Rio and BHP shareholders should enjoy the cash deluge while it lasts

Rio Tinto and BHP shareholders are about to be awash in cash, again but the two big diversified miners will be looking beyond the current iron ore price that is flooding them with that cash towards the more threatening future moving rapidly towards them.

With an iron ore price holding above $US200 a tonne the companies are generating cash well beyond their internal requirements, with the capital allocation policies they adopted after the last commodities supercycle ended almost dictating that they return that surplus cash to shareholders.

The iron ore bonanza that has spurred on BHP and Rio is under threat.Credit:Louie Douvis

BHP’s Mike Henry and Rio’s Jakob Stausholm are, however, well aware that the prosperity being driven by the surge in iron ore prices is likely to be threatened before the end of this decade.

Brazil’s Vale will eventually gets its act together and add substantial new volumes of high-quality and low-cost ore to the market and China’s determination to reduce its steel industry’s reliance on Australia will accelerate the development of new resources in Africa. Both BHP and Rio believe the giant Simandou deposit in Guinea (in which Rio has an interest) will be developed by China by 2030.

Beyond this decade the steel-intensity of China’s economy will start to fall and its recycling of scrap will become a bigger source of its supply.

For the Australian miners, while their low costs and high-quality ore will ensure they have a continuing large and highly profitable presence in the market, peak iron ore and lower prices and profits are on the horizon.That’s a particularly acute issue for Rio, where iron ore dominates its earnings base. For BHP, it adds to the challenge of repositioning the company for a lower carbon future.

BHP is exiting thermal coal – its Mt Arthur mine in NSW is its last significant asset – and is trying to sell its lower-grade coking coal assets within the BMC joint venture with Mitsui in Queensland. Its metallurgical coal business supplies the steel industry and, with about 40 per cent of the seaborne market, remains a key part of the BHP portfolio.

Recent reports that BHP is mulling an exit from petroleum aren’t surprising, given that BHP has been regularly but quietly reviewing petroleum’s place in the portfolio for decades. It sacked a respected head of the division, John O’Connor, in 2006 when he publicly advocated its demerger but the fit of the business within BHP has been continuously debated internally and externally.

The debate has been given a sharper focus by decarbonisation and the seeming inevitability of a decline in the demand for oil and gas over the next couple of decades, albeit that demand should remain strong for at least another decade and prices should be held up by the lack of investment in new resources.

While BHP does have a number of big new projects, in which it has invested heavily, that will come online over the next couple of years, it would be very aware that petroleum will increasingly bring with it black marks from ESG investors; that it does have a limited future and, while it is high-margin, it generates relatively low returns on capital.

The commodities that BHP and Rio are looking at to offset the probable declines in the profitability of their core iron ore businesses in the next decade aren’t likely to be as high-margin as the earnings they will replace.

It’s also arguable that where petroleum once provided diversification and reduced the volatility in BHP’s cashflows, the new “financialised” commodity world, where oil is an investment assets as well as a physical commodity, means that its price is now more correlated with other commodities and its role as a diversifier has been diminished.

There are “vulture” funds looking to acquire petroleum assets offloaded by the major companies — “Big Oil” has sold the best part of $US30 billion of assets in the past three years and is looking to offload a similar amount over the next few years – or BHP could demerge a business valued at up to $US15 billion in an environment where OPEC appears to have finally regained some semblance of control over the supply-demand equation and prices.

The cloud over iron ore and, in BHP’s case, the question marks over the future of its more carbon-intensive businesses, means the BHP and Rio boards and managements will be devoting considerable time and effort to thinking about the nature of their future portfolios and how they might use the windfall profits from iron ore today to secure their futures.

They both provided a small insight into their thinking this week, with BHP’s announcement on Tuesday that it had gate-crashed Fortescue’s bid for Canadian nickel hopeful, Noront, with a target board-endorsed $C325 million ($350 million) bid for its own and Rio’s announcement on Wednesday that it had committed the $US2.4 billion of funding for its proposed Jadar lithium project in Serbia.

BHP and Rio will face pressure as the steel-intensity of China’s economy starts to fall and its recycling of scrap becomes a bigger source of its supply.Credit:Bloomberg

Noront’s Eagle’s Nest nickel-copper-platinum and palladium deposits are regarded as the most exciting new nickel find in Canada since the discovery of Voisey Bay in the early 1990s.
BHP’s recent nickel supply agreement with Tesla from its Nickel West business in Western Australia underscored BHP’s view that nickel, a metal it wanted to get rid of not that long ago, is now seen as a key commodity given its importance in a less carbon-intensive future. The bid for Noront, if successful, could give BHP a big new nickel asset and a material presence in a highly-prospective region of Canada.

Similarly Rio’s Jadar project would give it one of the world’s largest new lithium projects in an environment where, like nickel, lithium stands to benefit greatly from decarbonisation and the demand for lithium-ion batteries in particular. Jadar’s hurdle is to gain Serbian government and community support and approvals.

Both BHP and Rio have also stepped up their efforts to add more copper – perhaps the metal that will benefit most from climate change – to their portfolios, with BHP looking to farm-into exploration and buy into early-stage developments, mainly in South America while eventually) expanding local production from Its Olympic Dam project and, perhaps, its Oak Dam prospect south of Olympic Dam.

BHP’s other “future-facing” project is its giant Jansen potash project in Canada, which is likely to get a go ahead from the board within the next few months.

The commodities that BHP and Rio are looking at to offset the probable declines in the profitability of their core iron ore businesses in the next decade aren’t likely to be as high-margin as the earnings they will replace.

New copper projects of the scale that would make a difference to BHP and Rio are particularly hard to find, expensive to develop and tend to be in riskier jurisdictions than BHP or Rio have traditionally operated but do offer growth as the world responds to climate change in a sector where the size of the two big miners’ balance sheets and their experience with large projects provides competitive advantage.

In the near term, as they continue to try to reposition their portfolios, shareholders are likely to continue to be deluged with the cash being generated by their iron ore businesses.

The golden period for their shareholders of the past few years is probably, however, one whose largesse will dwindle as the confluence of favourable factors underpinning the current prices unwinds over the next few years. Shareholders should enjoy it while it lasts.

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