While the US was still sleeping on its Labor Day holiday, the global commodity world was stunned on Monday when Glencore's CEO Ivan Glasenberg - formerly a perpetual optimist in all things commodity - 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, thereby defecting from the game theoretical "race to the bottom" equilibrium, and indirectly benefiting its biggest competitors. The reason: prepare for a "doomsday" scenario for commodity prices.
Glencore's unprecedented action was in direct response to an S&P downgrade warnings from the previous week, which threatened to strip the world's biggest commodity trader of its critical investment grade, BBB rating, which would have dramatic and adverse consequences on the company's trading operations: thing an AIG-like collateral waterfall. The S&P warning is also why last week the company's CDS blew out all the way to 450 bps, the widest since the financial crisis.
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Then, as a result of the capital raise, one which many took for admission the company would aggressively focus on lowering its net leverage to a far more reasonable for the current commodity bear market 2.0x target, Glencore's CDS tumbled by nearly a third in the past 4 days.
And then, something bad happened: the other rating agency, Moody's, agreed with us when we said that Glencore's deleveraging efforts may fall well short of the market, and put the outlook for Glencore's credit rating of Baa2, just a fraction above junk, on negative watch.
Why was the news particularly bad? Because Moody's confirmed that Glencore's doomsday scenario may not be "doom" enough. From the report [14]:
The measures that Glencore announced on 7 September 2015 will help strengthen and stabilise Glencore's credit profile when completed, however their scale reflects not just the challenges of the current commodity market, but also the growing possibility of a prolonged weaker pricing environment. On 28 August Moody's revised downwards its forecast for GDP growth in the G20 economies, reflecting the impact of a more marked slowdown in China and more prolonged negative effects from low commodity prices, with slower growth in China making a significant rebound in commodity prices in the near term unlikely.
The company proposed a $2.5 billion fully-underwritten equity issuance, announced a suspension of 2015 final dividend ($1.6 billion) and 2016 interim dividend ($0.8 billion) to be paid in 2016, and identified additional measures to raise about $5.3 billion in cash proceeds from further capex cuts, the sale of various non-core assets, as well as further release of working capital by the end of 2016.
The affirmation of the Baa2/P-2 ratings reflects our view that the proposed measures will allow Glencore to build sufficient financial flexibility and strengthen its credit profile. The Baa2 rating is underpinned by the expectation that the company will redeploy capital and reduce gross debt to restore its leverage metrics closer in line with the Baa2 rating guidance, including gross adjusted debt/EBITDA at around 3.5x times in the next 12 months, from the approximately 4x times debt/EBITDA level that we project at the end of 2015 (prior to any gross debt repayment in 2H 2015). It also factors our projection that Glencore will continue to generate free cash flow over the next 6-12 months, on the back of CAPEX cuts and working capital inflow, and will further add to its solid liquidity position in the operating environment that we expect to remain challenging.
What would catalyze a downgrade? "The ratings could be downgraded if debt/EBITDA remains persistently higher than 3.5x" which also confirms what we said several weeks ago: it is all about the Glencore cash flows, which in the current depressed environment and mothballing of two Glencore mines, will drop precipitously in the coming months.
And then there was the biggest kicker of all: copper prices. To wit: "Notwithstanding the company's broad capabilities to take strengthening measures, Moody's has changed the outlook to negative to reflect the scope for a prolonged difficult market that may cause a slower recovery in Glencore's financial profile, particularly if copper prices were to decline to below $2.2/lb on a prolonged basis from Moody's current copper price assumption of $ 2.35/lb for 2016."
As a reminder, the reason why we said back in March 2014 that going long Glencore CDS is the best trade to hedge against a Chinese collapse, is precisely due to Glencore's underappreciated sensitivity to copper prices...
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... which have since tumbled, and led to the recent surge in not only GLEN CDS but the record drop in its stock price.
What Moody's did with its warning after Glencore's deleveraging action announcement is to confirm our conclusion from Monday [16]:
as a result of today's asset-stripping and equity-raising activity, Glencore is now a that much better levered bet on China's economy in a broad sense, and copper pricing in a narrow one. In fact, with every passing week that neither China's economy rebound nor copper reverses recent losses, expect GLEN CDS to accelerate its widening once again, and overtake its recent multi-year high level of 445 bps in very short notice.
Sure enough, as of this morning GLEN CDS was up over 30 basis point, and has regained one-fifth of the recent drop on the capital raise.
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The worst news for Glasenberg is that at least one rating agency demands to be "shown" just how effective the company's capital raise will be instead of merely being "told." Which means that as we said on Monday of this week, as of this moment Glencore is an even better and more levered bet on not only copper, but China.
Finally, some have started to ask [18]: what happens if Glencore were to fail? Well, since Glencore is not just a miner, but probably the world's largest commodity trading desk, and is a key commodity counterparty for everyone, the answer is simple: Lehman... only this time in the commodity space.
