Glencore to Downsize $18 bln Commodity Inventory

Posted by Joseph Keefe October 29, 2015

Commodities mining and trading giant Glencore (GLCNF) is reducing its $18 billion inventory pile, industry sources say, a move ratings agencies say could help assuage concerns about its balance sheet.

The biggest player in the secretive commodities trading industry to hold a public share listing that requires it to disclose its accounts, Glencore has been battered by the global downturn in commodities prices.

Worries about its $30 billion debt burden saw its share price lose nearly two thirds if its value so far this year. The firm has pledged to reduce its debt by $10 billion by suspending dividends, reducing investments and selling some assets in order to protect its investment grade debt rating.

Sources close to the company say it is also reducing its vast trading inventory, driven in part by the winding up of "contango" market conditions, under which long-dated futures contracts were priced higher than spot prices, encouraging traders to store material to resell it at a profit later.

"If you look at where commodities prices are today and how the market conditions changed in the past six months - it is fair to say that the only way for inventories is to go down," a source close to Glencore said.

That could help appease ratings agencies such as Moody's (MCO) and S&P, which both rate Glencore just two notches above junk, with a negative outlook that means its investment grade rating is in jeopardy.

"Sometimes the balance sheet is just more important than the contango play," said the source close to the company.

A rating cut would raise the cost of borrowing. Some brokerage analysts see this as a potential threat to Glencore's business model. Glencore denies it would have a major impact but says it wants to avoid it anyway.

INVENTORY VOLUME BALLOONS
Despite the steep fall in commodities prices since last year, the total value of Glencore's inventory has barely budged, another way of saying that the volume of hydrocarbons, metals and other commodities the firm is holding has ballooned in size.

Under the "contango" conditions in place at the start of 2015, when traders expected the price of oil to recover from last year's steep falls, the cost of buying and storing it was lower than the price for contracts to deliver it in future months. Traders responded by storing millions of barrels in ships and inland tanks to earn a profit selling it later.

But in recent months, with a global oil glut growing, the cost of storage rising and the market now expecting low prices to persist longer, future prices for many commodities have fallen closer to, or lower than, spot prices. That means there is less to be earned from holding inventory.

Hence traders ranging from BP to Vitol have been reducing inventories. When Glencore presents investors with an update on Nov 4 it will most likely show a cut in inventory of billions of dollars.

Despite trading larger volumes in the first half of this year, Glencore's trading generated lower than expected earnings of $1.1 billion, down from $1.5 billion in the first half of 2014. Glencore expects to deliver $1.4 billion-$1.5 billion in trading earnings in the second half, although that task might prove to be challenging given shrinking volumes and an unwinding contango.

"You shrink your trading book and you shrink some trading profit margin opportunities," said David Staples, managing director at Moody's for EMEA corporate finance.

Nevertheless, the smaller inventory could produce benefits by reducing the need for the company to take other steps to shrink its balance sheet to assuage the ratings agencies.

SOLVENCY UNDER SCRUTINY
Both S&P and Moody's are awaiting the execution of the $10 billion debt cut plan to decide whether to keep their negative outlooks.

While details of Glencore's $30 billion long-term debt - in bonds and syndicated loans - are publicly known, much less information is available about the vast mountain of commodities it holds for trading purposes, which it finances throught short-term banking loans.

Glencore considers its inventory a trade secret and discloses only its total value, which was $17.9 billion in its last quarterly accounts. The full details are shared only with its auditors Deloitte and the ratings agencies Moody's and S&P.

The firm says the inventory should not matter in calculations of its debt: there is no risk to its solvency from holding a huge stock of metal in rail cars or oil in tankers around the world for trading purposes. The inventory is fully audited by Deloitte, accounted for at market prices and hedged to dampen the risk of possible fluctuations in price.

But the ratings agencies nevertheless apply a discount to their valuations of trading inventory, to account for what they see as risk that still remains despite hedging. That in turn increases their overall estimate of Glencore's debt.

S&P says it discounts the most liquid trading inventories like crude oil by 10 percent, and less liquid inventories like alumina by 25 percent. Those discounts are one of the reasons it tallies Glencore's debt at $37 billion, rather than the $30 billion Glencore says it owes.

"It is mostly just to recognise the risk that there is a haircut in a fire sale scenario, in a speedy liquidation. It is fairly standard to assume some kind of a haircut," said Simon Redmond, S&P's director for oil and gas ratings.

Because of Glencore's hedging, "there should not be material price risk on the trading inventories which is obviously critical from our perspective," he said. "But there is also some basis risk exposure because they can't hedge perfectly."

Moody's applies an even bigger discount of 50 percent to the inventory.

Reducing the inventory could reduce the need to shrink the balance sheet elsewhere, said Moody's Staples, although he said reducing long-term debt was still more important than cutting short-term borrowing related to inventories.

"A mining company without that kind of operation (trading), it's options are cut dividends and cut capex. Glencore has the extra lever, which is if they have to generate cash flow they can shrink their trading operations," he said.