BHP's inside lane out of the super-cycle

Both BHP Billiton’s Andrew Mackenzie and Rio Tinto’s Sam Walsh have made it clear that they are in cost-cutting and portfolio-trimming mode as they seek to lift shareholder returns in an environment of falling commodity prices and expanding supply. A Goldman Sachs analysis of the mining sector issued yesterday helps provide an insight into the impact the renewed emphasis on costs and capital could have.

The Goldman report, by analysts Craig Sainsbury, Hamish Tadgell and Owen Birrell, is actually a sector-wide analysis of the miners’ cash returns on capital invested over the period of the commodity super-cycle which concludes that returns have now re-based to the average level of the 15 years preceding that cycle.

They forecast that returns are now likely to stay at current levels through to 2020, despite an expectation of further falls in commodity prices, and that the market’s rating of the sector has now priced in much of the change in the industry dynamics since the super-cycle ended.

BHP and Rio’s position in the bottom quartile of the cash cost curve for the bulk of their commodities meant they had less leverage to falling cash flow levels from lower commodity prices than the sector as a whole.

The analysts say that, while they are not forecasting a period of expanding returns, the miners are covering their cost of capital and generating incremental returns.

They are particularly enthusiastic about BHP, which before the super-cycle traded at a 500-basis point discount to Rio. They expect it to trade at a 440-point premium to Rio from 2012-202 because of the underperforming businesses (Alcan, Riversdale, Coal & Allied) in Rio’s portfolio.

When the super-cycle turned shareholders became increasingly agitated about the continued heavy capital expenditures the miners had committed to.

Goldman’s deconstruction of the drivers of cash returns found that in US dollar terms the cash invested in the sector had increased by six times since 2004. Over the past four years that level had stabilised at around 10 per cent per year, or about $US150 billion a year of extra investment.

It is not surprising that as the level of investment continued to increase even as commodity prices first stabilised around 2006, and then began falling from 2012, that the cash return on capital in the sector fell from its peak of around 30 per cent in 2006 to around 15 per cent in 2012 and is now tracking towards 10 per cent.

Miners have responded to the lower prices by truncating new project pipelines, shutting down some less economic mines and attacking costs.

The interesting insight provided by the Goldman report, however, comes from its focus on the capital invested in the sector and the cash returns generated from that investment.

Between 1991 and 2001 BHP added $US4 billion of investment and Rio $US9 billion during a period when BHP’s Paul Anderson was re-making BHP and exiting its low-returning industrial businesses. Over the subsequent decade BHP added $US61 billion of gross capital invested and Rio $US106 billion, mainly as a result of its disastrous Alcan takeover and its big iron ore expansion program.

Goldman believes BHP will continue to invest heavily through to 2020 – it estimates about $US12 billion a year will be added to its capital base – and that Rio will add about $US8 billion a year, which the analysts say highlights how capital-hungry the businesses have become.

While those expanded asset bases are part of the reason for the reduction in returns, the investment has added some significant upside to returns for the companies, the report says. There is, however, a large component of invested capital that is under-performing.

The analysts modelled what BHP and Rio’s cash returns on capital would look like if they shed those under-performing assets.

Under their scenario BHP would spin-off or sell its energy coal, aluminium, nickel and manganese businesses, leaving it with energy, copper, iron ore and metallurgical coal businesses. Rio would spin off Pacific Aluminium and non-core coal assets, leaving it with hydro-based aluminium, iron ore, copper, mineral sands and quality thermal coal assets.

They estimate that a focus on its core assets would reduce BHP’s gross invested capital by about 18 per cent and lift its returns by 12 per cent to produce a 1.5 per cent absolute uplift on average from 2013 to 2019, increasing them from 12.1 per cent to 13.6 per cent.

For Rio the spin-offs would reduce gross invested capital by about 20 per cent, lift returns by 16 per cent and produce a 1.4 per cent uplift in average returns from 2013 to 2019, from 8.5 per cent to 9.9 per cent.

Conversely, the analysts say that had BHP not acquired its US shale gas assets its gross invested capital would be 8 per cent lower and its returns 110 basis points higher, while had Rio not acquired Alcan, Riversdale and Coal & Allied its returns would be 250 basis points higher.

The jury is, of course, out on the long-term impact of BHP’s entry into the shale gas sector, whereas as the verdict is in on Alcan, Riversdale and perhaps Coal & Allied.

Getting rid of their under-performing assets in the current environment isn’t, of course, straightforward for BHP and Rio even if there weren’t potential taxation implications and the complication that both groups operate within dual listed entity structures.

It’s is not easy selling straw hats in winter when everyone is selling very similar straw hats and there is only a very limited pool of potential buyers, as Rio discovered when after an extensive attempt to sell its diamond business it finally conceded this week that it would keep the business rather than sell it at a distressed price. It has also had difficulty coming up with a workable plan to distance itself from the worst of its aluminium assets, housed within Pacific Aluminium.

BHP would have got rid of its aluminium business several years ago if there were an exit option and it would like to exit nickel, and may well do so if it can attract a semi-reasonable price. Mackenzie has made no secret of his desire to focus on a smaller and simpler portfolio of BHP’s best assets.

With the entire sector pulling back on new investment and on exiting or simply shutting down sub-economic assets and commodity prices likely to fall further as China’s growth rate slows, the likely excess of supply over demand that many anticipate over the next couple of years might not be as severe as feared.

Indeed, as the Goldman report suggests, the response of the miners to the changed conditions post-super-cycle and the reduction in investment may be setting the sector up for its next positive cycle.

For the miners, a lagged and overly-enthusiastic response to rising demand and prices has traditionally been followed by a bust and an over-response to weaker demand and falling prices that eventually produces shortfalls of supply relative to demand, rising prices and another commodities boom. In the resources sector, history does seem to repeat itself.