BHP and Rio Tinto keep their cool amid commodity comeback

Despite their windfall from the recent commodity surge, both BHP and Rio continue to adopt a cautious stance.

Rio Tinto chief executive Jean-Sébastien Jacques. (Lyndon Mechielsen/The Australian)

Rio Tinto’s first major investor presentation under its new leadership makes it quite apparent that both the major Anglo-Australian resource groups are, despite the dramatic rebound in commodity prices this year, retaining strongly conservative and risk-aware postures.

Chief executive Jean-Sébastien Jacques has committed the company to generating an extra $US5 billion of free cash flow over the next five years beyond the cash cost reductions of $US2bn already targeted through to the end of 2017.

The path to that increase in cash flows is, as it is at BHP Billiton, largely increased productivity from the existing asset base along with an even more intense focus on capital expenditures. Rio also has three new projects — the Silvergrass iron ore project, the Amrum bauxite project and the underground mine at Oyu Tolgoi — under development.

The surge in commodity prices, if sustained, would see Rio generating $US10bn of cash flows next year but it remains sensibly cautious and is prioritising balance sheet strength rather than a splurge on growth.

While it generated $US9.4bn of cash flow in 2015, Rio’s first half operating cash flows this year were down 27 per cent at $US3.24bn.

Given that the big bounce in commodities was triggered by the coincidence of China’s decision to buttress its economic growth rate with a stimulus to infrastructure and property investment and its policy of rationalising the overcapacity in its steel and coal sectors, the risk-aversion of the major miners is understandable.

Both Rio and BHP appear to be using the windfall provided by the higher commodity prices — iron ore is holding just under $US75 a tonne while coal prices have also soared, with metallurgical coal trading at its highest prices for five years — to shore up their balance sheets.

Rio, after announcing the sale of its Lochaber aluminium smelter complex in Scotland for $US410 million overnight, has sold $US1.3bn of assets this year and has been using the proceeds to reduce its debt and stretch out the maturity profile of its borrowings. It has reduced its net debt to $US12.9bn and its gearing ratio to 23 per cent. Three years ago it had net debt of more than $US22bn.

In common with BHP, Rio is now prioritising value over volume and brownfield investment over greenfield, with incremental tonnes from existing mines a more cost-effective and less capital-intensive strategy than big investments in new stand-alone projects.

It believes it can get copper-equivalent compound annual growth in volumes over more than two per cent through to 2025 from its existing portfolio of assets.

BHP’s Andrew Mackenzie said earlier this year that, for an investment of about $US1.5bn, he could generate about a million tonnes of copper-equivalent growth in volumes, or an increase of more than 10 per cent in BHP’s production.

Both the big miners would be acutely conscious of the fragility of the external environment, both in terms of the sustainability of China’s current settings and commodity prices and the potential for real upheaval if Donald Trump follows through on his election threats to slap punitive tariffs on imports from China and ignites a damaging and destabilising trade war.

In the near term, they can treat the surge in their cash flows as this year has progressed as a windfall, passing some of it back to shareholders under their new dividend policies.

Earlier this year both Rio and BHP announced they would abandon their progressive dividend policies in favour of more conventional payout ratios, with the ability to top up shareholder returns through special dividends or capital management.

They can also use some of the extra cash to further strengthen their balance sheets.

A dilemma will arise if commodity prices remain at their current levels well into next year, which would have them questioning whether they ought to be adopting more aggressive and growth-oriented stances.

Both have options for major new projects within their portfolios, with Rio nominating the potential for a $US2.2bn investment in a new 40 Mtpa iron ore mine in the Pilbara, Koodaideri, which could be under development by 2019 and in production by 2021.

Rio’s view of the iron ore market is that there will continue to be exits of higher-cost supply through to the end of the decade, with the exits and the entry of new low-cost production essentially matched and, over time, producing a balance between supply and demand.

If iron ore prices remain at or above their current level, of course, the rate at which existing higher-cost production disappears might slow and it is conceivable that previously mothballed volumes might even re-enter the market.

Nevertheless, Rio appears reasonably optimistic that the market, if not iron ore prices, will remain relatively stable over the next few years.

If Western Australia were to adopt the Nationals’ plan to dramatically increase state production taxes on Rio and BHP’s iron ore output, however, Rio would inevitably have to reconsider its willingness and capacity to invest big chunks of capital to expand the business and, indeed, has threatened to do just that.

The question mark over the sustainability of current commodity price settings is a more immediate challenge for companies like Glencore and Anglo American, which are still in selldown mode to reduce more threatening debt levels.

If they misjudge the nature of the cycle, there will be significant opportunity costs from continuing to offload assets. Equally, of course, the environment could deteriorate, leaving Anglo in particular (given, unlike Glencore, the lack of urgency in its asset sales program) exposed.

For the moment, given the trauma the major miners experienced when commodity prices crashed, introspection would seem to be the most rational and the most favoured approach for both Rio and BHP.

Rio’s corporate memory, of course, is scarred from its brush with debt-laden disaster in the aftermath of its ill-timed acquisition of Alcan just ahead of the financial crisis. That provided a brutal lesson in the destructive combination of leverage and commodity price volatility that the current leadership is most unlikely to forget.