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A Glencore Peak?

Apr 21, 2011 - 12pm EST.

For our In Depth piece this month we examine the idea that the Glencore IPO will mark a post-crisis high for USD funded commodity strategies. As always, we rely upon our analytical framework in doing so. And as is the case with all our longer notes, our aim here is to anchor our medium term strategy, as well as to inform our more timely recommendations. Let us add that we have no particular agenda here regarding Glencore. Our focus is that which we have previously defined: to analyze topics of contemporary importance as impartially as possible, and to develop forms of analytical leverage which aid in the prediction of financial markets.

Macro Divergence

The Right Question

To start, let us emphasize that we think this is the right question. Over the past month or so we have witnessed a run of quite significant macro events: Fukushima, Libya, Greece (again), US rating revision, etc.. While various market based measures of risk aversion have flashed red, other measures, such as VIX and JPMVXFEM have made new post-crisis lows. In FX markets, AUD and CAD have made new cycle highs, and the outperformance of emerging markets, in both spot and volatility space, has been notable. We have commented extensively on these developments in real-time, and we have argued that diversification by reserve managers, out of USD and JPY, justifies much of what we have seen (JPY as Reserve Currency - Mar 14, 2011; Latam by Default - Mar 21, 2011; The Case for Swiss - Apr 6, 2011). Yet this pattern of selective de-leveraging is not one that we are necessarily comfortable with. And as we approach the end of QEII, we expect it will become more difficult to sustain. We can put this another way. There have been many moments post-crisis where sovereign debt sustainability in the West has been a key driver of price action. Yet by and large this focus has not brought the broader cyclical rally into question. A neat way to see this is in the retracement of a Glencore commodity basket, which we show overleaf. For all practical purposes we are back at the 2008 highs. The bounce is undoubtedly symptomatic of demand conditions in the developing world. And it has been aided, at least in part, by the aggressive fiscal and monetary responses in the West. But the East now faces inflation, and is tightening policy in a fairly co-ordinated, even if lagged, fashion. Meanwhile the West is seeking to exit

Figure 1: Since early March credit premia in developed markets have surged spasmodically. We normalize and invert the performance of 5yr CDS in Japan, the US and an average of Greece, Ireland and Portugal. Meanwhile the trending rally in commodity space, as proxied by AUD TWI, has continued apace. The moves are emblematic of post-crisis macro divergence, the durability of which we commence to question in this note.

emergency settings, whilst underlying economic conditions remain parlous, and whilst the overhang of aggregated private and public sector debt stocks has not been meaningfully addressed. At the same time, there is an increasingly vociferous debate over the regulation of commodity markets, with the real prospect of movement from the CFTC this year. Net, we think it is a logical time to question the durability of the rally, mindful of the complex interdependence which exists between East and West, as well as the lofty price levels which we have reached. One further note. The phrasing of our title obviously owes to the portentious call Grantham made on Jul 25, 2007 of a `Blackstone Peak'. We have no such aspirations with this note. We are certainly not as bearish on commodities now as GMO was then on private equity. We simply think it is an appropriate time to commence querying the consensus on commodities.

This document is protected by copyright. Distribution is strictly prohibited. Nothing contained herein constitutes an offer to buy or sell securities. This document has not been tailored to meet the investment profiles of individual clients. Past performance is not indicative of future results. Civic Capital Advisors, LLC is a registered investment advisor in the state of New York. Please refer to for other disclosures. 1


Glencore: A Macro Focus

Let us address an obvious pushback first. Why should the Glencore IPO, which in all likelihood will involve a capital flow of only US12-14bn, be considered a legitimate macro focus? Related, why should an idiosyncratic event matter, when the commodity rally is underpinned by more structural factors? Both are good questions. And to be perfectly clear we are not suggesting here that Glencore will literally cause a top in commodities. Our topic is whether Glencore may coincide with a peak in the commodity sector, and cyclical sentiment more generally. A related issue is why this may happen. We approach these issues in three distinct ways.

