The Glencore/Xstrata merger: does this mark a top for commodities?

Glencore is already the world’s largest commodities trader. Now it’s planning to get even bigger. It’s aiming to merge with leading mining group Xstrata.

Glencore already owns 34% of Xstrata. Combined, they’d form the fifth–biggest listed mining group on the planet. They’d also have one of the largest market caps on the UK market.

But the last time Glencore hit the news headlines – at the time of its IPO (initial public offering) – it neatly marked the top of the market.

So is this move telling us to expect a repeat?

The market likes the Glencore / Xstrata deal

Xstrata is a good fit for Glencore. The two firms operate in most of the same areas. What Xstrata digs out of the ground it sells to Glencore, which then flogs the stuff around the world.

Xstrata is one of the world’s largest mining and metals firms. It’s a major producer of seven commodities used in everything from making steel, to constructing buildings and delivering electricity to developing jet engines and mobile phones.

The combined entity would be the world’s biggest zinc producer with 15% of the market. And it would control 32% of the trade in thermal coal, still a key energy production fuel in China and the US.

The merger looks set to be confirmed this week. And investors seem to like the idea. Since Thursday, shares in Xstrata have rocketed 15% while Glencore has jumped up by 12%.

So if you have a pension, or maybe a FTSE 100 tracker fund, chances are you’re better off as a result of the merger talks.

The outlook is bleak for commodities

So why does the deal worry us? Because we don’t think this is a good time to be loading up on commodities.

Overall, in the last three years this has been a good sector for investors. But future profits at the Glencore/Xstrata combo would be highly geared to new requirements for raw materials. In particular, they’d be very dependent on future demand from China.

And that’s a big worry. Chinese economic growth is already slowing. Further, as I pointed out last week, some very bad news is emerging from the Baltic Dry Index (BDI).

In short, the BDI measures the cost of transport space (shipping rates) on ‘dry bulk carriers’ which carry cargoes of raw materials such as coal, grain, timber, steel and iron ore. The more ‘stuff’ being shipped, the greater the demand for transport space, which drives the cost – and therefore the BDI – higher.

But over the past month, the BDI has tumbled by over 60%. That’s partly because there are too many ships around. But that in itself nowhere near explains the plunge. The Harpex index of rates on container ships that carry finished goods has also collapsed – even though the supply of container vessels has changed little in the past six months.

So a huge drop in demand for commodities seems well underway. This will soon impact suppliers like the Glencore/Xstrata combo. In addition, the outlook for China isn’t getting any better.

“I wouldn’t be surprised to see [China’s growth] drop much further in 2012”, says my colleague Cris Sholto Heaton in his latest MoneyWeek Asia email.  “The ingredients are there for a much more abrupt change in the economy than most analysts want to admit.” That would crush demand for commodities even more.

Glencore’s great market timing

We didn’t like Glencore when it first came to the market last year. We reckoned the firm had timed its share sale at a market peak – and so it proved. Glencore’s stock price plunged by a third within three months of its May 2011 IPO.

The Xstrata merger will be an ‘all–share’ transaction. In other words, Glencore needs its stock price as high as possible. That’s so it can do the deal by issuing as few new shares as it can get away with.

Glencore has waited for the market to improve before making its latest move. Its shares have rallied by almost 40% from that low. So for the firm’s management, this is a great chance to effect the merger before bad news on commodity demand could hit the stock price hard again.

In a nutshell, we’d keep well clear of Glencore shares. And after its latest flip up, we’d be wary of holding Xstrata: take advantage of any further strength in its share price to sell out.

Sell Xstrata and short Australia

And if you want to do something to cash in on falling raw materials prices, here’s one way to do it.

Australia is the classic commodity country play. Its currency tends to move in line with overall commodity prices. So if you’re worried about these, you could ‘short’, ie sell, the Aussie dollar. You could use spread betting to make the trade.

If you’re not keen on the level of excitement that spread betting can provide, another option is to buy the ETFS Short AUD Long USD (LSE: SAUP). This fund gives you exposure to a short position in the Aussie dollar against the greenback. Clearly, again it’s not without risk. But I’d much rather hold this fund than Glencore/Xstrata.

• David Stevenson is investment director of The Fleet Street Letter, Britain’s longest-running investment newsletter. The Fleet Street Letter is a regulated product issued by Fleet Street Publications Ltd.

Category: Economics