Glencore's Collapse Gives Commodities Their "Lehman Brothers Moment"

Editor's Note: We're sharing this Sure Money Investor alert with you because Glencore's imminent collapse is going to have massive, market-shifting repercussions the likes of which we haven't seen since 2008. Michael wants everyone to be ready to avoid the volatility this will cause and, even better, profit from this historic failure. You can get regular updates on this situation from Michael by clicking here, but here's what you need to know right now...

On Monday, European commodities and mining powerhouse Glencore Plc. (LON: GLEN) had a very bad day, and its shares dropped 29%.

Maybe you hadn't heard of Glencore before Monday. But I'd wager that, by the end of this year, everyone will know the name. Just like they know the names AIG, Lehman Brothers, and Bear Stearns.

You see, what's happening with Glencore is an eerie, picture-perfect replay of what happened in the AIG meltdown of 2008.

And what happens next is going to rock the entire market.

I don't tell you this to scare you, though it is scary. This is a major "market event." I think it will get a Wikipedia page or two of its own when the dust settles.

But we know from history that it always pays to be on the leading edge of a crisis and get your money "sure." I'm here to show you how to do that and be in a good position to harness the upside from this event, too.

Right now the Glencore event is still playing out, as I'll show you (though the direction is clear to those of us who run in the credit markets). But one thing's certain. It is going to have a near-immediate, hard-hitting effect on all the risk assets out there - just like AIG's collapse did in 2008.

Feel free to forward this message to your family, neighbors, broker, money manager...

We all have to move quickly on this one...

Glencore's London-listed shares have collapsed by more than 80% from a 52-week high of £3.46 ($5.25) to open at £0.979 ($1.47) on Monday, as investors have lost confidence in the company.

But during Monday's trading, shares fell another 29% to £0.60 ($1.03). Even more ominously, the credit markets are now questioning whether the company will be able to survive the carnage in major commodities markets, which is battering the company's earnings and threatening its investment-grade credit rating.

Investors are fleeing Glencore's bonds as well. Its €1.25 billion ($1.4 billion) of notes due March 2021 fell to 78 on Monday, while its €750 million ($842.44 million) of bonds due March 2025 have dropped to 67, both record lows.

It was rebounding yesterday, but that won't last. Investors can't flee Glencore exposure fast enough.

Here's What's Wrong with Glencore

Glencore is facing a number of big problems.

First, its earnings are plunging on the back of lower commodity prices. Sales have plunged from $240 billion in 2013 to an estimated $162 billion this year. Net income has fallen from $4.3 billion in 2013 to an estimated $1.47 billion this year. That might still sound like a lot of money, but not when you are carrying over $45 billion of debt ($30 billion net of cash) like Glencore is. The company's interest bill will be about $1.25 billion this year. It simply has no further margin of error if commodity prices fall any further, which they are likely to do.

The company is fatally vulnerable to a weakening global economy and what that means for commodity prices - every 10% drop in copper lowers EBITDA (cash flow) by $1.2 billion. Glencore is facing a toxic mix of too much debt and plunging commodity prices, and there is no way out unless commodities stage a miracle rally - which isn't going to happen.

But there's an even bigger problem facing the company...

Glencore carries $19 billion of derivatives on its books. If Glencore loses its investment-grade rating - which is a virtual certainty - it is going to be required to post additional cash collateral for these contracts. And the company doesn't have enough cash to do that.

If this scenario sounds familiar, that's because it's very similar to what happened to insurance giant AIG in 2008 at the height of the financial crisis. AIG had written hundreds of billions of credit default swaps on subprime mortgage deals. When it lost its investment-grade rating and was required to post additional cash collateral for these contracts, it was unable to do so and had to be bailed out by the U.S. government.

Before that happened, the price of credit insurance on AIG blew out.

And that's exactly what's happening to Glencore now.

The World's Largest Commodity Trader Is at a High Risk of Default

For healthy companies, credit insurance is priced in terms of an annual payment that generally ranges between 100 basis points for investment-grade companies to several hundred basis points for junk-rated companies. Credit insurance for companies considered to be in financial trouble also includes an upfront payment that can range from 100 basis points to several hundred basis points.

And this is where things are getting interesting - in a bad way...

For the first time since during the financial crisis in 2009, sellers of credit insurance on Glencore are requiring an upfront payment in addition to the annual insurance premium. That is a very bad sign. Based on the latest data available, it costs 875 basis points a year, including the up-front payment, to buy insurance on Glencore, which equates to a 54% chance that the world's largest commodities trading firm is going to default.

