive the investment in India.

Following are the reforms:

  1. Guidelines on Marginal Cost of Funding have been given to banks. RBI has initiated the process of reducing the transmission losses. The banks have been asked to shift from the current system of Average Cost of Funding to a more advanced approach of Marginal Cost of Funding. It is expected to boost the monetary transmission mechanism and pass on the benefits to the economy in the shortest possible time.
  2. RBI has also asked the MCA (Ministry of Corporate Affairs) to create a road map for convergence of Indian Accounting Standards with the IFRS standards. The move was taken in view of resolving discrepancies in the analysis of companies and to be at par with the international standards for normalization.
  3. The real estate sector has been holding on inventories worth Rs. 70000 Crore from the past year, due to the fall in the prices. RBi had asked the realtors to clear the inventories at lower cost since the prices are supposed to be market driven. The response was extremely lukewarm in nature. Thus, RBI has now initiated the move through its monetary tools. It has given banks the liberty to reduce the risk weights on the housing loans, which will bring down their costs and ultimately the cost to the customers. This is an attempt of RBI to make houses more affordable by giving them lower rates of interest. The rates of interest for housing is supposed to hover in the range of 9.5-10%.
  4. With the chances of fed hiking rates in the early 2016 or so, liquidity might face certain pressure in the country. RBI has hence decided to reduce the SLR requirements by 25 bps each quarter till march 2017 to sustain the liquidity crunch that might arise. SLR requirements are supposed to come down to 20% from the current levels of 21.5% (6 Tranches of 25 bps reduction in each quarter).
  5. With a view to making identification of banknotes easier for visually challenged persons, the process for introduction of additional identification marks in banknotes in the form of angular bleed lines has been initiated and is being introduced in the denominations of Rs. 100,  Rs.500 and Rs. 1000 as raised lines on both the left and right sides of the obverse of the banknote: 4 lines in  100, 5 lines in 500 and 6 lines in 1000. Furthermore, the size of the existing identification mark in these denominations is also being increased by 50 per cent to facilitate better identification.
  6. Additionally, the investment by FPI route into the debt markets has been eased to boost investments.

Lets discuss a bit about the markets, will the rate cut boost the returns from the equities and if yes, then what time horizon it will require.

Historical evidence suggests that, with interest rates reducing, companies tend to save on their interest cost, leading to higher profits, high job creation and more demand boosting the revenue growth. The effects of the same, will be seen as increase in corporate earnings and attractive valuation. Generally, whenever rate cuts have led to a meaningful demand push, the corporate earnings and PE ratio have improved. The image below indicates the relationship between the rate cuts and the valuation as well as the corporate earnings.

Relationship Between Int Rate and PE (historical)
Relationship Between Int Rate and PE (historical)

Currently, the state of the economy looks extremely feeble in nature, although it is the fastest growing economy. Data till date, indicates that, if the repo is at or above 8% mark, valuation take a hit whereas if they are around 6%, valuation look up. The valuations are supposed to improve according to the data, but this time the global economies are under intense slowdown pressure. The effects of these rate cuts on the market will be extremely short – lived. I believe, supposing that the transmission improves and interest cost come down, rate cut aid alone can almost never make up for the absence of the household demands and corporate earnings. Although, the current year and the first half of the year 2016 does not seem overwhelming, rate sensitive industries will definitely stand to gain in the current fiscal. Industries like banks, capital good, constructions, auto ancillary etc will be the key beneficiaries. The investments in the equities as of now might not reap you extraordinary returns but by FY 2017, the returns will be substantial in numbers. My recommendation would be stay invested and keep looking for potential value stocks.

To conclude, the inverse correlation between the interest rates and the PE and the valuations usually takes time to unfold. Although, banks have already reduced their interest rates by about 70 bps on an average against a 125 bps rate cut by the RBI. We can only hope for a much better and an effective transmission. I expect the interest rates to come down by another 50 bps in the case of banks in the near future, which might reduce the interest cost for the corporates. Given the low base of corporate earnings in FY 2015, performance should ideally show some improvement on a y-o-y basis from the Dec Quarter. Going ahead, a genuine improvement is unlikely before FY 2017 and only then will we witness some meaningful gains. Short term markets are likely to be bullish, medium term are likely to be neutral, but with the series of rate cuts this year, long-term indications are undoubtedly bullish in nature with the corporate earnings showing improvements. The commodity prices are also expected to be dented in the near future, which might add to the betterment of the economic indicators. Although, the RBI has done its bit in boosting the growth and investment, rest depends completely on the domestic demand pickup in the near future and the Govt reforms.

Thank you. 🙂