Blind-sided BHP's mega lucky delays

BHP Billiton has been signalling for months that the cluster of mega-projects it had in its pipeline were going to be out on the shelf for at least 12 months, if not longer. Today it confirmed the obvious.

The Olympic Dam expansion and the Outer Harbour project at Port Hedland, both $US20 billion-plus projects, and the Jansen potash project in Canada, a $US10 billion-plus greenfields project, were to be the massive next wave of BHP expansion projects as part of the $US80 billion investment pipeline that Marius Kloppers once touted.

Today BHP said that with $US22.8 billion of major projects currently being executed it is ‘'largely committed'' for the 2012-13 financial year and that ‘'no major project approvals are expected over this timeframe".

The reason is obvious. Its cash flows have crashed, from $US30 billion last year to $US24.4 billion, and the group is now borrowing to fund the gap between its operating cash flows, its spending and its dividends.

In the year just ended BHP's interest-bearing liabilities increased from $US19.3 billion to $US28.2 billion and while its gearing remains reasonably conservative at 26 per cent it simply doesn't have the surplus cash flows to fund those massive prospective projects.

It isn't alone. All the major resource groups were caught unprepared by the rapidity and extent of the decline in commodity prices that has occurred as China's economy has slowed in response to the woes within the eurozone and the sluggish state of the US economy.

BHP, Rio Tinto, Vale, Xstrata, et al, are also shelving previously planned projects and adopting a far more defensive stance as it has become apparent that the ‘'super'' element of the commodity cycle and the windfall price-driven cash bonanzas it generated has ended.

If anything the BHP result, in which earnings before exceptional items fell 21 per cent from $US21.7 billion to $US17.1 billion, understates the extent of the reversal of fortunes as the prices of most of the key commodities have been falling steadily through this year. Most of them are down 30 per cent-plus since the start of the year and even more from their peaks last year – iron ore prices are down about 40 per cent.

As it was BHP attributed $US2.2 billion of the earnings reduction to price impacts, offset to some degree by $US308 million from a net increase in volumes.

In the absence of a near term strengthening of prices, which appears unlikely given that China, despite efforts to reflate its economy, is struggling to hold its slowing growth rate, the full effects of the price falls are likely to be felt in the first half of this financial year.

It is the rate of change in the external circumstances that blind-sided the big miners. A year ago their conversations were all about growth and the size of their project pipelines; today they are about discipline and frugality even while they remain convinced that the medium to longer term outlook for China and commodity prices and volumes remains positive.

The breadth of the impact on BHP's diverse portfolio of resources was evident from the fact that six of its nine customer segment groups suffered earnings declines. The exceptions were petroleum, up 0.3 per cent, energy coal, up 8.7 per cent and iron ore, up 6.6 per cent.

The aluminium division is, like most aluminium businesses, losing money ($US291 million in the year) the diamonds and speciality products business' earnings were down 66 per cent to $US199 million and the manganese business experienced a similar fall to $US235 million. Metallurgical coal operations were hit by both industrial action and price falls. Base metals, hurt by production interruptions at Escondida, saw earnings fall 54 per cent to $1.64 billion.

It hasn't helped that the price declines have occurred even as costs were rising. Costs, excluding inflation and exchange rates, were $3.14 billion higher and inflation added a further $US764 million. The impact on underlying earnings was about $US2.7 billion with BHP saying labour and contractor costs accounted for about a third of the impact.

Had it not been measured against last year's remarkable result, BHP's performance would have been more than creditable. At a production level it is performing quite solidly and with margins of 39 per cent and an underlying return on capital of 28 per cent whilst still in a growth phase it is by any measure a highly performing group.

The project still being pushed through the investment pipeline are regarded as high-quality, low-risk incremental expansion programs, like the planned increase in iron ore production from the Pilbara, which can continue for some time without the "big bang" expansion of Port Hedland with the ambitious Outer Harbour project.

Shelving the Outer Harbour project, or delaying Jansen, or putting Olympic Dam on hold while BHP tries to develop a less capital intensive approach to a project that would otherwise be returns and cashflow-destructive for six years while the overburden was removed are sensible and cautious responses to the environment. The options to proceed in future remain intact and valuable.

There will, of course, be disappointment in South Australia that the Olympic Dam open cut expansion isn't going to go ahead and underwrite the state's economy.

The investment, however, is so vast and the cash flows so distant that in an environment of lower prices, where operating and capital costs have blown out and with a strong Australian dollar it would have been madness for BHP to proceed. It deeds a radical change in the project's economics.

The safety net for BHP and Rio in a more uncertain environment and one of weaker prices is that their existing operations are high quality and low cost and the investments underway are largely incremental expansions and will deliver relatively low-cost volume growth. BHP's diversity provides further insulation.

Given the sea-change in conditions, however, the big miners in general are fortunate that the raft of mega-projects they were all contemplating are still on the drawing boards rather than underway, as they would have been had the super-cycle lasted another 12 months.