BHP rides the tail of a changing China

The impact of Andrew Mackenzie and the major shift in stance and strategy that occurred within BHP Billiton even before he replaced Marius Kloppers as chief executive earlier this year is starting to show up in the group’s results.

The steep drop-off in BHP’s earnings, which fell 31 per cent to $US11.8 billion excluding significant items, was expected given the big falls in commodity prices that occurred in the latter stages of 2012. It could, however, have been worse.

BHP’s response to the steep decline in prices as China’s demand softened and supply surged on the back of an earlier wave of resource sector investment was to start carving into costs and freezing new capital expenditures.

While it wasn’t sufficient to offset the $US8.9 billion impact of the lower prices, BHP did rip $US2.7 billion out of its cash costs and helped mitigate the impact on the group’s cash flows, which were down 25 per cent to $US18.3 billion. Mackenzie believes the potential for further cost reductions is significant.

With more than $US21 billion of projects still underway, the clampdown on new investment will take some time to flow through, although at $US17.9 billion investing cash flows were well down on the prior year’s $US32 billion, which included the Petrohawk acquisition. BHP also sold $US4.2 billion of assets during the year.

Despite a $US2.6 billion – $US800 million a year – commitment to continuing with the Jansen potash project in Canada that was announced with the result, Mackenzie is expecting the group’s capital and exploration spending to decline to $US16 billion this financial year and $US15 billion over the next few years as he pursues higher capital efficiency from the portfolio of projects.

The Jansen investment will enable BHP to finish sinking the production and service shafts for the project, giving the group the option of giving the project a full-scale (and expensive) go ahead in a couple of years’ time, perhaps with a partner.

Mackenzie is open to the notion of selling down an exposure to a project that could be one of the world’s largest and lower cost potash mines and sharing the risk and the funding requirement while establishing a value for Jansen.

The work to which BHP is committed won’t be completed until 2017 but the continuing investment does signal BHP’s interest in adding potash to its portfolio of core commodities as well as its willingness in a far more capital-conscious environment to still – selectively – entertain big investments in growth projects.

The leisurely approach will also give BHP the opportunity to understand the impact of the apparent break-up of the Russian end of the potash cartel recently. If the withdrawal of OAO Uralkali from its marketing joint venture with Belaruskali is permanent, which isn’t certain, potash prices would fall but would be set by more by the conventional market forces that BHP prefers.

Given that it expects growth rates for steel demand (and therefore for iron ore and metallurgical coal) to moderate as China’s economy matures and rebalances, potash, which would benefit from growth in demand for agricultural products, becomes an attractive and strategic long-term play.

BHP expects increased supply of commodities generally to continue to exert pressure on prices before, in the longer term, the winding back of investment in the sector should, it says, lead to a better balance between supply and demand. The growth in its own volumes added $US1.8 billion to the result, albeit nowhere near enough to offset the impact of the price declines.

The most severe impact of the price falls showed up in BHP’s iron ore division, where earnings before interest and tax were down 21.7 per cent from $US14.2 billion to $US11.1 billion, in its copper division, where EBIT was down 8.7 per cent to $US3.6 billion, and in its metallurgical coal business where EBIT slumped 73 per cent to a mere (by BHP’s standards) $US746 million.

Given that the met coal business lost money in the first half that represents the start of a turnaround, with the improvement aided by the major focus on cutting costs.

The combination of volume increases and cost reductions evident within the coal division was reflective of what has been occurring across the wider group. For BHP as a whole copper-equivalent volumes rose 7 per cent.

BHP, like most of the major resource companies, has been under considerable pressure from shareholders to cut back on capital spending in order to direct more cash to shareholders.

With the projects it is already committed to and maintenance investment effectively accounting for the reduced levels of cash it generated during the year there wasn’t any scope for any material lift in shareholder returns but BHP did increase its dividend from $US1.12 a share to $US1.16 a share and Australian shareholders will also get a boost from the lower Australian dollar.

With net debt of $US29 billion (a $US5.5 billion increase on the previous year and a level of debt which translates to gearing of 29 per cent) and an environment for commodity prices and demand that remains volatile and uncertain, BHP will inevitably be cautious about doing anything aggressive in relation to shareholder returns unless and until its reduced capital expenditures and cost-reduction programs boost its free cash flows.