Higher profits, lower growth: The future of mining

PORTFOLIO POINT: Major structural changes which will reduce the size of Australia’s mining investment boom are afoot, and the implications for both Rio Tinto and BHP Billiton – but particularly the latter – will be significant.

A series of events is unfolding, led by lower interest rates, escalating costs and US gas resurgence, which will reduce the scale of Australia’s mining investment boom. These events will increase the vulnerability of the Australian dollar, so for those looking to invest (or travel) overseas, 2012 is a good year to make the move.

Our longer term mineral investment boom is likely to now be concentrated on gas and iron ore, plus projects with low operating/capital costs. The investment implications are startling and have important ramifications for BHP and Rio Tinto, and many other companies.

BHP is our largest company and chief executives for generations have had a tradition of handing down more resources to their successors than they inherited when they took office. Suddenly, that tradition is being challenged. And it is being challenged as part of a total re-evaluation of mining expansion and, indeed, expansion in many other commercial areas.

In this new environment, I think Rio Tinto may be better placed than BHP.

Let me explain to you what is happening. In Australia, Europe and to some extent, the US, there is an ageing population which dominates overall savings. Investors are becoming more skeptical about expansion projects and much more interested in the dividends they receive from corporations. That desire for corporate dividends has been greatly increased overseas by very low interest rates, so retirement-oriented investors want more returns from equity savings and, via institutions, are turning to companies for income.

As Gerard Minack explains (No point dithering on rates, May 2), interest rates are set to fall further in Australia, so the higher dividend movement will gather pace here.

Traditionally, miners have been about paying low dividends and using their cash flow for major projects. Now the institutions are questioning that strategy, because their clients want higher dividends. Moreover, in the mining arena, institutions and other shareholders are seeing that a mine that, say, five years ago would have cost $1 billion, now costs $3 billion. The economics have become very different, so the institutions are saying “let’s stop and not go ahead and allow the cost of the mines to fall back”.

BHP has had a policy of matching its expansion with its cash flow, and in the current crop of expansion projects that BHP is embarking on, that philosophy is working extremely well.

But just behind the current set of projects is a series of mammoth projects. And with that size comes a much longer payback period. Among the gigantic projects are the iron ore outer harbour at Port Hedland; Olympic Dam; the US potash expansion; the Queensland coal expansion and of course the Browse LNG project. There is little doubt that Browse is going to go ahead, but BHP is now conscious of this new demand from shareholders and is talking about delaying projects such as Olympic Dam and the potash expansion. These projects require a large slice of capital. Unfortunately, just as our banks are finding it hard to fund their operations from overseas lenders, it is becoming increasingly difficult to get vast amounts of project finance for mining projects, particularly large ones. The best source of funding is China.

Yet these projects are the essence of BHP’s long-term growth planning. Rio Tinto has a somewhat different situation. Not only does it have better links to Chinese capital, but its iron ore projects are much more economic and are akin to the current BHP Port Hedland inner harbour expansion (as distinct from the outer harbour expansion). Mongolian copper is also a large operation, but again it can be done in stages and the long-term outlook for copper is very good.

As we look around the world, we see that large amounts of coal, particularly steaming coal, are becoming available and therefore the price is not likely to rise a great deal. BHP’s Queensland coal expansion has been jeopardised by the actions of the trade union movement, which has played hard ball. At the same time, the costs of the expansion have risen dramatically. Rio Tinto does not have the same coal labour problems (at least for the moment), but is looking at delaying its Australian coal expansion.

As Queensland coal is beginning to price itself out of the market, Mozambique coal is far cheaper to mine and has attracted the attention of Rio Tinto and other large miners. BHP always saw Indonesian coal as an alternative to Queensland, but new laws in Indonesia mean that it is not a favourable place to expand. At the same time, the availability of large amounts of coal and shale gas in the US is taking market share from US coal miners and their coal is going to come on to the global market if the coal price starts to rise. Accordingly, Queensland and NSW coal are squeezed between higher costs and stagnant or lower long-term prices, so expansion looks much less attractive.

We will discover on Tuesday, when the Budget is released, whether the government is going to increase the tax on these projects via the abandonment of the diesel rebate and extra overburden removal taxes.

If that happens, Queensland coal expansion for BHP is dead. Rio’s coal is in the same boat, but it will switch to Mozambique. Similarly, BHP’s Olympic Dam would be severely jeopardised because it is a massive overburden removal exercise. Olympic Dam is one of the world’s great deposits of copper, but it also contains uranium and removing that uranium in an economic way is not going to be easy in the current environment. BHP is looking to spend some five years removing massive quantities of overburden with no returns, until it reaches the bottom of the hole.

BHP has a major US potash project where it is attempting to break into the global potash market. It has a wonderful resource, but whether it will be able to attract large amounts of capital to that project remains to be seen, and it is likely to be deferred. This new era of minerals is going to challenge management, because corporations like BHP have been looking for huge projects and often turned their back on medium-sized projects.

The mining companies are going to have to be much more specific about the likely returns from each project they finance, and the “trust me” mentality is going to be challenged.

Two contributors to that change have been Rio Tinto’s acquisition of Alcan, which was a disaster, and BHP's acquisition in the shale gas sector, which wasn’t as big a disaster but was badly timed because the price of gas slumped within a short time of the acquisition. So institutions are now questioning the management of large mining companies at a time when there is not enough cash flow to fund these very large projects – especially as shareholders want more dividends. But in time, it is going to mean gluts of minerals will be restrained and mining companies will be more profitable, but with lower growth prospects.