Breakfast With BHP

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By Greg Peel

BHP Billiton ((BHP)) CEO Marius Kloppers hosted an early morning roundtable forum for sell-side analysts in Sydney yesterday, in order to field questions on the latest developments in iron ore. (For those not up with current nomenclature, the “sell-side” is your stock brokers and their analysts while the “buy-side” is your fund managers, who also employ their own analysts.)

The analysts from Deutsche Bank, JP Morgan and Citi provided reports on the meeting this morning.

On the subject of iron ore demand – so vital to the Australian economy – Kloppers suggested first that the global economy is “not enormously buoyant”. Paradoxical strength in iron ore demand has been driven by the Chinese re-stocking phase, making underlying demand difficult to read. Local Chinese production is also down 15-20% due to the higher costs involved, forcing China into more imports. BHP does not believe much of the imported ore is going into final products. Kloppers suspects the Chinese re-stocking phase is drawing to a close, or will soon.

The good news, nevertheless, is that a counter-balancing US de-stocking phase is drawing to a close, and that re-stocking should commence in the second half of 2009. Europe, on the other hand, is lagging about six months behind the US in its economic cycle, and re-stocking is not expected until at least late 2009. Combining all three regions, Kloppers does not believe the true demand picture will become clear until 2010.

As to the planned joint venture with rival Rio Tinto ((RIO)), which sees the two companies combining their iron ore projects in Western Australia’s Pilbara region at the operational level, Kloppers does not believe the European Union anti-trust authority will object, as it had previously the proposed BHP takeover of Rio. The fact that the JV relates to nothing other than Pilbara iron ore within both companies’ extensive global suite of commodity operations, and the fact that each will still market their ore independently, and undertake any production expansions independently, should see approval granted.

[One presumes the EU authority is nevertheless aware that the record iron ore contract price increase achieved in 2008 was only made possible because BHP and Rio agreed to form a united front for the first time.]

There are, however, a couple of changes needing to be made to the original back-of-the envelope calculations provided when the JV was announced. The two figures in question are the assumed US$10bn of synergies the JV would realise, and the US$5.8bn equalisation payment BHP would make to Rio.

In the first case, total expected synergies are attributable to the handful of minority parties in the Pilbara as well. While they will have no objection to the “free ride” they will be getting on the BHP-Rio coat tails, one must “net back” their interests to arrive at an actual synergy saving of more like US$8.5bn.

The synergies in question are derived from combining operations. If one can imagine the vast expanse that is the Pilbara, further imagine that currently all mining processes are duplicated by the two rivals, right down to having to build two railway lines almost side-by-side to get the ore to Port Hedland. In fact there are several railway lines running from different areas of the region. The synergies of a combined operation are obvious. But as both companies intend to move toward a “owner-operator” model, the big losers are the various contractors who have provided such operational support to date. This is quite a change in policy for BHP, although Rio has already adopted some level of owner-operator status.

In the case of the equalisation payment, Kloppers pointed out that the US$5.8bn figure quoted is not quite right.

The “equalisation payment” comes about because Rio’s operations in the Pilbara are actually a bit larger than BHP’s. As the two wish to split the JV down the middle, the one-off payment was intended to provide an equal starting point. However, the $5.8bn overlooks the fact BHP is already expanding its ore operations in the Pilbara as we speak, through its Rapid Growth Project No.5 (RPG5). It is likely the JV arrangement will take up to a year to finalise, in which case Kloppers estimates about US$1.5bn will be knocked off the equalisation payment in that time.

Apart from EU approval and approval from our own ACCC, the JV has also to overcome problems with existing WA state agreements in order for the full amount of aforementioned synergies to be realised. In particular it will be essential to address some restrictive clauses on ore blending.

On the subject of iron ore pricing, Kloppers suggested the annual contract benchmark system is likely to continue for Japanese, Korean and European customers, but that China was another case in point. The usual routine is that Japan negotiates a price first, and then everyone dutifully falls into line. China has reached the end of its patience with such a system given it is now by far the world’s largest consumer of iron ore. Why should Japan, which (a) prefers lump ore to fines (China the opposite), and (b) is in severe recession at present, set a global price for all?

To date Japan has negotiated a 44% reduction from last year’s lump price, but only 33% for fines. Analysts had expected as much as a 60% reduction at one point, but then Chinese re-stocking has set the spot market light in recent months. The spot market is clearly a starting point for annual contract negotiations. Korea fell into line as usual, but China is holding out for a better deal.

To that end, Kloppers suggested China’s objections indicate it would now prefer to price iron ore on a spot index system.

Will such a system be better or worse for the JV? Well that simply depends on the demand cycle at the time. A spot index system will simply smooth price changes throughout the year so we no longer – at least where China is involved – have these volatile step-jumps in pricing each year. It should even out over time.

It will be, however, important for Australian GDP, assuming iron ore continues to have its significant effect on the Australian economy going forward. Consider that everyone was excited because Australia avoided a “technical” recession by posting a positive March quarter GDP following only one negative quarter, being December. Ignoring the value or otherwise of such a definition for the moment, the March quarter was based on last year’s iron ore price. The June quarter will be based on this year’s price (at least 33-44% lower), meaning there is a real possibility June will again show negative GDP growth and send everyone back into a sulk. The clue was already there in the April balance of trade number, which shocked economists by showing a deficit instead of a surplus. It was all to do with iron ore.

To sum up Kloppers’ chat, Citi offered that the mood was less pessimistic overall than recent BHP commentary, “but still hardly optimistic either”.

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