First Glencore cut its coal production. Then a month ago as part of its "doomsday" deleveraging plan, the troubled Swiss miner-cum-trader announced drastic production cuts and major layoffs in its copper mining business, which would be reduced by 400,000 tons as a result of mine closures in Zambia and DR Congo. Then late last week the company surprised many when it once again slashed its zinc production by a third (while laying off 1,600 workers in Australia), in the process reducing global zinc output by 500,000 metric tons.
The logic, in theory, behind the move was simple enough. As DB summarized it, "$1650 for zinc is fundamentally too low and some of the capacity makes no cash at these levels - Solution: Shut it down until the price normalizes. While most market observers see the zinc market already in deficit, the dwindling price says otherwise and Glencore's move should bring forward the crunch point with a resulting positive impact on the metal price."
Additionally, DB provided a beautiful model of how said zinc production cut for Glencore - expected to be completed over the next 6 months - would look like, as well as the ensuing production ramp-up in 2017, "as the zinc price recovers."
On Friday the market, too, was delighted by this announcement, and led not only to a rally in price of Glencore stock but also unleashed the biggest surge in the price of zinc, which soared by over 10%, the biggest intraday move in history.
There was just one problem, and we laid it out in our response to the market reaction to Glencore's latest production cut - all it would take is for just one company to defect from this attempt to reestablish the "game theory" equilibrium, for the whole plan to fail.
"with sales a function of price and volume, and with Glencore aggressively cutting volumes, it is hoping the price increase will (more than) offset the drop in volumes. Which is a big gamble as other cash-strapped miners step up their own production, in the process boosting supply and once again slamming the price of zinc (and copper) lower."
It remains to be seen where the equilibrium price levels off after all these production cutbacks, although if the copper and zinc markets are anything like oil, it is certain that any volume reductions by Glencore will be promptly taken advantage of by Glencore's competitors, because in a global deleveraging and commodity supercycle repricing, he who cooperates while others defect, always loses the game theory.
This was once again spot on, because while Glencore's theory is admirable, it is what happens in practice that matters.
And what happened is that just as expected, overnight the world's second biggest mining company, Rio Tinto, warned that it will not cut copper production, saying it would be illogical to hold back output and leave space in the market for higher-cost rivals.
And just like that Glencore's assumption that others in the space will act rationally, and "cooperate" with the attempt by Glencore to impose a new game theoretical equilibrium by reducing supply, and thus boosting prices, has crashed and burned.
According to the FT, Jean-Sebastien Jacques, head of copper and coal at Rio, said the Anglo-Australian mining group would not reduce output even though current prices of the industrial metal did not reflect “fundamentals”.
His comments come just days after rival commodities group Glencore said it would slash its zinc output by a third after the price of the industrial metal fell to a five-year low on concerns about slowing economic growth in China.
Rio and its peer BHP Billiton have been ramping up production of their main commodities during the current price rout, betting that their low-cost assets will enable them to survive and maintain market share while higher-cost producers go bust.
While copper prices have been slumping, Rio has been spending billions of dollars expanding output at its giant copper project in Mongolia, and is preparing a second underground phase of the mine.
Furthermore, just as we said that the crude paradigm of the past year is now dominant, so it has spread to all other commodities: a world where diversified miners are hoping they can take out the high-cost marginal producers by keeping the price painfully low through production below cost. The CEO confirmed this:
“Why should I make cuts?” Mr Jacques said, in an interview ahead of LME Week, the biggest annual gathering of the metals and mining industry.
“If you have marginal assets and marginal projects and you have a pretty weak balance sheet I think you may be in trouble pretty soon,” he said.
Which in turn brings up monetary policy, because just like Saudi Arabia has been hoping high cost US shale producers would have long since burned out by now, they keep finding gullible junk bond investors who fund them at below-cost prices, if only to clip at least one hefty double digit coupon before the company defaults (because at the end of the day, the year-end bonus paid out from other people's money, is all that matters in the ZIRP world).
So about that pretty Deutsche Bank zinc production chart shown above... well, scrap it because while it will be absolutely correct about the drop (unless Glencore renegs on its production cut plan just days after announcing it) there will be no rebound, unless Glencore wants to suffer even greater costs and negative cash flows associated with unmothballing stalled operations at prices that remain vastly uneconomical and loss-making.
Jacques also spoke to Bloomberg, reiterating his philosophy on boosting production at below-cost prices:
The metal is “not trading on fundamentals,” Rio Copper & Coal Chief Executive Officer Jean-Sébastien Jacques said in an interview in London. “There is lots of short-selling in copper and we’ve seen the pick up in terms of short-selling in copper on the back of what happened in China a few months ago.”
“It can be a very dangerous game in the medium and long term,” he said. “You don’t want to have a short position when the market moves into a deficit. From an industry standpoint, the sooner we move back into a deficit situation the better it is because currently there is a lot of noise in the system.”
Of course, with Rio Tinto set to boost production to take up the production generously given up by Glencore, the moment when the system shifts to equlibrium has been indefinitely delayed.
Worse, once Glencore realizes that its olive branch has been rejected, the miner will have no choice but to turn those machine back on, and proceed to regain all the market share it has lost because it, like the gullible longs, believes theory and practice are the same.
As for Glencore, the market is starting to realize the big picture, and the stock was down 4% as of this moment, its biggest drop in two weeks, and back to the level of the September equity follow on offering.