Thanks to Glencore, That "Ticking" Sound You Hear Is the World Stock Market

It's the biggest commodities-trading player on Earth.

And it's in big trouble.

I'm speaking, of course, about Glencore Plc. (LON: GLEN).

Its near-term prospects are bleak.

And thanks to its size and market influence, the ripple effects of any problems will be widespread.

For instance, if the company can't pare its debt load fast enough, if it can't sell assets to raise cash fast enough, if ratings agencies knock its thin investment grade rating down to junk, if commodities prices keep falling, Glencore could implode - violently.

The disruption caused by a Glencore meltdown would be global: The company's implosion would affect commodities markets, debt markets, derivatives markets, emerging markets and, of course, U.S. and global stock markets.

As someone who's closely watched the company for many years (I even wrote the story of Glencore's infamous founder for Forbes magazine several years back), I'm as well-positioned as anyone to tell you what's really happening.

Here's the truth about how close the company is to the edge of the cliff, how markets would be affected by a Glencore "credit event," the signals that will tell you a crash is imminent - and how to protect yourself and profit from this company's extreme difficulties.

Let's start with the "players" who set these potentially calamitous events in motion...

Lighting the Fuse

GlencoreIvan Glasenberg, Glencore's hard-charging CEO, got his start under the company's infamous founder, Marc Rich - the man I told you about in our last talk. From a coal marketer in the 1980s, Glasenberg eventually became a worldwide director, and ultimately was a partner on the management team that bought Rich out in 1994.

Glasenberg became a billionaire in 2011, raising a whopping $10 billion by taking Glencore public. His 8.4% stake in the company alone was worth nearly $10 billion.

But running the world's most powerful commodities trading company - and being a multibillionaire - wasn't enough for Glasenberg.

In 2013, almost at the height of the commodities super-cycle, he bought the 66% of publicly traded mining giant Xstrata Plc. that Glencore didn't already own. That $30 billion all-stock deal - coupled with subsequent mining purchases - transformed Glencore into a global mining powerhouse... a strategy designed to augment the firm's hyper-lucrative trading operations.

Today, Glencore controls about 50% of the world's copper production, 60% of zinc production, and 45% of lead production. Besides huge nickel, coal, and oil and gas operations across the globe, Glencore has massive agricultural holdings and a monster ag-trading operation.

The company's problems began when its huge hard-asset commodities positions started taking hits last year as prices plummeted in the wake of slowing growth in China.

As China slows, so go commodities prices.

Copper, which rose to a 26-year high of almost $4.50 a pound in 2011, now trades at $3.69 a pound - an 18% drop. Zinc, which was as high as $1.20 a pound in 2010, now trades at $0.81 a pound - a 33% drop. Thermal coal, which spiked to almost $83 a ton in 2010, now fetches $42.13 a ton - a hefty 50% plunge.

Oil is down more than 50% since 2011.

And aluminum prices have dropped almost as much - a full 43%.

The bottom line: Every single major commodity that Glencore owns and trades is in a bear market.

Bloomberg's Commodity Index of 22 raw materials fell 17% in 2014. And most of the commodities in the index are down another 2% to 6% already this year.

Goldman Sachs Group Inc. (NYSE: GS) recently said it expects to slash its three-year forecasts by an additional 10% to 20%.

Debt... That Four-Letter Word

That freefall in commodity prices is a huge problem itself. But that's exacerbating an even bigger problem facing Glencore.

I'm talking about the company's massive debt load.

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Glencore has almost $50.48 billion in gross debt (excluding cash and marketable securities). Even its net debt load is nearly $30 billion.

In other words, Glencore's debt load is five times its cash flow (as measured by a closely watched metric known as EBITDA - or the money the company has after expenses but before taxes and "paper" charges like depreciation and amortization).

But the immediate concern isn't the company's total debt load, which management has promised to slash by a third through as much as $10 billion in asset sales.

It's Glencore's short-term debt that's become the company's financial Achilles' heel.

Thanks to its $18 billion "trading book," Glencore's trading operations typically account for about 75% of the company's total earnings.

But the short-term debt that finances that huge trading book has to get "rolled over" (refinanced) every 30 to 45 days.

And that's the slice of Glencore's finances that's really pushing the firm toward the brink.

Because of the market's fear over Glencore's potential insolvency, continually rolling over that hefty amount of short-term debt is becoming a problem.

