It would be tempting to look at the massive $US23.6 billion ($A22.5 billion) profit BHP Billiton announced yesterday and see, as some do, those earnings as easy windfall gains from the China-inspired boom in commodities.
While there is an element of that — within the group’s revenues of $US71.7 billion there was, of course, another major ($US17.2 billion) contribution from increased prices — the reason BHP has transformed itself into the world’s biggest diversified resources company in the space of a decade lies within its unique model.
The diversity and resilience of its cash flows — the fact that it has big exposures to both ferrous and non-ferrous commodities and to energy coal and petroleum — and a conservative approach to its balance sheet has enabled it to invest about $US75 billion in its operations over the past decade, with a staggering $US20 billion planned for this financial year.
Moreover, that distinctive model has allowed BHP to adopt a “through-cycles” approach to investment. In 2008 and 2009 when all its rivals were carving into their spending, BHP invested $US20 billion.
The results of that model and strategy are reflected in its record profit, which was built not just on the elevated commodity prices but from record levels of production in four of its commodities and 10 of its operations.
By continuing to pour capital into expanding its operations during the worst of the GFC, BHP leveraged its ability to capitalise on the return to more normal settings.
It isn’t just that it has a bigger production base to benefit from the higher prices, or that it has a massive pipeline of projects commissioned over the past few years that will keep flowing into the market over the next few years, but rather that BHP was expanding while all else were contracting.
One of the reasons why commodity prices have remained at such persistently high levels is that the crisis disrupted the supply response to China’s demand. While the industry is rushing to catch up and bring new production on stream, that rush is resulting in escalating costs — BHP said that cost inflation last year impacted its earnings by $US635 million. That pressure continues to mount, particularly in Australia.
The group already has existing large low-cost mines because of its strategy of only pursuing tier one assets and much of its expansion has been incremental investment in expanding its existing mines.
The nature of much of its investment, and the fact that a significant slab of it occurred during the immediate aftermath of the GFC before cost pressures really flared, means it remains at the lower end of the cost curve.
Most of the new projects that have come on stream post-GFC, or that will be brought into production over the next few years, are fully exposed to those pressures and therefore while BHP will be affected, in relative terms its operations will be less affected than most of the rest of the sector.
Over the past decade it has shown it can produce very consistent base cash flows, high margins and high returns on equity regardless of the external conditions. Its actions over the past three years have buttressed that position.
It also helps BHP that two of the biggest sources of cost pressure are fuel and energy, and that its exposures to energy — and the scale of that exposure is unique to BHP — makes it a big net beneficiary of higher prices.
Its unusual positioning means that if China and India continue to sail along at high single-digit growth rates, BHP will continue to deliver dazzling profit and growth numbers because the rising floor of costs under the sector will ensure commodity prices have to remain high.
If, however, China were to slow and prices were to fall back, a lot of new production and potential production would quickly become sub-economic or worse, remove the higher-cost supply from the market.
The big established low-cost producers such as BHP and Rio Tinto, but particularly BHP, have developed structurally defensive positions by pouring capital into their existing tier-one mines.
In the meantime, cash is pouring through BHP — cash flow from operations was $US30.1 billion last financial year.
With gearing of 9%, even after the $US12.8 billion of capital expenditures and completion of a $US10 billion buyback six months ahead of schedule, it can afford to continue to make acquisitions such as the $US15 billion purchase of Petrohawk Energy while ploughing capital into organic expansion.
The $US20 billion BHP has now outlaid to build a position in the US shale gas sector and the massive and continuing flow of capital it plans to develop those operations meant there was little prospect that it would announce another capital management program, and it didn’t.
A 22 per cent “re-basing” — a planned permanent increase — in the group’s final dividend, however, was a gesture to shareholders who have been urging BHP to direct more of those torrents of cash it is generating towards them.
*This article first appeared on Business Spectator