BHP's battle against a slumping ore price

BHP Billiton's productivity strategies appear to be paying off, with its low-cost, high-quality ore starting to drive out lower grade production in China. This could see the big miner wield more influence over prices in the long term.

BHP Billiton’s full-year production numbers demonstrate that Andrew Mackenzie and Rio Tinto’s Sam Walsh are continuing to execute the strategies they implemented when taking charge of the two big Pilbara iron ore producers.

Last week Rio’s production report showed a double-digit increase in the output from its iron ore operations in the first half of the calendar year. Today BHP announced a 20 per cent increase in its West Australian production volumes for the year to June.

Its West Australian iron ore business comfortably exceeded BHP’s guidance of 217 million tonnes, producing 225 million tonnes. BHP’s share of that output was 204 million tonnes, a dramatic 20 per cent increase on the 170 million tonnes it produced in 2012-13. BHP has now lifted guidance for its WA complex in 2015 to 245 million tonnes, with its share to rise to 225 million tonnes.

The playbook Mackenzie and Walsh are following is deceptively simple. They are both scrambling to increase volumes across their bulk commodity businesses while carving into their cost bases in an attempt to offset the declines in commodity prices. They are also focused on rationing capital.

That drive for more volume could also be seen in BHP’s metallurgical coal business, where production also increased by 20 per cent, to a record 45 million tonnes.

The well-recognised challenge for the major miners, of course, is that despite their success in expanding volumes and lowering costs it is improbable that they could do enough to offset the slump in commodity prices.

Last year BHP’s average iron ore price was $US110 a tonne. BHP’s average price for the latest financial year was $US103 a tonne. Today’s iron ore price is around $US98 a tonne.

Last year it received an average of $US163 a tonne for its met coal. This year it was $US131 a tonne.

Put the iron ore and coal businesses together and that’s the best part of $US3 billion of revenue and probably around $US1.5 billion of profit that has evaporated because of the price declines.

The big volume increases therefore are unlikely to offset the price effects, but together with the attacks on costs should at least soften their impact.

There is also a longer term dimension to the productivity strategies. In the near term the still-rising volumes of Pilbara iron ore pouring into the market (BHP has plans to increase production to 270 million tonnes a year) exacerbate what appears to be a market already experiencing an over-supplied position and therefore adding to the downward pressure on price.

There are signs, however, that their low-cost high-quality ore is starting to drive out high-cost and low-quality production in China and even among the smaller producers in Australia. It is also impacting the pricing differentials for different grades of ore; Fortescue recently revealed it is receiving a 20 per cent discount to the benchmark price.

As their ore displaces higher cost and lower quality ore, the big iron ore producers will regain greater influence over prices in the longer term, although prices are unlikely to return to their commodity boom peaks in the foreseeable future.

BHP is the most diversified of the major resources groups and it was able to report a small (2 per cent) increase in copper production and a 4 per cent increase in petroleum production, with a further five per cent increase forecast for this financial year.

Its US onshore shale gas business delivered a 73 per cent increase in petroleum liquids for the year and BHP says it is confident that business will be strongly EBIT (earnings before interest and tax) positive in the 2015 financial year.

While BHP’s average realised oil price was down 4 per cent for the year natural gas prices were up 16 per cent and its US natural gas prices 25 per cent.

Mackenzie said in the report that BHP remained focused on value over volume -- he has been shedding unprofitable, lower-returning or non-core assets -- and was prioritising its brownfield development options. He also said BHP was continuing to actively consider the next phase of its simplification, including structural options.

BHP’s Nickel West business is on the market. There has been speculation that it would consider selling its manganese business and its aluminium operations are sub-scale. The structural options are a reference to the potential for BHP to demerge its non-core businesses into a new entity if it doesn’t receive offers that it considers properly reflects their value to shareholders.