BHP Billiton: What’s Next For The World’s Largest Miner?

Last week, the world’s largest listed diversified miner, BHP Billiton announced that it will take a $4.9 billion post-tax, $7.2 billion pre-tax, exceptional impairment against its US onshore hydrocarbon assets. After this write-down, the value of these assets will fall to $12 billion after a deferred tax liability, down from $21 billion pre-tax in June.

In addition to the impairment, BHP has cut the number of US onshore rigs it is operating from 7 to 5 (down from 10 mid-2015). The impact of the lower rig count will reduce the group’s onshore US production to 110MMboe for 2016 (down 3MMboe) and 98MMboe for 2017.

Citigroup estimates that these moves will save the company around $100 million in capex during 2016. US onshore capex is now set to fall to $1.3 billion for FY 2016, and then again to $1.1 billion for FY 2017. And based on these figures, Citigroup believes that BHP’s US onshore operations to generate cash of almost $500 million for FY 2017, after burning $200 million in FY 2016 and $900 million. However, these figures assume higher oil prices by 2017. At spot, onshore assets would have a cash burn of $100 million in FY 2017.

Low oil prices have forced BHP to take these drastic actions. Unfortunately, the consensus among Wall Street analysts is that this is just the beginning of a multi-year crisis for the miner.

If 2015 Was Terrible For The Mining Sector, 2016 Could Be The Dagger

BHP: Facing a perfect storm

The company is facing a ‘perfect storm’ of events. Built around a ‘four pillars’ strategy, BHP produces four key commodities, copper, oil, coal and iron ore. By using this approach, it was assumed that BHP would always be able to find growth somewhere. Management also assumed it unlikely that all four commodity prices would fall to record lows at the same time. Over the past year, these assumptions clearly haven’t held, and now BHP’s diversification strategy lies in ruins.

Barclays believes that BHP will generate virtually no earnings this year, based on the bank’s base case price estimates for key commodities (copper $1.98/lb, iron ore $43/t, thermal coal $50/t and Brent oil $48/bbl). At spot prices, BHP’s earnings and free cash flow are likely to be negative, which implies that a dividend cut (current yield of 9.8% in London), as well as further capex cuts, are now likely. A dividend cut of 50% is now inevitable, assuming spot prices hold. (Spot FCF generation has fallen from +$5.8 billion at the start of the year to -$1.1 billion currently, a $6.9 billion swing, outweighing the current dividend payment of $6.4 billion.)

But things are now getting so bad for the miner than even a 50% dividend cut won’t be enough to offset commodity price declines. Barclays estimates that even after cutting its payout by 50% (current cost $6.6 billion per annum), management would still need to cut capex and opex by $3.9 billion in FY 2016 and $1.2 billion in FY 2017 to avoid increasing leverage.

If spot prices persist, Barclays estimates the company’s dividend shortfall will increase to $4.4 billion, $3.0 billion and $1.9 billion in FY 2016-18 respectively.

Dividend vs. growth

If management remains set on its dividend commitment, Barclays estimates BHP would be forced to gear up by $7.7 billion in FY 2016 and $6.3 billion in FY 2017. That is equivalent to almost the entire capex bill of the company, or 28% and 27% of combined capex and opex in FY 2016-17, respectively. Credit Suisse’s analysts are expecting BHP’s net debt to fall by $200 million during 2016 to $25.3 billion. A further reduction in debt to $24.5 billion is predicted for 2017. Although, it should be noted that Credit Suisse’s outlook for commodity prices is vastly more optimistic than Barclays’ above (FY 2016: copper $2.23/lb, iron ore $54/t, thermal coal $78/t and Brent oil $42/bbl).

The only way for the company to protect its dividend, and keep gearing under control would be to cut capex to $3.5 billion (down from $8bn for FY 2016), an extreme scenario BHP’s CEO hinted at last year. This strategy would provide an extra $5 billion of cash in FY 2016 and $3.5 billion in FY 2017. However, that would entail moving the US onshore business into run-off, abandoning all exploration and early-stage activity. Such drastic action is almost certain to impact BHP’s long-term growth and net asset value.

The bottom line

Overall, it looks as if BHP is stuck between and rock and a hard place. Consensus suggests that the company will be forced to choose between its dividend payout and capex this year. Cutting capex to the bones will hit long-term growth while cutting the dividend will hurt income seeking shareholders. Unless commodity prices snap back to more attractive levels, BHP’s management is going to have to make some difficult choices this year.