Glencore Commodity Basket

Figure 2: Since Marc Rich exited on Nov 29, 1993, a crude basket of commodities in which Glencore is involved has rallied some 3.5x, and is back near 2008 highs. Our basket includes: crude oil, natgas, coal, aluminium, copper, lead, zinc, corn, sugar, wheat. All weights are 10%, though note coal is included only from Sep 2004. Weights are not intended to be indicative of Glencore's actual operations.

i) IPO Analogs

First, we note that from a purely empirical perspective, high profile IPOs have tended to arrive close to the short term peak for equity markets, and also at short term lows for market volatility. We illustrate this in more depth overleaf. The basic point is that even leaving the question of `why' aside, there are some decent analogs here which we expect will provide some pause subsequent to Glencore's listing.

monetizing their stakes ahead of key shifts in macro variables which remain entirely exogenous to their own performance. It goes without saying that no one would expect to see an IPO at the lows. And to be sure there are any number of IPOs which did not quite make it to market (KKR is the best example). Yet we want to keep this broad point in mind, especially as Glencore's pre-IPO convert, issued in Dec 2009, would have avoided penalty rates all the way through until Dec 2012.

ii) Deferred Judgment

On the `why' question specifically, there are any number of plausible rationales for why a high profile IPO may indicate, if not a market peak, then a sectoral one. Some are outright conspiratorial, where the listing firm, along with its syndicate, through their promotional zeal, encourage a form of sellers' strike going into the launch. More reasonably, the market may come to perceive the listing firm as having deeper expert insights into both their sector and their own value, and through various acts of deferred judgment, conclude that the sector must be near a peak. The performance of the IPO post-float also gives the market a new metric by which to make a realtime assessment of the sector.

Marc Rich + Co.

Before moving to our substantive analysis, we highlight that it is not the purpose of this note to pass judgment on Glencore itself. We make only passing reference to its purported valuation, to its disclosed financials,1 to the various corporate governance issues which have been circulating, and to the durability of the franchise under increased public scrutiny. We also ignore the likelihood that the holders of the converts will double their investment upon listing, after only less than 18mths. On matters idiosyncratic to Glencore we have one main point to make. Since Marc Rich was bought out on Nov 29, 1993,2 the price of a basket of commodities which Glencore is exposed to, has rallied some 3.5x, and is now back close to the highs reached in Q2 2008. Our focus is not whether Glencore is cheap or rich, it is whether the commodity sector is close to a peak, and whether the Glencore IPO is an indication of that.

iii) Market Timing

An alternative `why' response is that IPO firms may just have great market timing. That is, irrespective of sectoral and valuation parameters, it is plausible that such firms are adept at

1 See: 2 For a useful history of Rich's exit from what would become Glencore, see: Ammann, D. (2009). The King of Oil. pp233-5. All rights reserved. 2


IPO Analogs

We consider three high profile IPOs here: Goldman, Fortress and Blackstone. These IPOs have a few metrics in common, most importantly size, and for the lack of a better word, hype. Goldman is perhaps the most common analogy drawn to Glencore.3 It listed with a market capitalization of US33bn in 1999, versus the current range for Glencore of US60-70bn. It was also a partnership, and is of course regarded as smart money. It is often remarked that Goldman sold into the Nasdaq bubble. In fact they were well ahead of it. We think a better characterization is that Goldman capped the 50% rally in US financials post the LTCM crisis. Our chart shows this, and that the broader market was fairly flat both before and after. The Fortress IPO was materially smaller, at US7.5bn for listed market capitalization. Still it was a very high profile deal: the first of its breed to go public. Our chart overleaf shows its stellar performance out of the gates, and that it took some 4mths for it to breach the IPO price. Notably, the broader market shifted down sharply not long after Fortress listed. We also highlight VIX overleaf, which was traded up from 10 to 20 post Fortress. These lows have not been revisited since. The Blackstone IPO is well known, especially in Asia where CIC's US3bn stake became both a topical and an awkward subject. The listing market capitalization was US33.5bn, and the timing coincided with a second peak in US financials for 2007, from which the market has not recovered. VIX also surged post Blackstone, and the deal itself was marked down heavily, some 20% within one month. Naturally these observations beg the question: is Glencore more like Goldman, or is it like Fortress and Blackstone? We think the best answer is that Glencore is like Glencore. It is clearly a different animal, and their PR has gone to lengths to emphasize its integrated business structure and its physical supply network, and to downplay its trading revenues and its various legacy issues. Glencore is less reliant upon abundant credit conditions than private equity was through 2005-07, and their overall profile is likely to appeal to the strategic motives of SWF, a point already evident in the placement of the converts. In short, we expect Glencore will be perceived by most as a commodity rather than financial play.

