Shale bears the brunt of BHP's diversity blues

BHP Billiton is moving swiftly and predictably to respond to the extra layer of challenges it faces after the oil price more than halved in the second half of last year, replicating the savage falls in iron ore, coal and copper prices and undermining BHP's diversified resources model.

The obvious target for conserving cash and capital was BHP's US onshore oil and gas business, where Andrew Mackenzie had budgeted to invest $US4 billion a year (or about 30 per cent) of his 2014-15 capital expenditures.

In today's BHP December-half production report, Mackenzie announced the group would cut the number of drilling rigs operating in the US onshore oil and gas unit by 40 per cent, from 26 to 16, by the end of this financial year.

The revised drilling program will focus, he said, on the liquids-rich Black Hawk acreage but it would also be kept under review. There could be further changes if BHP believes deferring development would create more value than near-term production.

A 71 per cent increase in production from that onshore business had contributed to record oil and gas production in the December half, with volume up 9 per cent. With BHP's average realised price for oil $US85 a barrel in the half, the full impact of the plunge in oil and gas prices won't be visible until BHP's full-year results.

The plunge in prices and BHP's reduced drilling program haven't affected its production guidance. It still expects shale liquids volumes to be up about 50 per cent for the financial year. It could, however, derail the group's plans to offload its Fayetteville dry gas acreage, which it has been trying to sell. BHP said it will only pursue the sale if full value can be realised.

BHP and Rio Tinto, which issued its full-year production report yesterday, are pursuing very similar strategies in response to the collapse in commodity prices and the surpluses of supply over demand by driving volume increases while focusing on carving into their cost bases and the capital intensity of their businesses. (see: Rio's production numbers speak volumes about Walsh's strategy, January 21.)

BHP's overall volume increase in the half-year was 9 per cent, which it said would bring to 16 per cent the increase in production volumes over the two years to the end of this financial year.

Iron ore production was up 15 per cent and on track to achieve BHP's target of 245 Mtpa for the year to June. BHP says increased supply chain capacity will enable it to increase production to 270 Mtpa without additional fixed plant investment and, beyond that, de-bottlenecking projects had the potential to increase total capacity to 290 Mtpa by the end of the 2017 financial year at a very low capital cost.

Metallurgical coal production was up 21 per cent in the half but BHP's average realised price was down 23 per cent. Copper production was modestly lower and that division has yet to experience to full impact of the steep decline in copper prices that occurred towards the end of last year.

The core strategy both BHP and Rio are pursuing is to improve the productivity of their asset basis by lifting production volumes over reduced cost bases with as little additional capital as possible to blunt the impact of the brutal price declines.

The side effect of their emphasis on increased volumes will be to drive out much of the higher-cost capacity developed during the period when commodity prices were at record highs. The Saudis are pursuing the same strategy in oil, maintaining output rather than sacrificing volume and market share to support the price.

The scale and breadth of the price declines across BHP's portfolio has caused some to question whether it should proceed with the proposed spin-off of its South32 assets and the cash that they generate at a time when its own cash flows have come under pressure.

Mackenzie remains committed to the demerger. He said that BHP's operational performance over the past six months had been strong and had seen costs reduce and operating and capital productivity across the group improved faster than originally planned.

BHP believes spinning out those non-core assets will simplify the parent company, reduce overheads and produce a greater focus on its best assets. Self-evidently it also believes that the loss of the cash the South32 assets generate won't materially impact its own ability to satisfy shareholder expectations.

The demerger is on track to be completed this financial year, Mackenzie said, with the transaction likely to be put to shareholders in May.

By itself, the continuing commitment to the demerger suggests that while Mackenzie and his board might be even more focused on costs and capital to maintain cash flows in the face of the plummeting prices, they aren't yet sufficiently alarmed to abandon a key component of Mackenzie's simplification program.