When Chip Goodyear took over from Brian Gilbertson as BHP Billiton’s chief executive in 2003, the company’s earnings before interest and tax (EBIT) was $US3.5 billion. This year it is $US24.3 billion, a seven-fold increase.

In 2003 the prices of oil, iron ore and energy coal were all less than $US30 — per barrel and tonne. Now they are all over $US120.

But amazingly, only BHP’s production of iron ore has increased — by 50%; output of oil and energy coal have actually declined.

This underlines the incredible price wave that BHP Billiton is surfing, and the profit leverage the company gets from screwing the desperate Chinese.

It was shown again in the breakdown of this year’s profit: EBIT from net price increases was $US6.5 billion, a figure that is around 50% larger than the net increase in EBIT of $US4.1 billion. The contribution from increased volume ($US1.8 billion) was more than wiped out by higher costs and exchange rates.

It also means that any analysis of BHP’s future is all about commodity prices because the ability to increase production volumes is even more constrained now than it was in 2003 and, as CEO Marius Kloppers made clear yesterday, is getting worse all the time. Obviously constrained supply will help prices, but not if there is a global recession.

In the past few weeks commodity markets have begun to factor in a recession. Oil, copper, nickel and gold are all down sharply, and even iron ore is looking soft.

The spot thermal coal price has fallen 17% in five weeks, alongside the oil price, although in many ways Chinese demand for coal looks strongest of all.

So BHP is a proxy for the Great Australian Question of 2008: will Chinese industrialisation and urbanisation offset the coming global slowdown caused by the bursting of the credit bubble?

In that context, the takeover of Rio Tinto can be seen as insurance — as a defensive play, rather than an aggressive one.

Major greenfield expansion is out of the question, and it would be higher cost and lower margin production in any case. Rio looks like being stymied in both Guinea and Mongolia.

And although Kloppers spruiks the diversity of BHP’s portfolio with good reason, if you look through its production report it’s quite clear that the two businesses that it shares with Rio Tinto — Escondida and WA iron ore — are by far its biggest.

The bid for Rio Tinto is not an expansion but a consolidation, a plan to increase both profit margins and pricing power. It is all about building on strengths: for BHP the EBIT margins of Escondida and WA iron ore are 75% and 525 respectively (by the way Bass Strait still produces the greatest profit margin — 82%).

That’s why it is hard to get through the competition regulators, but also why investors will embrace it.

The only weakness in BHP’s strategy, it seems to me, is its neglect of energy coal. This product has the lowest capex to revenue ratio (6%, versus 20% for iron and petroleum) and the least exploration.

That is understandable I guess. Watch Al Gore’s film or read the Ross Garnaut’s report on climate change and you wouldn’t spend a cent on trying to find and mine more coal.

But the uncomfortable fact is that China has a dire electricity shortage and it simply has no immediate alternative to coal. There have been reports recently that the government is planning to impose a 10% tax on coal exports; in March it reduced the export quota and will probably reduce it again.

There is a fair chance, indeed, that energy coal will be the only commodity whose price goes up in 2009.

It is a melancholy irony that just as the world attempts to seriously grapple with climate change, the best thing to be producing is coal.

Peter Fray

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