Commodity company distress may be turning point for markets

By Jonathan Leff

NEW YORK, Oct (HKSE: 3366-OL.HK - news) 1 (Reuters) - Commodity traders have a message for big raw material producers: modest cutbacks in production are not enough; they want to see blood.

And they may get their wish because of pressure from the capital markets.

After a rout that has more than halved the price of many major commodities over the past year, the financial pressure on some producers is becoming too much to bear, particularly those laden with tens of billions of dollars in debt accumulated during boom times.

Swiss-based mining and trading giant Glencore PLC (Xetra: A1JAGV - news) 's shares have fallen more than 35 percent in the past month, even as the price of key commodities it produces such as copper have begun to stabilize.

U.S (Other OTC: UBGXF - news) . oil and gas producer Samson Resources Corp filed for Chapter 11 protection two weeks ago, the largest but not likely the last big driller to fail or get bought. Alcoa (NYSE: AA - news) this week split in two, shining a harsher spotlight on a struggling bulk smelting business.

While painful for investors, these corporate crises may be cathartic for commodity markets, forcing a more rapid halt to higher-cost mining and drilling operations - something perennially optimistic chief executives are often loathe to do.

"It (Other OTC: ITGL - news) 's high time that overcapacity in commodity markets is wound down," said a trader with a major trading firm, speaking on the condition of anonymity. "But I've come to the view that this will only be possible through capital markets, meaning insolvencies."

The trader said that immediate output cuts by some producers had been "cosmetic at best." Those included Glencore's announcement a month ago that it would close down the equivalent of 2 percent of the world's copper production; small-well shut-ins by some Canadian conventional producers; and cutbacks at aluminum smelters across the world.

Those measures may have helped stem the rot in commodity prices, but further reductions in supply - or a more robust pick-up in demand, unlikely due to China's slowdown - would be needed for markets to quickly bounce back, some say.

Corporate woes could help convince some traders that the rebound is coming.

"We would not be surprised if the well-publicized problems at Glencore actually mark a trough for the prices of many industrial commodities," Julian Jessop, Head (Other OTC: HEDYY - news) of Commodities Research at Capital Economics, said in a note this week.

RELATIONSHIP CHANGING?

There are signs that the relationship between commodity prices and capital markets is beginning to shift in ways that may lend hope to bullish traders.

For most of the past year, falling raw material prices were driving up borrowing costs for producers, pushing high-yield bond indices to their widest spreads versus benchmark Treasuries since the 2008 financial crisis.

Lately, however, they have decoupled, with credit pessimism deepening despite the relative stability in commodity prices.

Last month, while U.S. oil prices traded in a narrow channel around $45 a barrel, the Bank of America Merrill Lynch high-yield energy index - comprising 167 issuers with notional debt of US$210bn - widened by nearly 150 basis points to Treasuries plus 1115 on Wednesday, a new post-2008 record.

As a result, it is now a deteriorating credit market that may be contributing to a glint of optimism in commodities.

The "rebalancing is under way already ... less credit speeds up the process," says Greg Sharenow, executive vice president at PIMCO overseeing its commodities portfolio, which has about $16 billion in assets that track a basket of prices.

ROCKS NOT GOING ANYWHERE

To be sure, not everyone agrees that upheaval and consolidation among commodity producers is going to wipe away persistent oversupply any time soon.

Jan Stuart, global energy economist at Credit Suisse (LSE: 0QP5.L - news) , expects to see further consolidation as companies with stronger balance sheets buy up good assets from weaker companies - but says that doesn't necessarily lead to less production.

"In some industries you could argue that if a company disappears, there go the assets and whatever it was producing," he said. "In this universe, the rocks aren't going anywhere." (Reporting by Jonathan Leff, additional reporting by Henning Gloystein; Editing by Stephen R. Trousdale)