Goldman IPO

Figure 3: The Goldman IPO marked the peak in the post LTCM rally in US financials, but came well before the Nasdaq bubble of late 1999. S5FINL is the financials sub-index of the S&P 500.

Fortress IPO

Figure 4: The Fortress IPO marked the first peak in US financials in 2007.

Blackstone IPO

Figure 5: The Blackstone IPO marked the second peak in US financials in 2007. Note it took another 9 months for Bear Stearns to fail.

3 See for example: All rights reserved. 3


Our broader point is this. Despite the salient differences, it is not difficult to see the Glencore IPO being viewed as a realtime referendum on the state of the commodity market. This is how Goldman was perceived for investment banks, and it was certainly how Fortress and Blackstone were perceived for private equity. If we add in an opaque business structure and a large dose of media driven intrigue, the parallels become quite clear. To push the analogy further we would highlight the froth evident in various commodities, most notably in silver. To the extent that these propositions are accepted, two points follow. First, the performance of Glencore in the aftermarket will be very closely tracked, and may become a useful real-time indicator for the broader commodity complex. Second, as a purely empirical proposition, the IPOs for Goldman, Fortress and Blackstone, each marked significant sectoral highs in US financials. For Fortress and Blackstone, significant lows in market volatility where also signaled.

IPO Normalized Performance

Figure 6: Goldman and Fortress performed strongly on launch, whereas Blackstone traded straight down. Each IPO coincided with a peak in US financials.

IPOs and VIX

Deferred Judgment

The argument that significant parts of the market will interpret Glencore's management as evincing a degree of belief in a peak for commodities, and that this will in turn influence their own actions, is a much more tenuous proposition. We do not think it is irrelevant, but at the same time, we do not want to make too much out of this point. Ultimately this sort of debate comes down to alternative perceptions of how financial markets work. We think that the actions of powerful market participants are important, hence insider selling is a development we take notice of. Still, at any time, the market is grappling with a myriad of other forces, most of which are more fundamental, and any of which may trump a more idiosyncratic focus. To stretch the point to its limit you essentially need to be a convert to a Foucault like perspective of `power-knowledge'.4 On this view insiders are expected to have materially more knowledge of the present and of the future than outsiders, and thus their actions, which speak louder than their words, should always be heeded. While this sort of thinking lies at the bedrock of any socially constructivist perspective, we think its precise application to

Figure 7: Market volatility, as proxied by VIX, was structurally higher at the Goldman IPO in 1999. VIX spiked directly after both the Fortress and Blackstone IPOs in 2007.

financial markets is taken too far at times. Institutionalized risk takers, and increasingly retail too, tend to guard their own judgment and processes jealously, and are unlikely to be swayed purely by the acts of another. Still, we agree Glencore will be viewed, at least at the margin, as insiders looking to monetize a full valued company at or near the cyclical highs. Given their standing, we expect this to modestly influence others, albeit in ways which are subtle, even unobservable. The media buzz both going in and coming out is part of this. And the listing price versus guidance, as well as the performance of Glencore post-float, will each form part of the narrative which is ultimately constructed.

