Upbeat IPO pitch downplays risks run by commodity trader
Commodity giant Glencore yesterday kicked off the Hong Kong leg of its HK$78 billion initial public offering with chief executive Ivan Glasenberg insisting he is untroubled by the plunge in commodity prices this month.
He claimed the decline - which has seen the price of copper fall 10 per cent, wheat slide 14 per cent and oil slump 16 per cent - merely blows some of the speculative froth off the top of commodity markets.
The falls do nothing to diminish Glencore's business prospects, argued Glasenberg, who said that underlying demand for physical commodities remains strong among the company's Asian customers.
In fact, Glasenberg even claimed that falls in commodity prices could benefit the company, by freeing up large amounts of working capital.
Perhaps - but potential Hong Kong retail investors should not be lulled by Glasenberg's cool trader's exterior.
It is true that Glencore has been wildly profitable in recent years. The combined trading and mining company claims an average return on equity over the last ten years of 38 per cent, far higher than any of its competitors (see the chart below).
But the danger for investors is that Glencore may have earned such a high return on equity not because of its brilliant staff and unique business model, as Glasenberg would like you to believe, but simply by running much greater risks than its competitors.
In essence, Glencore has two business lines. The older and more profitable is the company's commodity trading arm (although Glencore prefers the word 'marketing' to trading).
Company executives describe this as a physical arbitrage business, in which Glencore diverts pre-sold cargos of metals, grains or hydrocarbons to where ever demand is keenest and prices highest, filling the original orders with other cargos purchased in the spot market.
Company executives claim that its traders are pure arbitrageurs who never - or at least seldom - take positions on the future direction of prices.
But despite their insistence, Glencore's trading business has shown itself to be heavily exposed to steep falls in commodity markets. In 2009, following the commodity price slump, earnings before tax and interest at the trading arm fell by half compared with the previous year.
Glencore's trading arm also plays the contango in commodity markets, using its heft to arrange cheap finance and storage for the commodities it buys in the spot market, and selling them for a fat premium in the forward market. But that too can be a patchy business, evaporating entirely when markets move into backwardation, with forward prices falling below spot market prices as they have for many commodities this month.
Glencore's mining business looks risky as well. With mines in the Democratic Republic of Congo, Zambia, Kazakhstan and Bolivia, the company operates in some of the trickiest countries in the world for political, legal and environmental risks.
In Zambia, for example, Glencore has been accused of evading local taxes. In Bolivia, one of its smelters has been nationalised and the government of president Evo Morales is insisting the company must fold its mines into joint ventures set up with local state-owned companies.
Meanwhile the mining business looks just as exposed as the trading arm to a protracted decline in commodity prices.
Glasenberg may have shrugged off that risk yesterday, pointing to continued robust demand from Asia. But not everyone shares his optimism.
In a research report published on Wednesday, Julian Jessop at London-based research house Capital Economics warned that commodity prices could be nearing the end of their long bull run.
Current prices factor in a steep increase in Chinese demand for commodities over the next decade, Jessop argued.
But if Beijing achieves its objective of steering the economy away from capital investment and more towards consumer demand and services, then the mainland's future commodity demand may be only around half what the market is anticipating.
'Any rebalancing of China's economy over the next decade is likely to see the commodity intensity of activity there drop sharply,' Jessop explained. 'If commodity prices are in a super-cycle, it is surely in its late stages.'
That's a minority view, but the reminder is salutary. Glencore may well have been fantastically profitable in recent years, but that's because it's a risky company operating in a risky market. Investors should take care.