BHP's coal sweat

BHP Billiton’s coal position would be unsustainable even if that market hadn’t suffered a structural shift. Big cost reductions are its only chance at a viable future.

BHP Billiton’s coal division presentation today illustrates what’s happening, and not happening, not just within BHP but across the resources sector. For those other than shareholders it isn’t a pretty picture.

The “problem” BHP’s coal business is confronting, and which the resource industry generally faces, is that the combination of soaring costs and falling prices has decimated its profitability. Where BHP’s sector-leading metallurgical coal business generated earnings before interest and tax of more than $US4 billion in 2008-09, in the first half of this financial year it actually lost money.

That’s part due to coal prices having more than halved since their 2011 peak, partly to production interruptions caused by aberrational rainfall and prolonged industrial disputes but also to a more than doubling of cash costs in the past five years in the core Queensland coal mines.

The position of the coal business, which dominates the seaborne trade, would have been unsustainable even if there hadn’t been changes to the structure of the market.

The production constraints in Australia forced up prices and brought US coal, some of which is being displaced by the shale gas revolution in the US, into the market and the US now represents the swing producer.

While China’s steel production is expected to continue to rise before peaking in about 2025, increasingly it will be able to use recycled scrap and electric arc furnaces, with BHP forecasting a quadrupling of scrap availability in China by 2030. That’s not good news for coal producers.

BHP’s view is that in the absence of another major supply disruption net coal prices will be ‘’range bound’’ in the near term and, with the recovery in Australia production, the market will be ‘’comfortably supplied.’’ Its own Queensland coal mines, which were operating at only about 60 per cent of capacity a year ago, are now back to operating at 100 per cent of their capacity.

BHP’s response to the poor performance of the business is in keeping with the mantra of its new chief executive, Andrew Mackenzie, which is focused on simplifying and focusing the BHP portfolio, reducing its costs, slashing capital expenditures and improving cash flows.

The coal business has already taken an annualised $US800 million out of its cost base, with a majority of the savings coming from a reduction in the use of contractors and in renegotiated lower rates for those contractors still to be used – which provides context for the recent string of profit downgrades and share price implosions from the contractors.

It has closed unprofitable mines, cut back sharply on exploration costs, renegotiated terms with suppliers and reduced its effective head count by about 40 per cent. As a result cash costs are falling sharply, and are now running more than 20 per cent below the levels experienced last financial year.

In keeping with Mackenzie’s directions, capital and exploration expenditures will peak at more than $US3 billion this year and then fall steadily. No new projects are on the drawing board and by 2015 capital expenditure will be less than half this year’s level.

The group will also look at selling its less attractive mines, albeit with a “firm focus on value”, as part of a drive to simplify the portfolio. Mackenzie has made it clear he wants to rationalise what BHP already has and focus on improving returns from the best and highest margin assets in the portfolio.

BHP’s coal mines produce very high quality product and were once, as a low-cost producer, regarded as among the best assets in the resources sector. Their quality hasn’t changed but their economics have and the Mackenzie agenda is essentially a ‘’back to the future’’ gameplan, and not just for coal.

The key themes within the coal division’s presentation – shutting down new capital and exploration spending, slashing into overheads with a particular focus on contractors and headcount and exiting less profitable mines – are industry-wide themes that have particular relevance within the coal industry generally, given its significant loss of competitiveness and profitability during the boom period.

If they can carve into their cost bases and regain their status as high-quality and low-cost producers there will be a viable future for the producers despite the changing structure of the market for their products. If they can’t there’ll be more mine closures and job losses.