One of the corporate catalysts which unleashed the market "wobble" in August, in addition to the confluence of macro and geopolitical events, was the dramatic repricing of risk for all the commodity traders in general and for Glencore in particular as the market caught up with what we had cautioned since early 2014: Glencore is the closest (and most readily tradable) proxy to China's commodity and credit crunch, due to its extensive and direct exposure to copper prices.
So as commodity prices tumbled, the market looked to find a (levered) hedge and discovered it courtesy of Glencore CDS (in the process sending it wider by 600 points since our preview of just this event nearly two years ago), which as the chart below shows, may have been the single best liquid trade of 2015, as the probability of a Glencore default in the next 5 years has surpassed 50%.
[14]
More importantly, it was in early September that the rating agencies started noticing Glencor, which was bad news for the commodity trader as a junk bond rating would effective mean a collateral margin call cascade, requiring billions in additiona liquidity. On September 2 [15]: S&P announced: GLENCORE TO BBB/NEGATIVE FROM BBB/STABLE, which was unexpected as Glencore had just announced its first of many deleveraging program. It has since promised it would cut much more debt, even if it hasn't executed on any of these promises.
Then moments ago, it was the other rating agencies, Moody's which reminded Glencore that it is living on borrowed time and that it should move from mere deleveraging promises to actual actions when it downgraded Glencore from Baa2 to Baa3, the lowest investment grade category. The good news is that the outlook is stable, so Moody's won't proceed with another downgrade in the immediate future.
However, as Moody's writes, the downgrade may be inevitable as a result of the following conditions which would be sufficient to downgrade the giant commodity trader: "Weak earnings performance in marketing operations below the current EBIT guidance of $2.4-$2.7 billion could place negative pressure on the Baa3 ratings in the absence of any mitigating measures. A weakening of the company's liquidity position, delays with the planned divestments in 2016 or a material reduction in its working capital funding capacities by the banks, as well as sustained high leverage with adjusted debt/EBITDA exceeding 4x, will also put negative pressure on the Baa3 ratings."
In other words, unlike central banks which can get away with jawboning indefinitely, the raters have just started the countdown for Glencore which now has a few months in which to deliver asset divestment results, and enjoy a rebound in commodity prices, or else the worst case scenario for the company may unfold.
Full Moody's note:
Moody's downgrades Glencore's ratings to Baa3; stable outlook
London, 18 December 2015 -- Moody's Investors Service has today downgraded the long term ratings and short term ratings of Glencore International AG (Glencore) and its related entities to Baa3/(P)Baa3/P-3 from Baa2/(P)Baa2/P-2. The outlook on the ratings is stable.
"Our decision to downgrade Glencore's ratings by one notch to Baa3 primarily reflects our expectations that the pricing environment in mining will remain unfavorable in 2016-17, making a return to the previous level of earnings unlikely," says Elena Nadtotchi, Vice President Senior Credit Officer and Moody's lead analyst of Glencore. "However, we believe that Glencore has the capacity to adjust its balance sheet to a reduced earnings level in order to maintain its investment grade ratings."
RATINGS RATIONALE
-- DOWNGRADE OF RATINGS TO Baa3/P-3
Today's downgrade of Glencore's ratings to Baa3 reflects Moody's view that market conditions in the mining industry will not improve for a prolonged period of time. Weak metal prices have significantly reduced the earnings capability of the industrial division. However, Moody's expects that Glencore's substantial commodity marketing franchise will continue to contribute strongly to the earnings and free cash flow generation.
The rating agency expects that Glencore's adjusted EBITDA will have fallen by about 25% year-on-year in 2015 and will continue to decline by around 10% in 2016 on the back of Moody's lower metal price assumptions for the next year. The rating agency now assumes an average copper price of $2.15/lb in 2016 and only a modest recovery in the copper price to $2.35/lb average in 2017, compared to around $2.1/lb spot price today. While the rating agency bases its analysis on average metal price assumptions, it expects that metal prices will be highly volatile and as a result it will continue to review its price assumptions in 2016.
Given the deterioration in earnings, Glencore's debt/EBITDA (as adjusted by Moody's) is expected to have deteriorated to around 4x at the end of 2015. Moody's expects some improvement for 2016, however, metrics will likely stay above the 3.5x threshold compatible with a Baa2 rating.
