The end of Mackenzie’s beginning

BHP Billiton CEO Andrew Mackenzie in his Melbourne office. Aaron Francis/The Australian

The market is expecting big things from BHP Billiton. The company is about to report the biggest headline loss in its history yet it’s one of the most expensive stocks on the ASX.

Its price earnings ratio based on consensus earnings forecasts is 33.3 times; the company is priced for everything to go right.

BHP’s (BHP) share price bottomed at about $14 in January, not long after the iron ore spot price bottomed at $38 a tonne. Since then iron ore has gone up 50 per cent and BHP’s share price 45 per cent.

It has been one of the best performers on the market, driven higher by the iron ore price and a wave of optimism about the resources sector generally, and Andrew Mackenzie’s BHP in particular.

Tomorrow’s loss, expected to be around $7 billion, has been pre-announced; all focus will be on underlying cash flow and guidance for next year, and specifically Mackenzie’s views about the commodity cycle.

The most important — for Australia as well as BHP — is iron ore, currently sitting above US$60 a tonne having rallied this year from a low of less than US$40. Is there room for more?

Perhaps, but a lot depends on the Chinese housing market and whether the Politburo decides to make sure that the slump does not turn into a rout.

The iron ore price has risen 50 per cent despite the Chinese housing collapse because the strategy that BHP, Rio Tinto and Vale have pursued for several years, of driving domestic Chinese iron ore producers out of business, has worked.

Chinese iron ore imports jumped 9 per cent in the first half of this year and imports are now at 80 per cent of consumption, 10 per cent more than the historical average.

Steel consumption in China has not grown since 2013, which is why the steel mills embarked on a wave of global dumping, sending steel mills around the world to the wall, and why the big three iron ore producers embarked on a strategy of building market share to achieve growth.

BHP and Rio relentlessly drove production higher as the price fell below US$100 in mid-2014 and kept falling. It was a grinding war of attrition, with Chinese producers, many of which were mining iron ore underground, desperately cutting costs to stay alive.

Through 2015, the Chinese producers appear to have been losing plenty of money and operating purely for cash and employment, but by November last year, with the price around US$50, a tipping point seems to have been reached: imports surged to 85 per cent of demand, from the usual 70-75 per cent.

There is no longer much room for BHP and the other international producers to increase market share. Further price and volume gains will depend largely on the Chinese housing cycle.

On that score the news is encouraging: national house sales rose 19 per cent in July, having slumped in the previous three months.

The Chinese Government is juggling a desire to prevent a housing bubble with the need to keep the industry going to support economic growth. Exports contracted 4.4 per cent in July and there is no reason to think global growth is going to come roaring back and provide China with an export recovery any time soon.

Most likely is a continued easing of construction and a cap on the iron ore price somewhere not far above US$60.

The market knows all this, so the question is why is it putting such a premium on BHP?

The answer appears to be that it buys the Andrew Mackenzie story of cost cutting and higher productivity.

Mackenzie has promised to continuing lowering production costs across the board and to cheaply increase production, especially at the Escondida copper mine in Chile.

Tomorrow’s catharsis, with headlines of “biggest ever loss”, will be the end of Mackenzie’s beginning. Now he and his team must deliver.

Alan Kohler is Business Editor-at-Large of The Australian and publisher of The Constant Investor.