Commodity prices are falling across BHP Billiton's (NYSE:BHP) key markets, largely due to slowing demand from China. The price decline has contributed to a 15 percent fall in earnings this year. In response to the changing market dynamics, the world's largest energy company is proving to be very nimble. BHP is wasting no time shedding assets and refocusing on high margin businesses.
BHP is busy with asset sales as part of its efforts to steer its focus to high margin businesses. This means aluminum is being moved off the balance sheet while investments continue to be made in coking coal and iron ore - raw materials for China's steel production. BHP fed as much as 80 percent of its production into this market.
The risk of this strategy is that BHP is sharpening its focus on China's future raw materials demands. Non-core feasibility studies, exploration and projects are being put aside. Over the next decade, the company expects 7 to 8 percent growth from China. Over the same period, annual steel demand is forecasted to grow from one billion tons from 700 million. It seems to be the logical place for BHP to be. If and when China's steel demand slows, will a less diversified BHP be able to find new revenue streams fast enough?
Coming off a decade of record commodity prices, BHP along with other mining companies are now under the spotlight as they need to show if they have the operational strength to manage in a low commodity price environment. For now, China no longer needs as much steel for construction, autos and energy infrastructure. BHP is positioning itself for future growth in this market by investing in the coking coal and iron ore production that feeds the steel industry.
Several projects have been put in limbo by the decline in commodity prices. The company is hedging on its plans to build an 8 million ton potash mine at Jansen, Saskatchewan. BMO recently issued a report stating that due to overcapacity Jansen's capacity will not be in demand for another 10 years. The blocking by the Canadian government of its 2010 bid to takeover Saskatchewan's Potash Corp may have been good fortune. Potash prices and potash producer margins are falling. In October, BPH sold its 50 percent stake in a Guinea-based aluminum project to Global Alumina.
Another property in limbo is the Pinto Valley copper mine in Arizona, in which BHP has invested $195 million, although it is investing in its Escondida copper mine. The company is not holding onto non- or dismal performing assets but rather is taking measures to retain its industry enviable operating margins in the 32 percent range. Its debt-to-equity ratio is .43, below the industry average. All miners are facing escalating costs. BHP is trimming down so as not to be caught off guard by shifting demand and prices as has just happened to Barrick Gold (NYSE:ABX). Unable to contain costs, the gold producers earnings have taken a hit for four consecutive quarters.
Even in its core businesses, BHP is cutting back and staying closer to home. In iron-ore, BHP has slowed down exploration in West Africa and is instead focusing on Australia and Brazil. The world's largest iron ore producer Vale (NYSE:VALE) has put its Zagota project in New Guinea on hold. Rio Tinto (NYSE:RIO) has stayed in West Africa. It expects Simandou, a joint venture with Aluminum Corp of China, to start producing in mid-2015. The $10 billion project is expected to produce 95 million metric tons of iron ore before 2016. The biggest risk here for BHP is getting caught short on production when China's appetite for iron ore increases again.
The decline in commodity prices is forcing BHP, along with other producers, to cut costs. BHP is taking some innovative measures to reduce labor costs. One of its labor-cost savings measures is a fleet of robot trucks at its Pilbara mine. Competitor Rio Tinto is already using them. BHP is cutting office staff at its nickel operations in Australia and reducing production at its Mount Keith operations. Labor strife in its Queensland operations has ended with a three-year agreement aimed at producing some longer-term stability in labor relations. Another important cost savings front is materials.
While its cut back in productive assets is substantial, BHP is investing in expansion of its core businesses, which should give it room to respond to sudden increases in demand. Demand for coal started to bounce back in September. Its BHP Billiton Mitsubishi Alliance (NYSE:BMA) in Queensland increased to 80 percent of supply chain capacity. BHP plans to expand production at its Queensland facility by 50 percent to 66 million metric tons.
New production next year will also come from Duania, which is expected to produce 4.5 million tons a year. Two new projects include the Caval Ridge in Queensland, at a cost of $1.87 billion and the Appin area 9 project in New South Wales at $845 million. The projects will begin production in 2014 and 2016, respectively. A number of other projects and expansions with Mitsubishi have been shelved, and the Norwich Park and Gregory open-cut mine shut. Although it will expand production at its Broadview mine, another joint venture with Mitsubishi.
A more nimble BHP will be better prepared to deal with more swings in demand ahead. Iron ore prices have rebounded from a three-year low of $87 in September, falling from an average of $150 per ton in 2011. In response BHP cut back on annual iron ore production by 150 million tons with a revision to 220 million tons, down from an initial forecast of 440 million tons. At production costs of around $40 a ton, BHP has a wide margin even at low prices.
BHP Billiton has maintained good profit margins at 21 percent. Even with the earnings hit, BHP has shown that it did not get spoiled during the commodity price boom but can still manage effectively in a low price environment.