BHP's twin-engine grunt

The twin announcements from BHP Billiton this morning represent a statement of intent. The group is accelerating its expansion of iron ore in the Pilbara and signalling an aggressive and disruptive large-scale entry into the potash sector.

The BHP board's approval of the $US1.93 billion RGP6 expansion of its iron ore production represents an acceleration of an already ambitious growth strategy. It means that it will have three expansion projects – RGP4 (26mtpa), RGP5 (50mtpa) and RGP6 (about 35mtpa) – running concurrently.

Between them, the projects will lift iron ore production from 129 mtpa to 240 mtpa. Meanwhile, BHP has further expansions under investigation that could increase production further to 350 mtpa.

RGP6 isn't a project covered by the proposed joint venture with Rio Tinto. Rio would, however, have a 180-day option after the closing of the joint venture to acquire half the extra output by contributing half the capital required. BHP has a similar option over future Rio expansions, assuming the joint venture isn't blocked by competition regulators.

Rio, which is currently producing above the 220 mtpa nameplate capacity of its Pilbara system, has itself mused about increasing capacity to 320 mtpa. So, between them, the two iron ore heavyweights are presiding over a massive increase in supply.

Apart from being a vote of confidence in the long-term outlook for iron ore, the continuing investment in increased output tends to undermine the arguments of those opposed to the new venture that it is all about controlling supply and the pricing of iron ore.

As the low-cost producers, it is in BHP and Rio's interests to bring more ore into the market. The joint venture would enable them to do so more efficiently and profitably at any foreseeable level of pricing.

The other announcement was of an acquisition. BHP will spend $US320 million to acquire Athabasca Potash of Canada. Athabasca is a small company with a large exploration portfolio adjacent to BHP's own Jansen project. It also has a potentially significant development project in the region.

BHP recently committed $US240 million to the initial phase of development at Jansen, which has the potential to be a world-scale low-cost mine but would require eventual outlays of an estimated $US8 billion.

The Athabasca acquisition provides an insight into the sheer scale of BHP's ambitions. It also provides a better insight into its strategy for entering the potash sector.

BHP has made no secret of its interest in developing a substantial presence in potash, long-term demand for which is supported by the growth anticipated in demand from China and other developing countries for agricultural commodities as living standards continue to improve.

For much of last year there was speculation that BHP would gate-crash the sector by acquiring one of the big existing producers – the Canadian heavyweights Potash Corp and Mosaic were the two targets most heavily favoured. Either would be a massive, portfolio re-shaping transaction, with market capitalisation of about $US33 billion and $US25 billion respectively.

The two big Canadian producers are part of what is effectively a North American/Russian cartel that speaks for about 70 per cent of existing potash production and influences the supply/demand equation by selling through a joint marketing group.

Apart from their scale, given that BHP already owns a very large potentially low-cost potash deposit, a bid for one of the existing big producers would effectively mean paying a premium for membership of the cartel. BHP has demonstrated in diamonds (and in its efforts to encourage more market-related pricing of iron ore) that it prefers to market its own product in freely-functioning markets.

It would also be aware that Vale, having acquired Rio's potash assets, is also rapidly expanding its own presence in the sector, which also has adverse implications for the existing producers and their ability to influence prices.

If there were to be a major acquisition it would sensibly come after BHP and Vale have entered the sector, altered the supply/demand balance and undermined the existing oligopoly. Potash prices have already tumbled from stratospheric levels as a result of the impact of the global financial crisis on demand for fertilisers. Having reached about $US600 a tonne at their peak, contract prices have nearly halved.

A strategy of rolling up smaller exploration and development companies in the Saskatchewan Basin area of Canada would appear a more effective way to expand BHP's eventual position in the sector.

The appeal of potash to BHP is that it would add another differentiated layer to the basket of commodities in the most diversified of the major resource houses. The benefits of diversification – of commodities, geographies and marketing arrangements – were underscored by the resilience of BHP's cash flows during the worst of the crisis.

The simultaneous announcements of the modest potash acquisition and somewhat larger iron ore expansion underscore the options BHP has for deploying its vast cash flows and pristine balance sheet.

While the market has been agitating for either a major acquisition or a big return of capital, BHP has an existing project pipeline that absorbs about $US10 billion a year of capital.

The RGP6 expansion and the insight into its potash ambitions provided by the Athabasca acquisition makes it clear that BHP has plenty of options for using its cash and balance sheet to accelerate its organic expansion.

While it is conceivable that BHP could make a major acquisition, the prospective joint venture with Rio, its plunge into potash and the acceleration in its existing project pipeline says that it is under no pressure to do so.