Glencore: risky business?

Glencore shares hit a one-year low the day it announced it had set up the board committee to respond to the DoJ. The collapse in Glencore’s share price wiped billions off its market cap, and shares are now trading about the same level they were one year ago. Meanwhile, the FTSE 100 has risen by over 3%, and the FTSE 350 Mining Index has climbed by almost 11%. That has been aided by Glencore’s peers enjoying significant lifts over the past year: with Anglo American up almost 52%, BHP Billiton 29% and Rio Tinto 18%.

Although some analysts have argued the reaction is overdone, with no investigation guaranteed, it is evident that some are fearing the worst and that Glencore’s closet could be full of skeletons.

So, is the sell-off a sign of panic from the market, or is the company proving to be risky business?

Glencore, the Israeli billionaire and the Democratic Republic of Congo

While it is not yet clear exactly what has prompted the DoJ’s action, the subpoena comes just one week after Glencore reached a controversial settlement regarding a dispute over its operations in the DRC with Israeli billionaire, Dan Gertler. It also follows on from reports by Bloomberg in May that the UK Serious Fraud Office is seeking approval to investigate the company’s activities in the DRC and its dealings with Gertler and the president of the DRC Joseph Kabila.

Gertler is Glencore’s former partner in the DRC, where the company operates two copper and cobalt mines named Katanga and Mutanda. The billionaire has strong ties to Kabila and has been accused of acting as a middleman to facilitate the sale of mining assets in the country, and the US placed him under sanction last December based on allegations of ‘corrupt and opaque’ deals.

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With concerns that Glencore may have only entered the DRC with the help of Gertler, the company has stressed it acquired its interest independently and then partnered up with Gertler afterwards. It has tried to distance itself from the controversial character, striking a deal to buy out the billionaire’s interests in its two mines in the DRC for over $530 million in 2017, but it has not managed to get rid of him entirely.

Under a separate deal that he had with the DRC’s state-owned mining company Gecamines, Gertler was still entitled to royalty payments from Glencore’s two mines even after selling all of his direct interests in the operations. This has put Glencore between a rock and a hard place: it has a deal to pay Gertler royalties, but technically the company can’t pay him because he is subject to US sanctions.

To comply with the law, Glencore stopped paying Gertler those royalties when the sanctions were introduced late last year, but this prompted Gertler to file legal action against the company in the DRC in April, aiming to freeze the two mines and secure some $3 billion worth of damages.

The two mines are important to the company's portfolio and, eager to avoid any disruption, the company reached a settlement to pay Gertler his royalties – but now in euros rather than dollars in order to circumnavigate the sanctions. And while Glencore insists it has sought advice that the move is legitimate, many view it as a prime example of the company’s risky strategy backfiring. With the subpoena sent just one week after that settlement, the DoJ will certainly be looking into Glenore’s relationship with Gertler. Reports suggest the US slapped new sanctions on a swathe of other companies linked to Gertler only hours after the deal was reached.

A big reason why Glencore has run into trouble in the DRC this year is because of the new mining code that was adopted by Kabila’s government at the start of 2018, raising the amount of royalties and taxes that miners have to pay and ending the ten-year stability clause that had provided some comfort for companies operating in such a corrupt country.

Glencore: copper and cobalt are key to its future

‘As we look forward, the potential large scale roll out of electric vehicles and energy storage systems looks set to unlock material new sources of demand for enabling underlying commodities, including copper, cobalt, zinc and nickel,’ – Glencore.

After buying-out Gertler’s stake in the two mines, Glencore now wholly-owns the Mutanda mine and over 86% of Katanga, which both primarily produce copper cathodes (but also cobalt hydroxide). Both commodities are key to Glencore, as the firm is looking to capitalise on the growing demand for metals needed to build batteries as the world moves to electric vehicles and energy storage develops to facilitate wider-use of renewable energy.

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Katanga and Mutanda are both integral for Glencore’s cobalt operations. Ore reserves at the two mines demand grades of cobalt not seen anywhere else in its portfolio. At the end of 2017, the average cobalt grade of the total ore reserves at Katanga was 0.51% while Mutanda’s was 0.66%. Compare that to other operations that produce cobalt and you can see the difference: with Mopani in Zimbabwe delivering just 0.07%, for example.

Those three African copper mines delivered a 47% increase in revenue in 2017, outpacing the average growth of all its copper operations (which rose by 25%). With the prices of both copper and cobalt having improved, the three mines were by far the most improved part of Glencore’s portfolio last year after earnings before interest, tax, depreciation and amortisation (EBITDA) jumped to $668 million from just $264 million the year before, swinging to an EBITDA of $63 million from a $240 million loss in 2016.