RATIONALE FOR STABLE OUTLOOK
The stable outlook on the ratings reflects Moody's opinion that the company has the ability to manage its debt levels down to match the lower earnings levels.
Glencore's industrial operations remain robust, notwithstanding the adverse pricing environment. Over the last months of 2015, the company executed a number of operating measures in its industrial division, including suspending unprofitable production, improving cash cost positions across its key metals and minerals and announcing substantial capex cuts for 2016-17. These actions have improved the resilience of the industrial portfolio.
Moody's views the commodity marketing operations as a positive differentiating credit factor, given the relative stability in its earnings and its high FCF generation capability due to its low capex requirements. Glencore expects that its marketing operations will contribute $2.4-$2.7 billion of EBIT in 2016. This diversity of the operating model allows Glencore greater financial flexibility, compared to its mining peers. In the declining price environment, marketing operations release significant working capital, as seen in 2015, and help to repay debt to match the lower level of the earnings. Moody's recognises that the marketing business model relies on the availability of working capital financing. The rating agency has no indication that this has significantly deteriorated in the current commodity pricing environment.
The Baa3 rating and the stable outlook also recognises that the company is managing its balance sheet proactively. In H2 2015, Glencore placed $2.5 billion in equity, made divestments and delivered a substantial release of working capital, including from its marketing operations. Moody's expects that these measures will have arrested the deterioration in the company's financial metrics, with adjusted debt/EBITDA projected to peak at around 4x at end-2015, despite the accelerated decline in copper prices in the last quarter of this year.
In December 2015, Glencore also confirmed plans to further reduce debt in 2016, targeting about $3 billion of additional debt reduction compared to its September plans. Assuming lower metal prices, these plans will be in part supported by a further release of working capital, as well as the expected divestments. Moody's views the plan as credible and as a result factors some further improvement in Glencore's debt/EBITDA leverage metrics in 2016.
Finally, the Baa3 ratings and the stable outlook are supported by the company's financial policy that prioritises the investment grade rating, as demonstrated by the proactive execution of balance sheet strengthening measures in 2015, including equity placement, suspension of dividends and the accelerated repayment of debt.
LIQUIDITY
Glencore maintains a strong liquidity position, even as it continues to reduce its debt. In 2015, debt reduction was primarily funded by a substantial working capital inflow on the back of decline in metal prices and the release of capital from its commodity marketing operations, as well as by proceeds from its $2.5 billion equity placement and $0.9 billion streaming deal.
The company maintains substantial funding lines, which underpin its commodity marketing operations. Glencore has a $15.3 billion committed syndicated bank facility, comprising an $8.45 billion 12-month revolving credit facility maturing in May 2016 (with the term-out option to May 2017) and a $6.8 billion five-year 2020 revolving credit facility. At the end of September 2015, the company reported $13.8 billion in available liquidity, including cash balances and funds available under the revolving credit facilities.
STABLE OUTLOOK
The stable outlook on the Baa3 ratings factors the expectation that Glencore will improve its leverage profile in 2016 and will continue to maintain strong liquidity. The rating agency expects that Glencore retains sufficient financial and operating capacity and will execute additional measures to maintain its Baa3 credit profile, in particular if copper prices were to decline to $1.9/lb for a period of time, which is the rating agency's current stress case price assumption for 2016.
WHAT WOULD CHANGE THE RATING DOWN/UP
Large moves in commodity prices, and copper prices in particular, will continue to have an impact on the ratings.
Weak earnings performance in marketing operations below the current EBIT guidance of $2.4-$2.7 billion could place negative pressure on the Baa3 ratings in the absence of any mitigating measures. A weakening of the company's liquidity position, delays with the planned divestments in 2016 or a material reduction in its working capital funding capacities by the banks, as well as sustained high leverage with adjusted debt/EBITDA exceeding 4x, will also put negative pressure on the Baa3 ratings.
In the medium term, an upgrade of Glencore's ratings to Baa2 would be considered once leverage is sustainably reduced to the point where the company is able to build some headroom and maintain solid credit metrics. We expect that adjusted debt/EBITDA below 3.5x, backed by strong free cash flow generation and solid liquidity position will put positive pressure on the Baa3 ratings.
