Copper could cripple Glencore's merger hopes

If sustained, the implosion in the copper price has put paid to Glencore's ambition of revisiting its proposed merger with Rio Tinto when London's takeover rule handcuffs fall away in April. It also raises some uncomfortable question marks over the way the big end of the resource sector is structured.

The collapse in the copper price to its lowest levels in more than five years has smashed Glencore's share price, which has fallen about 18 per cent in the past fortnight.

Glencore shares are now trading about 35 per cent below the level they were back in August when it approached Rio with its proposal, which Rio emphatically rejected.

Rio's shares are down about 20 per cent of that same period. At the time of the original approach Rio's market capitalisation was about 20 per cent greater than Glencore's. Today it more than 60 per cent larger, effectively making it impossible for Glencore to impose any pressure on its target.

There are three factors that have undermined Glencore's share price and its ambitions.

Glencore is one of the world's biggest coal miners, producing mainly energy coal, and had already been impacted by the halving of coal prices.

It is also one of the world's larger copper producers -- copper accounts for nearly 40 per cent of its earnings -- so the delayed dive in the copper price has damaged another major foundation of its earnings base.

The third factor is timing. Until quite recently it was the bulk commodity producers of iron ore and coal that had been most affected by the plunge in commodity prices. Rio, with its massive exposure to iron ore and a substantial exposure to coal, was impacted more by that phase of the unwinding of the commodity boom than Glencore, which has a bigger portfolio of base metal assets.

Now that copper has succumbed to the wider fracturing of commodity prices, the gap in the relative market capitalisations of Glencore and Rio has become a gulf. Rio generates less than 10 per cent of its earnings from copper, although it does have some very large development options.

Had Rio shown any interest in the merger concept last August Glencore would have had to pursue a largely scrip-based bid for Rio, given both its own balance sheet and the market conditions. Today that would result in a reverse takeover of Glencore itself. Add in any takeover premium and its own shareholders -- among the biggest its senior management -- would be pillaged.

Lower growth and reduced rates of growth in demand from China for commodities, anaemic western world growth rates, oversupply and the apparent unwinding of the 'financialisation' of commodities that has developed over the past decade have pulled the rug from under all commodity prices, including 'soft' or agricultural commodities.

In soft commodities, Glencore is fundamentally a trader rather than a producer, so it is unclear whether that large part of its portfolio of businesses will be adversely impacted by the new pricing environment that has enveloped almost all commodities.

The fact that base metals have joined the bulk commodities, oil and soft commodities within the general panicky sell-off challenges long-held conventional wisdoms and experience within the resources sector.

Historically, the correlations between the various segments of the resources sector have been relatively weak, hence the diversified models pursued by the major mining houses.

BHP Billiton has, because of its large oil and gas exposures, traditionally been seen as (and indeed, has been) the resource group with the greatest degree of diversification and therefore the most resilient cash flows and earnings bases.

The extent and pervasiveness of the plunge in commodities challenges those diversified models.

It could be that once the financial component of commodities markets activity has largely been withdrawn and the market is based largely on fundamentals, that the historical relationships will re-assert themselves. If they don't, the models may need to be re-thought.