The mega demands of being BHP's boss

With BHP Billiton's annual results only three weeks away the market continues to obsess about both the likely deferral of the next generation of BHP's mega projects and the potential for write-downs against the value of the $US17 billion of US shale gas assets BHP acquired last year.

It is obvious, and BHP itself has flagged it, that the three mega projects – the $US30 billion Olympic Dam expansion, the $US20 billion Outer Harbour project at Port Hedland and the $US10 billion Jansen potash project in Canada – won't all get a go-ahead this year.

Indeed, the only one of the three given a realistic prospect of proceeding is the Outer Harbour project, given the continuing demand for iron ore and the economics of BHP and Rio Tinto's Pilbara operations. But even that project has a question-mark over it, as BHP could probably improve the capacity and productivity within the Inner Harbour as an interim measure.

Where investment in increasing the capacity of BHP's West Australian iron ore operations could be justified because of the exceptional margins those operations generate even with iron ore prices having fallen by about 30 per cent this year, Olympic Dam and Jansen involve big up-front investments for returns some years down the track.

While my colleague, Robert Gottliebsen, is right when he says that Olympic Dam's metallurgy is complex, if the expansion is mothballed the main reason will be the need to spend five or six years, and $US5 billion or $US6 billion, removing over-burden before any ore from the open-cut can be extracted.

With the dive in commodity prices and the fact that it already has 22 major projects in their development phases squeezing BHP's discretionary cash flows, Marius Kloppers and his board aren't going to commit to spending $US5 billion-plus today and then waiting five or six years before they start to see any cash flowing from the investment.

With every $US1 a tonne movement in the iron ore price impacting earnings by $US95 million and every one cent movement in the relationship between the US dollar and Australian dollar affecting earnings by $US100 million, the fall in commodity prices and the strength of the Australian dollar are going to have a very material impact on BHP's second-half earnings and its capacity to invest when they are unveiled on August 22 and, of course, some uncertain but likely lengthy period of time beyond that date.

Kloppers always refers to the mega projects as options that he or his successors can exercise when the circumstances are favourable.

While the South Australian government has made some noises about BHP having to renew its environment impact credentials if it doesn't proceed with the Olympic Dam expansion this year, given that BHP already has a producing mine at the site its option can't be taken from it and won't get any less valuable if it isn't exercised this year.

The option to develop Jansen, a potash project earmarked for a future when rising wealth in Asia drives demand for soft commodities and the fertilisers to improve agricultural productivity, is similarly valuable even if its exercise is deferred.

BHP's committed spending on new projects tapers off steadily beyond this year and its flexibility and financial capacity starts to really free up in 2015. While commodity prices remain much softer than they were a year ago, and the ability of the Chinese authorities to arrest the slide in their economy's growth rate remains in question, BHP will be mindful that it has less financial flexibility today than it has had.

Part of the explanation for that reduced flexibility is the $US4.75 billion BHP spent to enter the US shale gas industry in February last year, when it acquired a portfolio of interests around Fayetteville in Arkansas and the $US12.1 billion in spent a few months later to acquire the much larger Petrohawk Energy.

The Fayetteville assets contain dry gas and given the slump in the US domestic gas price from above $US6 per MBTU to just over $US3 (having been below $US2 per MBTU) would be worth significantly less today than they were in February last year. If there is to be a meaningful write-down of BHP's shale gas assets, Fayetteville is likely to be at the centre of it.

While the market has focused heavily on the potential for a write-down, in the context of a BHP balance sheet which contains total assets of around $US125 billion, a non-cash write-down isn't particularly meaningful.

It would really speak to the opportunity cost – the opportunity to buy into the sector more cheaply – rather than to the merits of the underlying long-term strategy and BHP's overall position in the US energy market.

There is something of an anti-Kloppers push developing, which might explain the focus on an impairment charge – it would appear embarrassing if BHP fessed up to overpaying for assets so soon after they were acquired – but BHP isn't a trading company and the ultimate judgment of its strategic plunge into shale gas shouldn't be made within 18 months.

The Petrohawk element of that plunge is at this point a more positive story because its assets are liquids-rich – far more liquids-rich than BHP or anyone else originally understood. BHP has upgraded its estimate of the recoverable resource from one billion barrels of liquids to 1.5 billion barrels.

Where BHP initially planned to deploy its drilling rigs evenly between dry gas fields and those with liquids it has changed tack significantly and its program is now dominated by drilling for liquids. There can be a payback of more than 100 per cent inside the first year of production from extracting liquids.

The significance of the anticipated deferral of BHP's mega projects and the focus on the likelihood of write-downs of some of the shale gas assets is that they can be woven, and to some degree are being woven, into a broader story of dissatisfaction with Kloppers.

Kloppers has been criticised for the deals he didn't complete (Rio Tinto, Potash Corp) and the shale gas deals he did; for the contrast between the $US80 billion of new investment in the pipeline he referred to last year and the likely shutting down of most of that pipeline of future projects this year. He's even taken some flak for BHP's workplace policies.

There are still some institutional shareholders unhappy that he spent money on the shale gas assets instead of returning it to them, despite the very large buyback programs that have been conducted during his time as chief executive. If the mega projects are mothballed those shareholders will still be unhappy that BHP won't have the financial flexibility in the current environment for commodities to increase their dividends.

There is a sense that, whether it's fair or otherwise, the market has taken a dislike to Kloppers despite his success in guiding BHP through the financial crisis, delivering a massive series of new projects largely on time and within sight of budget and emerging as the dominant force in the sector.

With commodity prices diving but costs still soaring this is not an easy time to be chief executive of any miner, let alone one as visible and as obsessively monitored as BHP. With the super element of the commodity price cycle now apparently history, however, it probably isn't going to get any easier.

Kloppers would know there are some in the market starting to agitate for change. He is no soft or unsophisticated target and it is going to be fascinating to see if and how he responds.