Gary Shilling Blog

Glencore Suffers Hit from Commodity Prices

As commodity prices continue to fall, bankruptcies among producers and industry consolidation will no doubt accelerate.  Suppliers of farm, mining and construction equipment are already troubled. With this onslaught, it's no surprise that Glencore, the huge Swiss company that dominates global commodities markets, lost a third of its value in a single day last week.

DYI Comments:  No doubt there will be industry consolidation as many of the marginal players are either bought out or left to die in bankruptcy.  This consolidation will move this industrial sector from low earnings or losses back to financial health awaiting the next upward move in commodity prices.

Glencore was founded in 1974 by Marc Rich, the commodity trader and U.S. tax fugitive who died in 2013. Initially the firm, called Marc Rich & Co., didn’t own mining assets because Rich believed they were too volatile. He focused instead on commodity trading and eventually turned the company into the world’s largest trading house. Rich tried and failed to corner the zinc market in 1993-94 and was forced to sell 51 percent of the company in a management buyout to a team that included Glencore's current chief executive officer, Ivan Glasenberg.   

The new company became directly involved in mining operations, yet continued to stress the stability of its trading profits. Glencore's 2011 initial public offering prospectus stated that its trading business is “less correlated to commodity prices than its industrial operations, making Glencore’s earnings generally less volatile than those of pure producers of metals, mining and energy products.” 

It hasn't turned out that way. The nosedive in commodity prices and $30 billion in debt have put Glencore on the ropes, at least in the eyes of investors and possibly credit-rating companies. Despite measures announced in early September to reduce debt by $10 billion through stock sales, dividend cuts, asset sales and cost reductions, the yield on its U.S. dollar-denominated bond maturing in 2022 leaped from 4.6 percent at the end of July to 11 percent recently. Glencore's stock plummeted 29 percent on Sept. 28 and is down 90 percent since its 2011 public offering, done at the peak in commodity prices. 

If Glencore’s huge trading operation can’t protect its mining business, what’s in store for giant, concentrated mining companies like BHP Billiton, Vale, Rio Tinto and Anglo American? Or mining-equipment companies like Caterpillar? And how about smaller, less financially secure firms? Alcoa just threw in the towel on basic aluminum production and split those operations from its downstream, higher-value-added aluminum businesses.  

Investors who are much less knowledgeable about commodities than Glencore will probably continue to be forced into agonizing reappraisals. This includes pension funds that got swept up in the commodity craze a decade ago and hoped further rapid price rises would help them achieve their investment goals in an era of low interest rates. Many elevated commodities into an investment class alongside stocks and bonds.

DYI:  My proxy, basic method of determining whether overall prices for gold primarily and the many other commodities is the Dow/Gold Ratio.  Not perfect, but will have you going in at low prices and reducing your exposure as prices move significantly greater than the Dow Jones Industrial Average (a proxy for financial assets).   As an example gold peaked in September of 2011 at $1889.70 per troy ounce and the Dow Jones at 11,509.  A little bit of simple arithmetic the ratio at 6.09 to 1.  Clearly prices of gold and the other commodities became way ahead of themselves in price.
 

DYI's weighted average formula when prices move above their mean valuations the formula aggressively reduces your exposure to that asset category.  Gold was no exception.  Of course the remaining small position dropped precipitously but in no way a killer to the overall long term performance of our investment model.  DYI is a valuation based investment method for secular trends.  It is not for fast buck trading.  What it is for, is to move slowly through the years between our four asset categories; stocks, long term bonds, gold, and cash(short term notes).  By staying predominately in undervalue assets higher gains maybe achieved with definitely lower volatility.

I’ve always insisted, however, that commodities aren’t an investment class, but a speculation. Sure, I use such commodities as crude oil, copper and sugar in the aggressive portfolios I manage, but on the short side. Since the mid-1800's, commodity prices, adjusted for inflation, have been in a steady downward trend. The price spikes due to demand surges in the Civil War and both world wars were soon retraced, as were the effects of the oil-supply curtailments in the 1970's.  

Sure, there’s only so much oil in the ground. Devotees of the Hubbert peak theory -- geophysicist M. King Hubbert's idea that world oil production had peaked in the 1970's -- thought that crude oil supplies would have been fully exploited by now, with surging prices as the result. Then came fracking technology and huge new supplies of relatively cheap shale oil.

DYI:  I depart a bit from Gary Shilling when it comes to hydrocarbons as I believe they are in a secular roller coaster bull market.  Fracking, horizontal drilling, fuel efficient cars, trucks, LED lighting, alternative energies etc. have all stretched out the use of oil/gas/coal.  So far there has not been a "game changer" technology that puts a serious dent into hydrocarbons.  When the price of oil drops significantly due to the economy or geo-political manipulation I'll bring this to the attention to the readers of this blog.  Conversely as prices move to their mean reduce your position, as prices begin to fly higher reduce a bit more, if prices move into rank speculation reduce significantly.  This process takes years to complete no wonder most investors including the so called professional forget this secular process.    

I can recall when serious economists predicted that the telecommunications expansion would come to a grinding halt because there wasn’t enough copper in the earth’s crust to make the needed wires. Fiber optics obviously eliminated that problem. 

Human ingenuity and free-market prices have always eliminated commodity shortages, and probably always will. Commodity investments may continue to be rewarding -- as long as they’re based on further price declines.

Gold is Money

DYI:  Gold is similar to cash.  If you have cash in your pocket it is not earning any dividends nor interest income.  The same is true for gold; having gold coins in your pocket earns neither interest or dividends.  The biggest difference gold as compared to cash [over very long periods of time] will retain its value.  Forty Dollars back in the 1930's is the same as $1,000 today.  Gold today despite its high volatility has retained the same purchasing power since the 1930's; American Dollars cannot make that claim.

The Dow/Gold Ratio chart above shows when stocks expensive/cheap and for gold when it is expensive/cheap.  Currently today gold has fallen back close to its mean neither cheap nor expensive. This is why our model account is only holding 15% in precious metals mining companies mutual fund.  However, that 15% appears to be very undervalued for the gold mining stocks as they have gone through a brutal bear market with prices from peak to trough of around 75%!  An excellent time to add an uncorrelated asset to your portfolio.

DYI