Shale of the century
Townsville PREMIUM Pilbara iron ore and those seductive shales, scattered across the southern states, half a world away in the USA, are the twin pivots of BHP’s future.
But they are very, very different pivots.
The iron ore is the absolute rocksolid cash- generating core of BHP. And indeed, even more tomorrow’s BHP.
In the latest year iron ore contributed a thumping $ US9.1 billion gross profit ( EBITDA). That’s nearly $ A12 billion.
Even more stunning was the profitability – an amazing 63c gross profit in every revenue dollar, generating a thumping 26 per cent return on the capital invested in iron ore.
BHP has almost as much capital invested in US shale – around $ US16 billion as against just shy of $ US20 billion in iron ore – but in the latest year all it delivered was red ink.
There’s very little prospect of it delivering much else in the immediate future. And to even minimise the red ink, BHP has to pump around $ US1 billion of new capex every year.
In their very different ways, shale and iron ore are equal keys to BHP’s future profit; and even more, again, its profitability; and indeed its very corporate future, with activist hedge fund Elliott Partners nipping at BHP’s heels.
The iron conventional.
First, it generates bottom line profit. The group gross profit went from $ US12 billion to $ US20 billion. That was entirely due to $ US8.2 billion extra from higher prices. All the other things like productivity, cost cuts and currency were not unimportant, but they tended to cancel out.
A huge part of that $ US8.2 billion came from higher iron ore prices, spread over much bigger shipments. Just like for Fortescue and just like for Rio Tinto.
But second, because of the huge investment in the Pilbara, the non- cash depreciation throws off very large cash flows. Because most of the capex expansion cost is now done, it will increasingly be free cash for the rest of the group.
Put it all together and BHP CEO Andrew “little- k” Mackenzie and his finance chief Peter Beaven were able to produce the seeming fiscal miracle of an underlying $ US6.7 billion group profit able to “fund” a $ US4.4 billion dividend and a similar $ US4.5 billion capex spend and still reduce debt by $ US9.8 billion over the year!
At the other end of the spectrum – literally, return on capital chart produced by Beaven – sits the shale. Like one big lump of indigestible concrete. That BHP is now going to spew out.
Because so much capital is tied up in shale, generating at best a zero return – shale will switch from being a huge drag on the group to suddenly making a huge “contribution” ( in absentia).
In the latest year the “24 carat gold” of iron ore returned 26 per cent on its capital invested. Coal ( met and energy) did almost as well at 23 per cent. Conventional oil and gas did a respectable 12 per cent ( off a world competitive $ US10 a barrel cost base).
But the group overall only earned 10 per cent – all because of the negative return from the huge investment in shale. Yes, copper – essentially ore contribution is Escondida, shared with Rio, in Chile – was only earning 6 per cent. But that will quickly go to around 14- 15 per cent as the benefits of the big investments there kick- in ( on current prices).
A better return – even a more than doubled return – from copper won’t move the group dial much because copper just ain’t big enough. On BHP’s guidance for 2018 that might kick the return up from 10 to 11 per cent.
Shale, very definitely in contrast, is big enough.
Dumping the shale would instantly do two huge things. Assuming a reasonable exit price, it would on its own kick the group return on capital ( on a same commodity price basis) from 10 to 15- 16 per cent.
And then, on to 20 per cent, right across the group by 2020!
On that reasonable return assumption it would also dump enough cash into the balance sheet, which when added to 2017- 18 free cash flow, would be enough to wipe out all or almost all of BHP’s remaining debt.
BHP won’t let that happen. Not only is the debt critical to its performance, it has also locked in some extended low- rate debt: why pay it off?
When and if – with two qualifications – shale is “exited”, BHP would direct most of that cash to shareholders via a special dividend and likely capital return.
There is no project or projects on BHP’s horizon to soak up so much cash – and especially not with the ( reasonable) expectation of continuing huge cash generation out of the Pilbara.
Similarly, BHP doesn’t absolutely rule out acquisitions; but there’s nothing blindingly obvious, either from inside the BHP bunker or just looking at the global resources horizon from the outside.
The other exception is if BHP “exits” the shale in a way that gives it the vital performance boost in terms of its capital employed, but doesn’t give it the big cheque.
This would happen if it demerged shale into a separate, presumably listed vehicle, like it did with the assets it put into South 32.
This is clearly not the preferred option. Although it was included in Mackenzie’s options list yesterday, BHP very clearly would prefer to get both the profitability boost and the big cheque.
Its hand might be forced, though, by the pesky Elliott. The impregnable “old” BHP might have been able to ask shareholders to “trust it” in postponing the profitability boost, to get a bigger cheque “later”.
But in today’s low return world a 15 per cent return is hugely more alluring than an 11 per cent one.
Especially, as behind it lies a 20 per cent return.
Then, there’s the irony: BHP has finally embraced the necessity to reduce its size by around 20 per cent, at the same time it has embraced a new motto: Think Big.