Can BHP prevent history, its own and its peers', repeating itself? It’s going to try.
The miner's chief financial officer, Peter Beaven, gave a detailed briefing to investors on the group’s capital allocation process on Wednesday in which he tried to explain why next time things will be different.
Capital allocation has been a major and pointed topic in the sector in the past few years as the legacies of the big pro-cycle investments during the China-inspired post-crisis boom in resources resulted in torrents of red ink for miners as the boom deflated.
BHP chief financial officer Peter Beaven explains the lessons learned from its US shale debacle.Credit:Wayne Taylor
In BHP’s case, while it didn’t proceed with some of the biggest bubbles on its famous "bubble charts’’ – the $US20 billion-plus Outer Harbour and Olympic Dam open pit projects – it was the disastrous and value-shredding incursion into the shale oil sector in the US that forced both management changes and a rethinking of its approach to managing capital.
Bevan’s description of what went wrong in shale and the lessons learned provides a context for the new framework.
Shale has a fast payback and so the mid-point internal rates of return thrown up by conventional analysis said BHP should invest aggressively.
Shale is, however, also capital-intensive and the value generated relative to the investment dollars is weak. "All-in" costs are high so cash margins are thin and there is little optionality in what are short-life assets.
"So you have one shot at making money. If the near term cycle goes against your expectations you can easily lose value,’’ Beaven said.
The experience taught BHP that it had to assess both risks and returns, actively manage the risk and think beyond simple hurdle rates for investment.
The losses from the near $US1 trillion of investment made by resource companies at the top of the commodity cycle, including BHP’s shale misadventures, fit within the sector’s historical pattern.
Within the long cycles that characterise the sector, the miners hunker down in the downturns, conserving cash and capital. That constrains new supply and eventually prices respond, triggering an escalating wave of investment that eventually leads to over-supply and another downturn.
The long lead times and the scale of the investment required means the cycles are prolonged, with gulfs between the troughs and peaks and lots of volatility throughout the cycles.
Timing resource investments perfectly is, as history demonstrates, near-impossible and the temptation to grab the quick paybacks on investments available in a boom period is hard to resist.
BHP paid a hefty price for its foray into US shale.Credit:Alan Baxter
The BHP approach is to try to incorporate more discipline, rigour and a longer term and more sophisticated framework into its processes for allocating capital while recognising that the depleting nature of its resource base means it has to continually invest large amounts of capital through the cycle; ideally counter-cyclically because that’s where value is maximised.
The starting point for its framework is that its balance sheet has to be strong at the bottom of a cycle, both to protect against lower prices and cash flows but also to give it the capacity to invest through the cycle and take advantage of any opportunities that arise. A strong balance sheet also lowers its cost of capital and provides competitive advantage.
BHP has separated the various functions that assess investment proposals, a process that now starts with long-term market and scenario analyses and the evaluation and stress-testing of its existing portfolio.
The group’s assets and business development team develops options for investment that a separate team assesses against its capital prioritisation framework. All decisions are tested for their balance sheet impacts and against returning capital to shareholders.
The proposed investments are also risk-adjusted, rather than relying on simple hurdle rates of return. Bevan’s favourites, obviously, are low-risk and high-return projects and his least favoured are high-risk and low-return projects.
The tricky ones are the high-risk but high-return options with high optionality for future investments and lower-risk and lower-returning projects.
The Jansen potash project in Canada is the example Beaven provided of the latter. It’s a big investment but could be the sector’s lowest-cost producer, with a multi-decade resource base and the potential/optionality for future capital-efficient expansions.
Its scale, however, could also have a material impact on the market – it could create oversupply and lower prices – hence BHP is moving slowly and cautiously and may try to introduce a partner to reduce the risk.
Having a balanced portfolio of commodities and options which has the appropriate and optimum mix of risks and returns to generate strong project and shareholder returns through cycles is the objective, albeit one more easily stated than delivered.
Beaven described the change in BHP’s mindset in funds management terms. During the boom period it was a "growth’’ investor. Now it is a "value’’ investor, or, in the industry’s parlance, it has elevated value over volume.
Whether it can maintain that mindset through a boom period of the cycle, when its peers begin opportunistically chasing volume growth and a leveraged exposure to high prices – and are taking market share - will be the real test of BHP’s new capital allocation disciplines.
Its own history and that of its peers would suggest it won’t be easy to retain those disciplines in the boom-time environment that the resource-sector cycles will inevitably re-produce, albeit perhaps not quite with the intensity of its last peak moments.