Great article on FT-Alphaville about Glencore’s latest results. After dubious accounting charges at Noble Group, Asia’s largest commodity trader, Glencore has been in the spotlight – its profit from trading dropping some 30 percent. Reading this I was immediately reminded of Jim Chanos’s quote from the Enron testimony:
(…) It is an axiom in securities trading that, no matter how well “hedged” a firm claims to be, trading operations always seem to do better in bull markets and to struggle in bear markets (…)
Of course, all the executives are busy explaining how falling commodity prices are actually good for them as it frees valuable working capital and they hasten to point out that profit from trading, albeit significantly lower, came in at respectable USD 1.1 billion.
This argument is faulty in my view.
For, if you look closer at Glencore’s results it shows a net loss of more than USD 650mln for the first six months, due to USD 1.5bln of one-off items, such as write-downs of some mining assets. No doubt, the firm wants us to focus on its supposedly recurring trading business (actually Glencore calls this marketing). But write-downs on “unrelated” mining investments are still very important, as they influence the company’s credit rating. I do not know about Glencore, but in my post on Noble group a few weeks ago, I concluded that more than 90 percent of the book value of equity was backed by capitalized profits from long-term contracts, which implies that Noble’s mining investments were more or less exclusively funded with debt. Not good.
Further, on my Asia trip last autumn (here), I saw many deals were commodity traders financed the operations of mines with the purpose of securing a stable long-term supply. When I asked why anybody would do this, I was told the commodity traders get the benefit of securing long-term supplies at – and this is important – below market prices. Buying at below market prices virtually guarantees a positive trading profit even if fully hedged. But this profit is not a real “flow” profit, as it comes at the expense of significant credit or – as in Glencore’s case – participation risk. No doubt, without these participations trading profits would have been much lower, if not negative. Hence, they are not unrelated…
Over the past 15 years commodity trading firms have boomed and become the darlings of the financial press. I have felt their news presence is way heavier than for, say, manufacturers. A formerly obscure business operating in murky places is, no doubt, attractive to many and a lot of money was made. We all know this was due to the rise of China and its insatiable demand for commodities. These times will not come back, regardless of what CEOs tell you. Therefore I expect commodity trading firms to fade back into obscurity, of course not without some spectacular fall-outs and bankruptcies on the way…