BHP and Rio's voice of caution

A year ago the major miners were boasting about the size of their capital expenditure pipelines. Suddenly, however, they have started talking about flexibility and prioritisation.

This week both Rio Tinto and BHP Billiton have given voice to that shift in tone. Rio's Tom Albanese, in the country ahead of next week's Australian annual meeting, has been making it clear to everyone from the prime minister down that Rio is re-thinking its investment program and is likely to stretch the timetable for its major new projects to lower risk.

BHP's chief executive for aluminium, nickel and corporate development, Alberto Calderon, expressed very similar sentiments at an investment conference this week, saying that while BHP remained confident about the long-term growth outlook and the fundamentals of key commodities it would now sequence its projects to reduce risk and balance short-term and long-term returns.

The factors influencing the relatively new-found caution within the two big miners are both global and local.

China has slowed its growth rate significantly and the composition of its growth is steadily shifting from investment to consumption, changing the nature of its demand for commodities. At the same time a wave of new supply, which had been deferred by the financial crisis, is starting to enter a market that has been impacted by the continuing economic and financial instability in Europe and the anaemic state of the US economy.

Those factors have made the miners more cautious. They have also, moreover, had an impact on their investor bases.

In Europe and the US, superannuation is still largely dominated by defined benefit schemes and pensions, unlike our defined contribution regime. That means pension funds need long-term income streams and has traditionally seen them invest heavily in fixed interest securities.

The response of the European and US central banks to the crisis, flooding their debt markets with ultra-cheap liquidity, has pushed interest rates in those economies down to negligible levels, indeed into negative real rates territory.

That has in turn led to the pension funds searching for higher yields elsewhere and exerting pressure on the miners to divert more of the massive cash flows generated by the resources boom towards shareholders rather than capital investment. They want income today not investments that might produce returns in the long-term. For similar reasons BHP and Rio are facing similar calls from Australian institutions.

It is a coincidence, but a convenient one, that Albanese and Calderon have been expressing the evolution of their thinking just ahead of the federal budget, with Albanese illustrating the issues by raising a question mark over the planned $2 billion Mount Pleasant coal project in NSW.

If the big miners are now going to prioritise their project pipelines and spread their planned spending out over a much longer timeframe projects like Mount Pleasant are competing directly for capital against others, like the continuing expansion of Rio's Pilbara iron ore business, or the giant Simandou project in Guinea, or the Oyu Tolgoi copper-gold project in Mongolia or the Riversdale coal project in Mozambique.

Albanese has made it clear that costs, both capital and operating costs, are soaring in Australia. He hasn't been as explicit, at least in public, of warning of the threat to investment created by government action.

The miners, having negotiated it, can live with the Minerals Resource Rent Tax. Given that it was framed as commodity prices were peaking, and that they have fallen significantly since, it's not going to be much of an impost.

They are, however, really concerned about next week's budget and the informed speculation that the government is going to axe the diesel fuel excise rebate and is considering changing the tax treatment of overburden removal, now a deductible expense, to one where it is a capital item that would be depreciated over time.

Consider BHP's proposed Olympic Dam expansion, one of its mega projects whose cost will run into the tens of billions of dollars but which, if it goes ahead, will have a dilutive impact on BHP's returns for much of its first decade. The expansion involves digging perhaps the largest man-made hole on earth, shifting massive amounts of over-burden in the process and using enormous volumes of diesel in the process.

It has been apparent for some time that Marius Kloppers has been cooling on the idea of giving that project a go ahead this year and committing the group to such massive outlays even as the commodities markets have softened and the risks within the global economy have re-emerged. Abolition of the diesel fuel rebate and a change to the tax treatment of over-burden removal probably confirm his reservations.

It is probable that Rio's planned expansion of its Pilbara operations, from 230 million tonnes a year to 353 million tonnes, will go ahead at a cost of more than $US15 billion, although that expansion can be phased in smaller increments. BHP will also probably go ahead with the even more expensive expansion of its Pilbara business, which involves building new port facilities in the outer harbour at Port Hedland.

BHP and Rio have pricing power in iron ore but also a significant cost advantage over emerging producers and the marginal producers in China. They expect the iron ore price to fall over time and that their extra volumes will displace that marginal production, allowing them to offset their loss of margin with the extra volume.

Projects like Mount Pleasant, or BHP's planned Queensland coal expansion, or its massive Jansen potash project in Canada don't, however, have that same level of inherent protection against downturns in price and demand at a time of escalating costs, shifting energy mixes and shareholder demands for a greater share of the current cash flows.

The big miners are dialling down their risks and the pace of their previous dash for growth to adjust to the evolving near to medium-term environment and to focus their spending on the projects with the strongest medium-term returns.

The new reality means that there is now a global competition between the rafts of projects within their portfolios – and between the economies that host those projects. It is to be hoped that when Albanese spoke to Julia Gillard this week she understood the implications of his message.