If Glencore's trading desk - the "engine" of its profits - sputters or stalls because the company can't serially refinance those short-term loans, the firm's revenue guidance will keep getting cut.

Thanks to the bear market in commodities, that's already been happening.

At $1.1 billion, total trading revenue in the first half of this year was 29% lower than it was in the first six months of last year.

In the first six months of 2014, Glencore posted a profit of $1.72 billion. In the first half of this year - when Wall Street was anticipating a diminished profit of $728 million - the company actually reported a $676 million loss.

On top of all that, the company's equity cushion got hammered as its stock price fell as much as 85%.

On Sept. 28 alone, shares of Glencore experienced a single-day plunge of 29%. That plummet - exacerbating earlier declines - meant shareholders had lost nearly $52 billion since the company's initial public offering.

But buyers took heart from Glasenberg's Sept. 29 assertion that Glencore had "no solvency issues" and was taking immediate remedial action.

Besides promising to cut net debt by a third, the company axed its dividend and raised a quick $2.5 billion by selling stock. Investors took note that Glasenberg and company insiders bought 22% of the $2.5 billion stock offering. And since the frightful sell-off, Glencore's shares have rebounded.

On Oct. 5, for instance, Glencore shares (HKG: 0805) trading in Hong Kong skyrocketed as much as 70% and ended the day up 18%. So the shares have rebounded a bit from their lows. But they are still down nearly 60% over the past year.

Unfortunately, the trouble is far from over for Glencore.

Bad Feedback

In addition to the major challenge Glencore faces in financing its huge trading book, there are big concerns about the firm's credit rating.

Here's why.

If the ratings agencies - Standard & Poor's, Moody's, and Fitch, for instance - slash Glencore's credit rating to "junk" status, all sorts of debt covenants get triggered and the company has to post more margin on its $19 billion in derivatives liabilities.

That derivatives challenge is a big one. Back in September, "credit-default swaps" (CDS) associated with Glencore's debt rose to the point where it cost more than $1 million to insure $10 million of the company's borrowings against default for five years. That price implies a chance of actual default of greater than 50%.

CDS prices have fallen over the past weeks and now trade at around $600,000. Still, that's a big bet on a potential ratings cut that could trigger a "credit event" in some of Glencore's debt covenants, meaning the firm could end up in technical default.

And any cascade of unexpected, negative events could bring the company to its knees.

One such event would be the unwinding of the Chinese copper "carry trade."

For years, Chinese speculators, and others, have been buying copper, warehousing it, and borrowing in dollars (because U.S. interest rates are so low) against their copper collateral. Then they've been speculating in higher-yielding Chinese fixed-income securities, Chinese real estate, and Chinese stocks.

That's called a "carry trade." Cheap financing is used to carry higher-yielding positions.

To bolster a slowing economy, Beijing has been lowering interest rates, which narrows the spread between U.S. interest rates and those in China. That dampens the carry trade and puts pressure on the Chinese yuan (which makes paying back dollar-denominated loans more expensive) - even as the U.S. Federal Reserve is talking about raising U.S. rates. More importantly, it's also happening as the price of copper - the collateral backing Chinese carry-trade loans - keeps falling.

In other words, if a massive carry-trade unwinding takes place because the value of copper collateral collapses, Glencore, with all its copper holdings and derivatives bets, including its own carry trades, is toast.

Global panic over falling commodities prices, especially copper, will immediately impact emerging markets - because so many of them depend on commodity exports. That will ignite a situation known as "capital flight" - causing the dollar to strengthen as investors pile into the greenback in a flight-to-quality move.

A strengthening dollar will trigger even lower commodity prices, because most commodities are priced in dollars, a situation known in finance as a "negative feedback loop."

Such a massive negative feedback loop could be touched off by Glencore imploding - or by a steep drop in the price of copper, which would trigger Glencore's collapse.

In its own documents, Glencore says its $6.5 billion in EBITDA drops by $1.2 billion for every 10% drop in the price of copper. That gives you some indication as to how important the price of copper is in the Glencore saga.

The price of copper is also key to the intriguing trades I'm going to outline for you - in my next report.

Follow us on Twitter @moneymorning.

The Man Who Started It All: The tale of Glencore founder Marc Rich is a crazy one, although it pales in comparison to the company's current unfolding story. As the commodities giant teeters towards the cliff's edge, take a look back at where the Glencore saga started, where it's going next, and how you can profit from the impending implosion...

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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