To put that in perspective, 875 basis points is where a B- rated company trades - which is six levels below investment grade.

In other words, the market has already decided that Glencore no longer deserves its investment-grade rating. It is only a matter of time before the credit rating agencies, like Moody's and Standard & Poor's, catch up. Once that happens, the next problem will be whether Glencore can post enough collateral to keep these derivative contracts in place or whether it will default on its $45 billion of debt and $19 billion of derivatives.

If you check press reports, you will see that "sources close to Glencore" claim that the company has enough liquidity to meet its obligations.

But... if you go back in time to 2008 and read similar press reports about AIG and Lehman, those ever-helpful "close sources" said the same thing about those two companies. If they said anything else, it would further spook the markets and it would be GAME OVER right now.

If you want to know what's going on, pay attention to what the markets are saying, not what these so-called "sources" are saying.

Defaulting on $64 billion of debt obligations is bad enough. But the story doesn't end there.

Because this is where the consequences of the end of the "Debt Supercycle" come in.

$155 Billion Is Serious Money with Serious Consequences

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Glencore doesn't exist in a vacuum today, just like AIG didn't exist in a vacuum in 2008.

Glencore is an essential link in a networked global financial system. It is an important counterparty to many of the largest financial institutions in the world, who are in turn counterparties to other financial institutions, who are in turn counterparties in an endless chain of relationships that keep the global markets operating.

And the global counterparty chain is only as strong as its weakest link. In 2008, its weakest link was AIG, until the government stepped up and bailed out the insurer. Then the weakest link became Lehman Brothers, and when the government refused to step up and bail out the brokerage firm, all hell broke loose.

Fortunately, Glencore is a lot smaller than Lehman Brothers, with a balance sheet of $155 billion compared to Lehman Brothers' $600 billion in 2008 when it went belly-up.

But $155 billion is still a big mess to clean up. And Glencore is connected to a lot of other counterparties who will have to scramble if it collapses. A Glencore bankruptcy will be a disaster for markets that are already on the run.

The most important message I am trying to convey right now is that you should monitor the situation since it has the potential to deteriorate quickly and rock the markets. But there are a number of ways to protect yourself and profit, too.

Let's walk through the consequences of a Glencore failure... and the pockets of opportunity.

Opportunity No. 1: The Commodities Sector in Chaos

As the largest commodity trader in the world, Glencore's failure would throw the severely depressed commodities sector into chaos. Commodities hedge funds are already reeling from catastrophic losses, which would only worsen if Glencore couldn't meet its obligations. A number of them would likely fail. Wall Street trading desks, which have done nothing but cut risk since the financial crisis and the advent of Dodd-Frank, aren't going to step up and fill the void created by Glencore's failure.

A Glencore bankruptcy would send already battered commodity prices into a freefall - creating an opportunity today to short commodities (and catch them on the way back up).

Opportunity No. 2: Stocks and ETFs to Focus On

You can sell short Glencore shares on the London exchange, although this may be out of reach for many investors.

The stock could easily go much lower since the company is going to lose its investment-grade rating, which could trigger a total collapse of its business. Today may be a good time to move, as the stock has recovered by around 17% to about £0.80 ($1.21).

Glencore's collapse is putting pressure on other large Asia-Pacific commodity stocks such as Sydney-listed Rio Tinto Ltd. (ASX: RIO) and BHP Billiton Ltd. (NYSE ADR: BHP), as well as Singapore-listed Noble Group Ltd. (SGX: N21). Expect these stocks to follow Glencore down in the days ahead as the entire commodities complex goes from bad to worse. These stocks could also be shorted.

You can also short the commodities complex more broadly by selling short ETFs, but there are surprisingly few large commodity ETFs or ETNs. The PowerShares DB Commodity Tracking ETF (NYSE Arca: DBC) ($2.5 billion) or the iShares S&P GSCI Commodity ETF (NYSE Arca: GSG) ($750 million) are among the few relatively large broad-based commodity ETFs.

You can also consider shorting specific commodities for which Glencore is a dominant trader, such as copper.

There will also be an opportunity at the height of the chaos for patient investors to buy assets on the cheap. Stay tuned for that.

I know all of this is ugly. But it's another reality check that will reset markets and create some great investment opportunities. It gets brighter.

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Michael's Sure Money Investor readers get free access to his Super Crash Report. Previously, this information was available only to Michael's high-net-worth, paying clients, but volatility is getting so bad, and the stakes so high, that he wanted to publish his recommendations for everyone. Click here to get the report and regular updates from Michael.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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