BHP, potash and China’s great eat forward

BHP has shrugged off shareholder reservations in continuing to develop its Canadian potash project. If successful, it will create a fifth pillar of its diversified portfolio – one that will rely on China's growing appetite.

There’s something of a disconnect between the optimism in Jac Nasser’s address at the BHP Billiton annual meeting today and the urgent and relentless drive to lower costs occurring throughout the resources sector.

For BHP, the future is all about Asia – but most particularly China. Nasser told the meeting that “despite slowing slightly”, China’s economy was expected to grow at about 7 per cent next year. Along with other emerging economies, it would continue to be the major driver of global economic growth in the long term.

This, he said, could deliver up to a 75 per cent increase in demand for some commodities over the next 15 years.

BHP’s chief executive Andrew Mackenzie told the meeting that the group’s focus now was on extracting more value from its existing operations.

On a copper-equivalent basis, BHP expected to increase production by 8 per cent a year while delivering productivity-led cost savings. In its iron ore business, productivity gains had unlocked an extra 40 million tonnes of capacity. Its coal resources in Queensland had delivered 7 per cent volume growth.

It is the increasing volume growth occurring throughout the industry that fills the gap in the logic of strong long-term growth in demand but a fixation with lowering costs and rationing capital.

During the period of the resources investment boom, the major resources groups – BHP, Rio Tinto, Xstrata, Vale and Anglo American – had capital expenditures of around $US350 billion.

Not only did that investment boom have a big impact on supply, which is climbing even as China’s growth rate has tapered, but the competition for people and equipment saw dramatic cost escalation.

The legacies of the spending spree are mismatches in supply and demand in some key commodities. At lower commodity prices, there have been sub-economic returns from the high cost of capital and operating costs embedded in the projects.

In energy coal, those factors have decimated the profitability of the sector and have left a majority of Australian mines either incurring losses or only marginally viable.

That’s why the new generation of industry leaders, like Mackenzie or Rio’s Sam Walsh or Xstrata’s Ivan Glasenberg, are so focused on costs and productivity.

If BHP’s confidence in China is borne out, there is going to be sufficient growth in demand and solid (rather than spectacular) profitability if they can bring their cost structures and capital intensity into line with the different supply-demand equations.

While Mackenzie has shut down much of BHP’s pipeline of prospective new big projects, there is one exception that has made some of the group’s institutional shareholders unhappy. He has committed to spending $US800 million a year on the Jansen potash project in Canada.

BHP is sensitive to the criticism of its continued interest in developing Jansen – a project in the double-digit billions if it gets the final go-ahead.

Its determination to invest in the Jansen option, however, is an indication of the potential Mackenzie and his board see to make potash BHP’s ‘fifth pillar’ alongside its core iron ore, petroleum, copper and coal units, as well as the confidence in the economic development path of China.

Mackenzie told the meeting that BHP expected demand for potash would growth at 2 or 3 per cent a year out to 2030 on the back of a rising population and greater prosperity in developing economies, particularly China. That would necessitate higher yields from increasingly constrained areas of arable land.

The continuing pursuit of the potash option, despite some shareholder reservations, is also effectively a recommitment to BHP’s strategy of maintaining a diversified resources portfolio. Nasser described this as a core strength and the driver for BHP’s outperformance against its peers over the past decade.

If potash was added to the portfolio, the combination of commodities would meet Nasser’s description of a portfolio able to meet every phase of the economic development cycle – from investment to consumption-led economies.

The low correlations between the prices of some of the commodities would also give BHP less volatile cash flows and less vulnerability than peers with exposure to narrower ranges of commodities.

This greater resilience allows the group the luxury of taking long-term positions (and accepting the risk) on potentially big new plays like Jansen, while the rest of the sector is focused inwardly on limiting the damage to returns on their existing capital.

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