4 See for example: Foucault, M. (1977). Discipline & Punish. At p27. All rights reserved. 4


Market Timing

The topic of market timing raises the more fundamental issues which are generally viewed as underpinning the commodity rally. The question becomes `why might Glencore be selling?', rather than assuming the act itself is an outright negative. While it is clear that this transaction has been in the pipeline for a long time, we think the timing is noteworthy. The window to avoid punitive interest on the converts was open for another 18mths, and it is fair to say that the new board was cobbled together over the past few weeks. Leaving aside commodity market fundamentals, we think the timing makes sense for at least three reasons. First, we have obviously seen significant year to date strength in prices, led by front dated oil. Second, listing ahead of the end of QEII avoids the considerable uncertainty around that topic (The Liquidity Debate - Mar 29, 2011). Perhaps the more interesting angle though is to do with commodity regulation. As we have previously referenced, there are significant changes afoot due to the Dodd-Frank Act, both with respect to single position limits and also the regulation of swaps. A full review of this area is beyond the scope of this note. Yet even a brief inspection of the 600 pages of public comments which the CFTC received on single position limits, before closing its submission on 28 Mar, is telling.5 Reuters provides a useful summary of high profile comments, the general tone of which confirms that much is at stake.6

WTI Oil - Year to Date

Figure 8: Oil has rallied month over month this year, and has been led by maturities out to Q1 2012.

A Glencore Peak?

Let us bring these various strands together. We have argued that on the basis of IPO analogs, the propensity of the market to defer to the judgment of insiders, and market timing, that Glencore is both a macro focus, and one which will provide a useful litmus test for the commodity rally. We recognize that the case we have made may be perceived as contrarian to a fault, particularly given the rampant price action of the past few days. But we maintain that looking for signals of a peak in the commodity rally is an important task, particularly levels we have reached, and also given the proximity to the end of QEII. We highlight that if some of the reflationary sentiment comes out of commodities, the pricing of many other assets and currencies will need to adjust quickly and significantly. This argues for optionalizing the view where appropriate, as we do overleaf. Finally, we note the risk we face in boxing ourselves in against what many regard as a secular rally in commodities. To be clear, we are not. We have participated on the long side ourselves, and, as always, we reserve the right to stop our recommendations, to change course, and also to alter the expression of the view. In this case we expect to hold the position at least until we get a glimpse of Glencore's post market, and beyond that, through the end of QEII.

It is likely that this entire process bogs down for a while now under juridical challenge to the CFTC's authority to impose limits under Section 737. The political environment around this subject will nonetheless remain toxic, especially with brent pushing onto new highs ahead of the US driving season. More substantively, we highlight that no one really knows the impact position limits would have on market direction or volatility. It is the sort of topic which arouses much academic angst, as is evident in a widely cited OECD paper on point.7 Still, it is clear, at least to us, that the imposition of limits would make it much more difficult to run a large commodity trading book. In short, we think regulatory risks in the commodity space are material, and are also relevant to Glencore's timing.

5 At: 6 At: 7 At:

All rights reserved. 5



We express the view outlined via a bearish calendar spread on AUDUSD. We sell 1mth AUDUSDput, struck 1.05, which will mature approximately when Glencore comes to market. We buy 4mth AUDUSDput, struck 1.05. Our spot reference is 1.0750. We choose AUDUSD as the sole underlying currency as we judge Australia to be strongly linked to the global commodity cycle, and the closest to an easing cycle based upon domestic conditions. We note that the positive slope of the volatility curve has tightened in of late, and that the strategy captures the view we have expressed quite precisely. We are conscious of 1mth breakeven rates here. There is significant event risk next week around the FOMC, and we are no longer ruling out RBA intervention as we approach 1.10 in AUDUSD (irrespective of Rudd's comments overnight). In other words, we are mindful of both the downside and upside risks to this view over the next month. We structure the position in line with all our Risk. The maximum loss is 1% of capital, or US1mn, and we limit the notional to US50mn, which gives us tolerance to hold to around 1.15 in 1mth, all else equal. The strategy is less sensitive to an early downside move, which we would also likely benefit from elsewhere in our book. We will revisit this note when Glencore lists.

AUDUSD Vol Spreads

Figure 9: The AUDUSD volatility curve has a modestly positive slope at inception.

Calendar Spread - 1mth Breakevens

Figure 10: We construct a calendar spread sensitive to our US1mn stop loss limit over the next month. At the first expiry the payoff profile will come to resemble an outright long put position, which will also remain subject to our Risk parameters.

For the formal definitions of all italicized words please refer to our Glossary. Data is sourced from Bloomberg, unless otherwise stated. All rights reserved. 6


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