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Overreaching Catches Up to Glencore

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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Marc Rich, commodity trader extraordinaire, once gave this advice to an employee: "As a trader you often walk on the blade. Be careful and don't step off." Glencore, the world's biggest commodity trading company, which Rich founded, now seems to be falling off the edge, its business model in question. 

On Monday, Glencore's shares were down about 30 percent. Apparently, Glencore's executives themselves didn't know the reason for the freefall, judging by this tweet from Gianclaudio Torlizzi, founder of the consulting and market intelligence company T-Commodity:

 

The immediate explanation was probably a report from the financial company Investec, which said that if commodity prices remained at the current lows, almost all of Glencore's equity value "could evaporate." And something similar could happen to Anglo American, another mining giant, the report said.

It's easy to see how these findings set in motion a sell-off. Yet Glencore already was on a downward trajectory -- it has lost more than three quarters of its value since April. Its peers among commodity trading companies also were under pressure. Bunge, which trades in and processes agricultural commodities, and energy trader Kinder Morgan are both significantly down from this year's peaks.

Relatively few commodity trading houses are publicly traded. They were usually set up by crafty individuals such as the late Marc Rich to look for arbitrage opportunities in commodity markets. These opportunities arise when it makes more sense for the end user to buy from a trader a bundle of services -- transportation, warehousing, sometimes processing -- in addition to the commodity itself rather than buying the commodity from the producer and dealing with the logistics separately. 

Many commodity deals are just bets on price moves, without any involvement with physical commodities. Yet industries obtain energy and raw materials through physical trades, and this is what companies such as Glencore do best, keeping logistical costs as low as possible, buying when and where it makes more sense, moving vast quantities of oil, iron ore or wheat efficiently around the world. These companies have expertise dealing with unsavory regimes that produce raw materials -- they were among the first big investors in the former Soviet Union -- and they also master the most sophisticated aspects of marine transport management or hedging. They can even serve as banks.

This versatility usually offers protection against problems in specific markets, and traders usually hedge against commodity price fluctuations. There are other risks, however. In a primer on the economics of commodity trading companies published in March, Craig Pirrong, a finance professor at the University of Houston, identified one of the dangers as the "margin and volume risk." Pirrong wrote that "the quantity of commodity shipments, as opposed to variations in commodity flat prices, are better measures of the riskiness of traditional commodity merchandising operations":

The profitability of traditional commodity merchandising depends primarily on margins between purchase and sale prices, and the volume of transactions. These variables tend to be positively correlated: margins tend to be high when volumes are high, because both are increasing in the (derived) demand for the transformation services that commodity merchants provide. This derived demand changes in response to changes in the demand and the supply for the commodity. A decline in demand for the commodity in the importing region will reduce the derived demand for logistical services.

In other words, when trade volumes rise, so do trading houses' margins, and vice versa. Margins swelled during the recent commodities super-cycle, with China driving growth. According to a 2013 investigation by the Financial Times, the trading companies reaped $250 billion in profit in the preceding decade, more than Goldman Sachs, JPMorgan Chase and Morgan Stanley combined. 

Now, China is slowing and so is global trade. That means a drop in profitability for the traders. Bunge's net income per share fell to 50 cents in the second quarter of this year, from $1.71 in the year-earlier quarter. 

Glencore's merger with Xstrata, completed in 2013, made the company one of the world's biggest mining operations, and that probably compounded its problems. The move made sense at the time, as Glencore's logistical expertise made it an extremely competitive supplier of coal and non-ferrous metals, but mining also exposed the company to risks that pure trading doesn't have. Pirrong wrote: "As some commodity firms have moved upstream into mining, or into commodities with less developed derivatives markets (e.g., iron ore or coal), they typically must accept higher exposure to flat price risks."

Big traders, most of which made similar upstream investments during the boom, are being squeezed from all sides. Investment banks, many of which closed their commodity trading arms last year, were probably right to get out. On the other hand, Alcoa, the aluminum producer, is making the right move by splitting off its smelting and refining business -- a commodity arm that was fast turning into a liability -- from the lucrative business of making parts for the aerospace and automotive industries.

Trading houses cannot shed only the risky parts of their business because these days, all parts are vulnerable as demand plummets in commodity markets. It's too soon to say whether some of them will be wiped out by a crisis like the one that killed off a number of U.S. energy traders, including Enron, in 2002, but the conditions are challenging. Not even Rich, with his limitless capacity to walk the edge of the blade, could escape unscathed.

(Corrects Bunge and Kinder Morgan share price declines in fourth paragraph and Bunge's net income in 10th paragraph of article published Sept. 28.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net