Will a commodity price collapse foil BHP's demerger?

There's an emerging discussion occurring over whether the planned demerger of BHP Billiton's newly-named South32 portfolio of non-core assets should proceed as scheduled next year. The conclusion isn't necessarily straightforward.

Earlier this year, when the concept of the spin-out started to take real shape, the logic of it was compelling.

By focusing on its core basin assets -- its iron ore, petroleum, copper and coal assets -- BHP would dramatically simplify its structure without sacrificing anything material in terms of earnings and cash flows. Its margins and returns on capital would rise significantly.

The spun-off vehicle, now known as South32, would contain a basket of lower-returning but still high-quality and cash flow-positive assets and a portfolio that had a late-cycle tilt.

Hived off within a separate vehicle the assets would attract capital to generate growth whereas within the larger BHP portfolio they couldn't compete for increasingly scarce capital with the core assets. The market would also assign value to them that wasn't obvious within the larger BHP.

The strategic thinking behind the division of BHP into core and non-core assets and between the continuing BHP and South32 was embraced by the market … until the collapse in the iron ore price as the year has progressed was joined by a collapse in the oil price.

The iron ore price has almost halved since the start of the year and the oil price, which began tumbling mid-year, is down about 30 per cent since that dive began. Coal and copper prices are also depressed.

There are two dimensions to the impact the collapse in prices has on BHP and the demerger concept.

One is obvious. Lower commodity prices means lower cash flows and earnings.

With BHP investing around $US14 billion to $US15bn a year while committing to a 'progressive' dividend policy losing cash flows from the South32 assets, which generated earnings before interest, tax, depreciation and amortisation of about $US1.8bn last year, raises a question mark over the ongoing core entity's ability to sustain its planned investment program and returns to shareholders.

The other relates to BHP's key differentiator from other resource groups: its diversification.

There was a view within BHP that spinning out the South32 assets would have only a minor impact on the degree of diversification within the core portfolio and the base cash flow at risk in worst-case scenarios for commodity prices and demand.

That view is being challenged by the unusual correlation of prices across the core portfolio. All of the commodities have experienced savage price falls this year.

South32 isn't immune to the sliding demand, rising supply and withdrawal of financial players from commodity markets but its assets -- nickel, coal, silver, manganese, alumina and aluminium -- do represent a different set of exposures to metals that are to some degree in different parts of the commodity cycled to BHP's core commodities.

The plan is to give it an essentially debt-free balance sheet, although it will have about $US2bn of lease liabilities. With earnings of more than $US500 million last year and cash flows of more than $US1bn, it would be reasonably well-positioned to ride through the current price cycle.

It is improbable, at this stage, that BHP would abandon the demerger or even delay its planned execution in the first half of next year, although that could change if prices continue to slide.

The more likely response to what has happened in commodity markets would probably occur within the continuing BHP.

Andrew Mackenzie has already had significant success in driving costs down and volumes up within the basin assets, as well as reducing capital expenditures by about a third. He'd have to go harder on productivity and be more stingy on capital of South32 is spun out in the current, or worse, circumstances. An obvious target would be the planned $US4bn a year of investment in BHP's onshore gas business in the US.

BHP has said that the demerger would enable it to focus on (and carve into) the $US3bn of 'functional' costs it incurs as a consequence of its sprawling and complex structure today. The 'new' BHP would be a far simpler and more focused company.

With shares in South32 being distributed to BHP shareholders their exposures to the suite of assets within the wider BHP portfolio isn't changed by the demerger but the gain the option of managing those exposures.

The strategic arguments for the demerger remain intact, even if the synchronised dive in all BHP's commodities is creating some tensions within them. In the absence of further seismic shocks, it is likely that South32 will proceed as planned.