Keeping BHP's shale to scale

One of the curious aspects of the market's reaction to BHP Billiton's results last week is that the issue that seems to have concerned it most relates to the newest group of assets in the BHP portfolio.

The result itself was very respectable, given that commodity prices were significantly off their peaks and there were aberrational production issues in several key projects. The critical focus of analysts and investors, however, was mainly on the relatively newly-acquired shale gas assets in the US and the fact that Marius Kloppers is already changing the strategy for exploiting them.

Last year, in two deals, Kloppers outlaid almost $US20 billion to enter the US shale gas industry, initially via the $US4.75 billion acquisition of some of Chesapeake Energy's assets in Arkansas last February and subsequently through the $US15.1 billion acquisition of Petrohawk Energy.

Unfortunately for BHP, prices for shale gas have been dropping steadily. Before the financial crisis they were up around $US8 per British thermal unit, but have been dropping steadily since – almost 40 per cent last year – to reach 10-year low levels, below $US2.50 a unit.

The prices are being buffeted by the combination of a mild winter, a weak economy and a glut of production caused by a structural shift in the industry from the small under-capitalised and entrepreneurial companies that pioneered it to the industry heavyweights like Exxon, Total, BG, ConocoPhillips and, of course, BHP.

As the big companies have moved in to consolidate the sector and brought their capital and major project expertise to bear, production has soared to record levels.

BHP is responding by changing its approach and scaling back on drilling, particularly of dry gas resources. It will focus for the time being on those resources richer in oil and other liquids and pull back sharply on plans for what had been a $US7 billion a year capital expenditure program.

Earlier this month BG Group announced it would slash its planned drilling program by nearly 80 per cent because of the low prices. That combination of a focus on liquids and a dramatic scaling back of drilling activity appears to have been adopted by virtually the entire sector.

The issue for BHP and its analysts, of course, is whether the current pricing is going to persist for some lengthy period and force BHP into major write-downs of the value of those assets.

One commentator has referred to shale gas as Klopper's likely ‘'Magma Copper Moment,'' a reference to the disastrous acquisition that contributed to the destabilisation of the group in the 1990s and led to a traumatic overhauling of its senior management and its structure.

It is possible that BHP's entry into shale gas in the US will, with hindsight, turn out to have been a mistake – or at least that it got its timing wrong and consequently overpaid –, although it is probably more than a bit premature to make that call at this point.

The magnitude of the scaling back of drilling occurring across the industry will by itself have an impact on the supply and demand equation and ultimately on price. Oil and gas prices are inherently volatile and can be affected by external developments and there have been some signs of life within the US economy.

BHP was attracted to the sector because, where oil prices are high and therefore acquisitions are prohibitively expensive, gas prices were low (albeit that they are now lower again) and the immaturity and capital intensive nature of the sector meant that it could bring its big balance sheet to bear and take advantage of the growing pains of the industry pioneers, which have found that the more successful they are the more cash they need to sustain themselves.

It was also, moreover, a strategy based on BHP's assessment of the market fundamentals and a view that shale gas would grow to become a major source of US energy, helping to make the country energy self-sufficient. BHP, of course, considers its investments within time horizons of decades, not months or a year or two.

With prices for gas in Asia about five times that being achieved by the US shale gas producers, an obvious way to respond to the domestic glut in the US would be to export the surplus gas, except that there are no export terminals in the US at present and there has been some discussion within the US whether, for reasons of energy security, any should ever be allowed. Ultimately, if the glut persisted, the appeal of export prices would, one would think, be irresistible.

An interesting conundrum for Kloppers is that the low prices are flushing out more gas assets. It originally entered the sector by buying a portfolio from Chesapeake Energy, the second-largest of the shale gas producers, as that group sought to raise some cash to develop its other holdings.

This week Chesapeake announced it would sell another $US10 billion to $US12 billion of assets to fund a major cash shortfall created by the low prices, high debt levels and its continuing drilling program.

Kloppers could up his bet on shale gas, and probably average down his entry cost, by taking advantage of the industry stress. That would, of course, make the stakes even higher for BHP and probably him personally. BHP might look at investments in decades-long time horizons, but shareholders tend to be less patient.

More to the point, the entire tone of Kloppers' commentary on the BHP result was one of caution.

While BHP has the financial capacity to make sizeable acquisitions, the brittleness of Europe, the weakness of the US economy and some slowing of the rate of growth in China has caused him to focus more on conserving cash and capital and stretching out some of the group's major capital commitments than on a continuing dash for growth.

From his perspective, scaling back the immediate capital expenditure program in the US would fit that more defensive mindset and the BHP view that an expansion program slowed or deferred isn't an opportunity lost but a future option created.