The dubious logic of Glencore's coal experiment

Glencore's tactical shutdown of its coal mines has done little to aid its quest to force Rio Tinto into a merger, and could help Rio make the case for increasing its iron ore output.

This week Glencore re-started production at its Australian coal mines after a three-week shutdown that was ostensibly both a response to an over-supplied market and an illustration of Ivan Glasenberg’s position that big commodity producers shouldn’t increase supply into markets in surplus.

That criticism has been directed primarily at Rio Tinto and BHP Billiton for continuing to pump more iron ore into a market whose surplus is growing. Glencore, of course, approached Rio last year about a scrip-based merger and, while the proposal was summarily dismissed by the larger company, there is a wide expectation that Glencore will return to the fray when UK takeover laws allow it in April.

Thus the Australian coal shutdown, which withdrew about five million tonnes from the thermal coal market -- slightly more than 2.5 per cent of Australia’s annual thermal coal exports -- was seen as much as a tactical manoeuvre by Glencore in its quest for Rio as a commercial decision.

As a commercial decision it didn’t really stack up, at least at the macro level. When Glencore announced the decision in mid-November, thermal coal was selling at around $US67 a tonne. When the shut-down started in mid-December, it was trading at $US63 a tonne. It’s now at $US61.20 a tonne.

If Glasenberg’s thesis was that withdrawal of supply, or at least a moratorium on increases in supply, would produce higher commodity prices the Glencore experience doesn’t support it, at least not from the modest experiment the group (the world’s biggest thermal coal producer) has conducted.

Logically, a temporary withdrawal of five million tonnes wouldn’t have an impact – to the extent that there was demand for that coal other higher-cost producers would supply it. The surplus might be reduced marginally but it would still be there unless meaningful supply was withdrawn permanently, or at least semi-permanently.

As the lowest cost producers in iron ore, Rio's and BHP’s increased output is displacing higher-cost production and, while they might be adding to the surplus in that market in the short term, will accelerate the point at which the market returns to something approaching a balance. It helps them that, even at current iron ore prices of around $US70 a tonne, they remain strongly profitable.

Thermal coal prices have more than halved since their peak of about $US136 a tonne three years ago and much of the Australian industry (probably close to half the industry) is losing money. The bigger and lower-cost producers like Glencore and Rio have carved into their cost bases, closed some mines and remain profitable even at current prices. Glencore has said that all the mines it shut were making money.

That makes the Glencore shutdown even more perplexing, although at a micro level it might make sense to close the mines temporarily over Christmas, force works to clear out their annual leave entitlements and undertake whatever maintenance might be required during the holiday season.

The reality within the coal industry, however, is that even if they are losing money, those producers that don’t own their own infrastructure and have 'take-or-pay' contracts to access third-party infrastructure might find they lose less by continuing to produce. Glencore’s gesture might make internal sense but it won’t have much, if any, impact on the sector-at-large.

It is doubtful that it will have much impact on Glencore’s prospects of forcing Rio into a merger. Rio, with a market capitalisation of about $100 billion, is about 30 per cent bigger than its suitor and has made it clear it doesn’t see the appeal in what would inevitably have to be a primarily scrip-based combination.

Glasenberg is trying to position himself and his team as superior, shareholder-focused managers but Sam Walsh and his team have credibility as first-rate operators of their tier one assets – their fabulous Pilbara iron ore business in particular -- and have an opportunity when their annual results are announced to get in first and unveil a medium-term program of shareholder rewards.

Despite the low commodity prices, the market expects Walsh and his board to announce some form of capital management program when the group’s full-year results are announced next month.

They won’t underestimate Glasenberg and have had plenty of time to devise the tactics they will employ to try to keep him at arm’s length. The apparent failure of his experiment with tweaking supply in the coal market may help them make the case to institutional shareholders -- if, indeed, they need to argue the case -- for their strategy of expanding Rio’s iron ore output.

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