BHP sits shale and hearty

With the iron ore price in freefall and Fortescue scrambling to keep its balance sheet reasonable, the decision by BHP Billiton to diversify into shale gas is starting to look better by the day.

There is an interesting and telling contrast between Fortescue’s current predicament and BHP Petroleum’s Mike Yeager’s upbeat presentation to a conference in New York overnight.

Following yesterday’s announcement of a savage cut-back to Fortescue’s planned expansion program Nev Power today announced the $US300 million sale of the group’s power station at its Solomon iron ore mine in Western Australia and a "life of mine" power purchase agreement with the buyer, TransAlta Corp. Fortescue has also said it is negotiating a partial sale of its North Star magnetite project and flagged the potential sale and leaseback of other assets.

As a pure iron ore miner in the midst of a massive expansion of its capacity, from about 55 million tonnes a year to 155 million tonnes (now reduced to 115 million tonnes) and one that is also highly financially leveraged, Fortescue has been the hardest hit of the Pilbara producers by the diving iron ore price. The spot price fell below $US87 a tonne overnight.

It had been relying on surging cash flows to supplement its hefty borrowings to fund the expansion but at current prices it wouldn’t have much, if any, free cash flow.

The scaling back of the expansion program, which will reduce the funding requirement by about $US1.6 billion, a $US300 million cost reduction program and asset sales will help improve the position in the near term, but adversely impact its longer term condition.

Fortescue won’t get the full benefits of the scale it originally targeted and the sale and leasebacks will result in higher operating costs for a producer that is already, relative to Rio and BHP, a high-cost producer which also has a product quality disadvantage.

Since the fall in the iron ore price really started accelerating in May Fortescue’s share price has tumbled about 44 per cent. That underscores how exposed it is to the price, as well as ruling out an equity raising as an option for stabilising its balance sheet (although Twiggy Forrest’s status as Fortescue’s major shareholder probably already precluded a major raising).

While it has been the most visibly harmed of the bigger iron ore producers by the plummeting iron ore price, Fortescue isn’t alone. Rio’s share price is down 25 per cent since the start of May and BHP’s is down 13 per cent.

Despite the fact that Rio’s portfolio of resources extends beyond iron ore and coal, the two commodities most affected by the slowdown in China’s economy and steel-making, iron ore accounted for about 93 per cent of its underlying earnings in the June half, so it isn’t surprising that its share price has also been hammered.

BHP is the most diversified of the major miners and, critically, in its oil and gas division, has a commodity that has little correlation with its bulk commodities operations.

While the $US20 billion it spent entering the US shale gas sector last year has been heavily criticised and caused a $US2.84 billion write-down in its June-year results, the value of the petroleum business has been underscored by the turmoil in the bulk commodity markets.

Yeager’s presentation highlighted the growth in the division, with volumes doubling to more than 600 Mboe/d over the past five years and underlying earnings before interest and tax now more than $US6 billion. With the shale assets and the Atlantis and Mad Dog fields in the Gulf of Mexico, which had been offline (Atlantis for a quarter and Mad Dog for the financial year) now back in production the division’s contribution to group earnings ought to soar.

The significance of the shale gas acquisitions is underscored by Yeager’s forecast that of the $US6.5 billion his division will invest this financial year about $US4 billion of it will be devoted to shale liquids. Overall BHP expects 8 per cent volume growth in the division – and 15 per cent growth in liquids.

The onshore US shale assets have a resource base of about 8 billion barrels of oil equivalent, the four key fields 50-year lives, relatively low costs, very quick paybacks and a lot of flexibility in terms of increasing or decreasing production or shifting the emphasis of drilling and production from liquids to dry gas or vice versa.

The value of BHP’s diversity can be seen in the better relative performance of its share price. If iron ore prices remain depressed for any length of time the importance of its oil and gas business and the growth Yeager is presiding over can only increase.

When iron ore prices were at stratospheric levels – they approached $US200 a tonne around this time last year – Rio’s larger iron ore exposure and the highly leveraged exposure to the price provided by Fortescue were competitive advantages.

Today, while it may have slightly mistimed its plunge into the US shale gas sector just ahead of a very sharp fall in gas prices, BHP’s $US20 billion shale play and the massive expansion of its oil and gas resource base is looking like an increasingly valuable strategic shift in the balance of its vast portfolio of resources.

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