How Metal Is Financing the Oil Value Chain

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Glencore Xstrata (LSE: GLEN  ) has been busy downshifting its global role in metals and pushing its efforts into higher gear for its mainstay oil. For the past year Glencore has been entering into massive pre-pay offtake agreements with Rosneft, Royal Dutch Shell (NYSE: RDS-B  ) , BP (NYSE: BP  ) , and other majors.

Last April, Glencore was reported to hold nearly 80% of the world's copper inventory in New Orleans and other Mississippi River warehouses. Manufacturers had similarly reported over 100 day delays in getting production grade copper into their facilities.

Given the timing of the oil supply pre-payments, it appears that Glencore has been using aluminum, copper, and other metals to finance oil.

Financing the oil value chain
Financing oil is a complicated business across the oil value chain. Discoveries are typically financed by limited partnerships and privately placed equity. At $70 million a well is a drop in the bucket of a major find, usually selling to commercial developers and producers for five times the discovery cost.

Next in line is the conversion of a discovery to a contingent resource. This means the oil or gas reservoir is further explored, further de-risked, and enough information is amassed to lay out specific production drilling sites. Limited partnerships, joint ventures with production companies, sometimes banks, and definitely more equity are used to finance development of contingent resources.

The proven developed field is bankable. This is where traders like Glencore, Vitol, and Trafigura, and their bankers, enter the picture. In order to back the lending against proven and producing reserves, banks require the existence of offtake agreements.

These agreements ensure that the oil is lifted and transported, and more importantly priced in cargo loads. Traders have the expertise to aggregate lifts from several wells into a shippable, and bankable, cargo. Traders have a huge incentive to do so, since offtakes are either prepaid or take-or-pay arrangements.

Traders have portfolios of physical, and financial positions, across commodities. Glencore has books of long (bought) and short (sold) positions in oil, natural gas, electricity, copper, zinc, aluminum, freight, forwards, futures, and options. These books are used to finance one another.

Glencore, Rosneft, and Russneft
Until last December, Glencore dealt for the most part with Russneft, one of Russia's largest oil and gas exploration and production companies, with proven and probable oil and gas reserves of more than 1,751.2 billion barrels of oil equivalent and production of 13.6 million tons of oil in 2011. Glencore was the only major trader not allowed to participate in Rosneft's huge oil export tenders, unlike rival trader Vitol and oil majors Shell and BP.

Rosneft has a minority stake in Rusal, the aluminum company owned by Oleg Deripaska. Deripaska was at odds with Rosneft's Chairman Igor Sechin, a longtime Putin supporter. Glencore has an interest in Rusal.

Sechin's goal was to buy rival TNK-BP from BP and an expatriate group of Russian investors. By prepaying for Rosneft oil, Glencore bought its seat at the Russian oil export table by helping Rosneft acquire TKN-BP for over $55 billion.

Glencore takes about 49 million of the 67 million tons of Rosneft's oil exports for the next five years for about $7.1 billion. Rival Vitol will take the rest. Russian crude will now be about a tenth of Glencore's global crude portfolio and puts Glencore into the China trade with Rosneft. Rosneft sells about 40 million tons per year to China.

Back to metal finance
Glencore's Pacorini warehouses have sheds in New Orleans, Vlissingen, Johor, and other locations. Much of the inventory is tied up in a finance deals. In this deal, a trader loans cheap money to buy a spot commodity, while immediately selling the commodity forward at a profit. This could only happen if the difference between today's forward delivery price and today's spot price was positive and big enough to pay the storage and finance costs.

In the interim from the current trade date to the nearby date, up to 45 days out, the trader strikes a cheap rental deal to store the commodity. If the trader owns the warehouse, storage costs can be very low. The trader's money desk will be lending the deal money. The deal thus prints money.

For example, let's suppose the trader can lock in a forward price premium of 20% on 400,000 tons of copper. The trader borrows at a 2% per annum rate on purchasing copper at $7,500 per ton. The 30 day all-in rent per ton is $20 per ton.

In 30 days the trader earns gross trading margin of $1,500 per ton times 400,000 tons, or $600 million. The trader pays $5 million in interest to the trading company's money desk and $8 million to the warehouse desk. The trading company has made $613 million on this deal in 30 days. If these numbers were to hold for 12 months, the amount earned is over $7 billion.

Back in April, Glencore had about 400,000 tons of copper in storage. I suspect that Glencore did not just use copper to finance its oil deals. The Glencore Pacorini warehouses have similar sheds of aluminum, zinc, and cobalt.

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