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Cobalt prices have soared in the last couple of years, and some have suggested that the recent troubles have centred on the metal. In a separate dispute that was settled earlier this year, Glencore agreed to write-off $5.6 billion worth of debt in order to protect its joint venture in the DRC with Gecamines. Coinciding with Gertler’s legal action, the state-owned mining company initiated legal proceedings in April with the aim of dissolving the joint venture (Kamoto Copper Co) and taking its mining assets after accusing Glencore of failing to lower huge intercompany loans.

The company produced 27,400 tonnes of cobalt from its own mines in 2017, but the joint venture is expected to produce 34,000 tonnes of cobalt in 2019, demonstrating why Glencore has been willing to spend billions to keep its hands on the venture, and why it operates in the DRC in the first place. The company has spent billions in the country and its African copper assets get the largest slice of the budget out of all its operations. Of the $3.2 billion overall budget last year, $1.9 billion was spent on its copper and cobalt operations around the world, of which $733 million was spent on the three African mines.

Glencore’s marketing operations in Venezuela and Nigeria also under spotlight 

While it is fair to assume that the DRC will be at the heart of any investigation by the DoJ (should one go ahead), the fact it is also looking into Glencore’s business activities in Nigeria and Venezuela demonstrates the widespread nature of the DoJ’s request.

As Glencore does not have any of its own operations in either country, the subpoena is likely to be looking into the company’s marketing division that is responsible for shifting not only its own commodities but that of third parties to countries around the world. Both countries are part of the Organisation of Petroleum Exporting Countries (OPEC) and both also import large volumes of refined fuels, making them perfect marketplaces for the likes of Glencore. Although neither is particularly renowned for providing a stable environment for business.

Earlier this year, Glencore (and its rivals Vitol SA and Trafigura) were among a long list of companies and individuals alleged to have used bribes in order to gain an inside-track on oil deals in Venezuela. Those accusations have been made by the country’s state-owned oil and gas firm PDVSA. While nothing more than allegations at present, it does demonstrate the business environment that many natural resource companies have to operate in. Mining and oil companies have often had to use middlemen to get deals done in difficult countries, although this is thought to be subsiding, which is why they often find themselves operating close to the boundaries of international law, and often straying beyond it.

Is Glencore’s risk-hungry business model under threat?

‘As a diversified sourcing, marketing and distribution company conducting complex transactions globally, we are exposed to the risks of fraud, corruption, sanctions breaches and other unlawful activities both internally and externally. Our marketing operations are large in scale, which may make fraudulent or accidental transactions difficult to detect. In addition, some of our industrial activities are located in countries, such as the DRC, where corruption is generally understood to exist,’ – Glencore.

There are major concerns about any potential investigation into Glencore’s business practices that go far beyond financial penalties. With its appetite for risk long being a unique selling point of Glencore over its rivals, investors are concerned that more damning stories could unravel if the DoJ or others start to dig deep and unearth any secrets that may be hidden away.

For Glencore, the firm is possibly more concerned about how an investigation could knock relations with its all-important lenders that provide the company with the huge lines of credit that keeps its marketing business ticking-over. There are not many sectors that are used to huge fines as the natural resources sector – BP has had to pay well over $60 billion for the Deepwater Horizon oil spill – but losing access to credit and liquidity would be much more of a problem for Glencore’s day-to-day operations.

At the very least – investigation or no investigation – there will be questions about whether Glencore should continue to chase opportunities where others daren’t, and if it needs to dial it down when it comes to risk. If Glencore has to revisit its business model and starts to look for lower-risk opportunities then it would represent a fundamental change for a company that has pursued risk for decades.

Some have suggested it could prompt Glencore to move away from its trading arm to focus on running mines. Over one-third of Glencore’s adjusted EBITA came from its marketing unit in 2017, contributing $3 billion, and when Glencore hit trouble in 2015 its results heavily relied on the unit. After commodity prices fell, Glencore’s mining operations saw adjusted EBITDA plunge to just $1.1 billion in 2016 from $7.3 billion in 2015, while its marketing activities proved much more resilient - with earnings dipping to $2.8 billion from $2.9 billion. If it was to scale down its marketing business then the company would be a fundamentally different business. Apart from its appetite for risk, its dual mining-marketing business is the other major USP that gives Glencore an edge over its rivals.

What next: a long and potentially damaging investigation is on the cards

While the outcome of the subpoena is far from known, shareholders should not expect any resolution to emerge anytime soon, meaning that there could be a cloud of uncertainty hanging over Glencore for possibly years to come.

With substantial fines and even criminal prosecutions possible there is a lot at stake for Glencore. While the news prompted a huge sell-off in Glencore shares, there are those who believe the subpoena and its potential ramifications have been oversold. While some are evidently not keen to take a bet and wait to see what the outcome of the subpoena is, there are many who believe the incident has been oversold and are willing to take a risk on, well, Glencore’s risk.

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Regardless, investors are questioning Glencore’s business model and debating whether it needs to abandon or tone-down its strategy of pursuing higher-risk projects and deals. But for many, Glencore without the risk might not seem much like Glencore at all.