PORTFOLIO POINT: BHP’s foray into US shale gas has paid off, and with extra cash and a low cost of capital more big deals are likely to be in its acquisitions pipeline.
In 2012 the big story was lower interest rates, and here at Eureka Report we spent a lot of time looking at the best strategies that can be mustered for investors to cope.
Rates have fallen further, and will fall again. My thanks to those who emailed me during the year; I appreciated your help, and all the best for 2013. I look forward to being back with you on January 25.
In my final piece for 2012, I want to look at the implications of the lower interest rates to the corporate sector. And, in particular, I want to talk about the remarkable company we have as our largest Australian listed enterprise – BHP Billiton. And, in a strange way, the two stories are linked.
BHP is a pillar of the equity section of most balanced portfolios, and in my view it will be an exciting stock in the next few years. Like so many large corporations, BHP has clear returns that it is seeking on new investments – nothing is more important in BHP than the cost of capital calculation.
In the corporate arena the cost of capital is normally set out at about 12%. Sometimes companies extend it higher, and sometimes a little lower, but 12% is the rough average. That means that if you are going to invest in a plant or make an acquisition you are looking for a 12% plus return based on your cost of capital. But for top companies the cost of capital is now nothing like 12%, so CEOs are making the wrong decisions.
A lower cost of capital
Towards the end of 2012 we have seen some change, and in particular at least one or two of our large miners are saying their cost of capital is now between 7% and 7.5%. Almost certainly BHP has reduced its cost of capital to the 7% to 7.5% range or will do so in the early months of 2013.
As a result, CEO Marius Kloppers is going to look at a very different acquisition landscape. Kloppers pulled off the deals of the decade when he bought into the US shale gas sector, acquiring assets from Chesapeake Energy Corp’s interest in the Fayetteville shale field, including the field’s mid-stream pipeline system, and later the sizeable US shale operation Petrohawk Energy. We know from history that the only way for a giant like BHP to get really good assets at the right price is to buy them on the way down.
If you are buying on the way up, the sellers ask for more and more – that’s what happened when BHP bought US-based Magma Copper in 1996 and lost its shirt. Kloppers snapped up the shale and gas assets when US gas prices were on the way down and that meant that today’s accountancy standards required him to make a write down almost immediately.
That short-term pain is almost inevitable if you are buying on the way down – it’s a case of accountants gone mad. As all investors will tell you, you can never pick the bottom unless you are incredibly lucky. But Kloppers was not far off the bottom, because the ink was barely dry on the BHP US gas purchase writedown when the value of the BHP’s shale liquids and later shale gas began to soar. The advantage of shale is that unlike natural gas wells, which you drill and exploit for a couple of decades or so, the shale gas wells are cheap but only last around two years As soon as soon as the gas price falls the drilling stops and the supply is curtailed and the price rises again.
In the case of BHP, it moved to exploit the shale that had a high liquids content and then it found more liquids. It is now clear that if BHP wanted to sell its $20 billion acquisitions it could get $30 to $35 billion for them. But all the indications are that within the next year or two BHP will have doubled its money and will be on the way to trebling its money. It is now clear that the low-cost US gas is not only going to be used for US domestic purposes (and revolutionising the US economy) but at least some will be exported. And the BHP view is that if some US gas is to be exported as LNG, then gradually the export price and the US domestic price will come together enabling BHP to make much bigger profits from domestic US sales.
US shale price to rise
Most commentators correctly point out that the amount of US gas that will be converted to LNG to compete with Australian LNG exports is relatively small. But the US is going to replace vast amounts of energy from the Middle East, Venezuela and other places and that is going to create energy surpluses that will put pressure on long-term gas and oil prices. And already the Japanese are demanding that gas be priced on its own, so effectively the US gas price may become the global gas price. Of course, you have to add on the cost of converting to LNG and shipping LNG. If the US gas prices move towards being the global gas price, then BHP’s US shale assets will be worth a lot more money. Conversely, Australian natural gas assets will be worth less, particularly those that have paid too much for the construction phase in recent years.
And that is the secret reason why BHP sold out of Browse. The BHP current rate of capital expenditure and the $20 billion lump sum BHP required to buy the US shale liquid and gas assets means that BHP does not have as much spare cash as it used to. But the Browse sale has helped. In addition, it is possible that it will sell part of its Canadian potash project – perhaps to a customer. And, down the track, my guess is that BHP will look hard at selling part of Olympic Dam, probably to a uranium buyer. The most obvious buyers are either Indian or Chinese enterprises, which would cause political controversy – although if BHP maintained a majority interest, that controversy would probably become manageable. But that is further out.
When you make a significant acquisition, as BHP did in US shale, it makes sense to invest further and become a major player – particularly when your base price is low. BHP has the chance to have a world-ranking asset and become a major player in what is going to be one of the major mineral growth markets in the world in the next couple of decades.
Of course the institutions will not want BHP to go in deeper, but BHP has a unique opportunity and that is why the reduction in its cost of capital to 7.5% will enable it to play in that game and make competitive bids for US shale, gas and liquid assets – if opportunities arise.
For Australia, it means the great cash flow being generated by BHP is going to be invested offshore. But we can’t complain about that, because we combined bad industrial relations laws and militant unionism with some bad management to really boost our construction costs. They have to come down. Meanwhile my message for 2013 is, watch the “Big Australian”.