Glencore's convenient greenfield gripe

The release of the Xstrata and Glencore results this week help put Glencore chief Ivan Glasenberg's recent accusation that ‘'the big guys really screwed up'' during the commodities price boom into perspective.

In making those comments last month, Glasenberg was blaming BHP Billiton, Rio Tinto, Anglo American and his own merger partner Xstrata for bringing too much new production into the market, leading to over-supply and tumbling prices.

In announcing the Glencore results, he went a step further and said the merged Glencore-Xstrata group (assuming the Chinese clear the shareholder-approved deal) wouldn't pursue greenfields projects but would instead focus on cheaper and less risky brownfield developments of existing mines.

‘'Greenfields are risky. Greenfields do have capital over-runs. Greenfields do have delays that kill the NPV on those projects,'' he said.

‘'They may be good projects afterwards and they do generate good cash because they are lowest quartile in the area, but returns for the original investors (are) not so pretty,'' he said.

If one looks at all the impairment charges that have studded the results of the big miners in their latest round of results, one would conclude that's fair comment, just as one could conclude that as a group the big miners were too slow to get new supply into the market when China's demand began to accelerate and then over-did it as China's demand slowed.

Glasenberg, however, isn't a completely objective observer.

Glencore experienced a 25 per cent slump in earnings for the 2012 year while its merger partner Xstrata (in which Glencore has a 34.5 per cent stake) reported a 37 per cent decline. Compared with the other big miners those results are quite respectable given what has happened to the key commodity prices.

Within the Glencore results, moreover, its ‘'industrial'' businesses were down 32 per cent while its marketing businesses lifted their earnings 11 per cent. The industrial businesses are actually mines that Glencore owns, oil wells, logistics businesses, farms and ports.

The results tend to support the rationale that underpinned the merger – that the group's traditional commodity trading businesses, which are fundamentally margin businesses, provide something of a hedge against big shifts in commodity prices even though within the merged group they would probably represent less than a quarter of the group's earnings whereas today they are closer to half.

Those marketing activities would represent the merged group's key point of competitive difference with the other mega miners. The ideal conditions to exploit that advantage would, of course, be where there was a shortfall of supply relative to demand. It is in Glasenberg and Glencore's interests to promote a moratorium on new production.

Mind you, perhaps he should have had a stronger word to Xstrata's departing chief executive Mick Davis some years ago.

Davis, in presenting his results (which were down 37 per cent) described 2012 as a ‘'transformational'' year for Xstrata – and he wasn't referring to the merger but to the 10 Xstrata projects that were commissioned in the year as part of an organic growth strategy that started in 2009. In copper equivalent terms, Xstrata hopes to add 50 per cent to its 2009 production capacity by the end of next year, so it's as ‘'guilty'' as its peers of adding significantly to supply.

Presumably, within a Glencore-owned and Glasenberg-led Xstrata, there would be no new mines for the foreseeable future and therefore Xstrata would make a material contribution to the cessation of large-scale new supply that Glasenberg is calling for.

He, of course, isn't the only one. Institutional shareholders desperate for near-term cash returns are putting a lot of pressure on the miners – and having considerable success – to stop investing for the future in order to maximise returns today.

If that approach were adopted literally, of course, the absence of new greenfields projects would ultimately mean less scope for brownfields expansion and in the long-term declining earnings and cash flows for the miners and their future shareholders.

In the near-term, however, it does make sense for the new leaders at BHP, Rio and Anglo – and Glasenberg – to focus on lifting returns by cutting costs and working their existing invested capital harder while waiting for the supply/demand equation to move into a better balance as marginal production is forced from the market by lower prices.

It is ironic that Glencore's original interest in acquiring Xstrata came after its brush with disaster during the early phase of the financial crisis when Glencore, then privately held by its key executives, found itself financially constrained to the point where it had to sell a key coal mine to Xstrata in order to take up its share of an Xstrata equity raising.

The merger was about diversifying away from commodities trading and getting access to the cash flows and earnings of Xstrata's mines. The merger will transform Glencore from a trading house with some ‘'industrial'' assets to a mining house with some trading businesses.

In the current environment, however, the value of the trading and marketing activities has become clearer.

In a more supply-constrained world, of course, not only would the industrial assets and Xstrata's producing mines tend to be more valuable and produce higher earnings and returns on capital but the Glencore trading businesses' value and earnings would be near-uniquely leveraged.

No wonder Glasenberg is so keen to mount his case to the industry, and more particularly its investors, for the big miners to stop adding to supply.