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Commodity price forecasts: Optimism & pessimism

Groups such as ABARE are bullish on the immediate prospects for commodity prices on the basis of a continuing Asian recovery.  I have no idea if this perspective is accurate but equity markets obviously don’t think it is.  BHP-Billiton shares at around $46 are selling at about 10X projected 2012 earnings while Rio Tinto at $87 are selling at about 8X earnings.  Or is it all due to fears of a revamped mining tax?  Puzzled.

Update: A third option is that shareholders fear that these firms will waste tens of billions of dollars on a stupid takeover move.  Both companies have a history of doing just this as Terry McCrann points out in today’s Australian.  I was a strong opponent of the BHP-Billiton merger when it occurred – all the benefits went to Billiton and it is currently, as McCrann points out, delivering almost nothing to BHP-Billiton’s bottom line – the $100b of equity that BHP gave away is earning almost nothing today.  The Rio move on Alcan was also dumb but the cost was $40b which does not impose a permanent equity dilution on its shareholders.  I saved the whole McCrann article over the fold. Great reading.

(By Terry McCrann) “THE two biggest takeovers in Australian corporate history have both turned out to be disastrous duds.

Interestingly and instructively, they share three features. They were both driven by their company’s chairman, not the CEO. They were both exercises in “gigantism”. And they were both in aluminium.

Astonishingly, the assets for which the-then BHP gave away equity that is worth more than $100 billion today, in its takeover of the South African Billiton group in 2000, generated almost zero profit in the latest December half. And with precious little prospect of making anything much anytime soon.

This was implicitly conceded by BHP Billiton CEO Marius Kloppers in the group’s future investment commitments. In supreme irony, as he was “bought” by the old BHP along with Billiton, Kloppers is not making the same mistake twice of sending good BHP money after bad Billiton operations.

If the takeover had never taken place, a BHP share would arguably be trading at $80, not $46. And we would not have been reading about leaked conversations of a BHP Billiton CEO named Kloppers. Rio Tinto’s $40bn takeover of the Canadian Alcan group is a more obvious disaster. It’s more recent, it took Rio to the brink in the global financial meltdown, and it was real cash money. In contrast, Billiton has all but disappeared in time and the fabulous profits courtesy of China.

The use of cash by Rio to buy Alcan is actually one of the two features that make it less of a disaster than Billiton. Rio overpaid for Alcan. But in paying cash, it’s suffered a one-off loss.

In contrast, Billiton is forever. The shares issued to buy it are a permanent dilution unless and until bought back. At a price. Former Billiton shareholders get to share in BHP’s bounty forever.

The other distinguishing feature that favours Rio is that the assets it bought are in Canada, and they include permanent and permanently cheap hydro power. As Kloppers likes to say, in a carbon-constrained world that’s a huge plus. Indeed, it’s already helping Rio. In its full 2010 calendar year, its aluminium division generated $773 million of net earnings (after tax and interest). BHP Billiton’s aluminium division made just $17m before interest and tax in its December half.

True, Rio’s aluminium division is much bigger in both relative and absolute terms. That sub-$1bn profit was earned on $15bn of revenue, a quarter of group revenue of $60bn.

In contrast, BHP Billiton’s aluminium division had sales of only $2.3bn in the half, or just 7 per cent of group revenue of $34bn.

Rio earned nearly $13bn from the remaining $45bn of revenue from everything else. The main component of that “everything else” was of course iron ore. Some $24bn of revenue generated $10bn of profit. The rest — copper, energy coal and uranium and a few other bits and pieces — sat in between. Some $21bn of revenue and $3bn of profit.

Now BHP bought essentially two things with Billiton: aluminium and energy coal in southern Africa. In the latest half these two divisions generated just $351m of EBIT combined on revenue of $5bn. The old Billiton component of this was even worse as these two divisions also include the old BHP Australian energy coal and aluminium operations, which from the comments in the interim report clearly did better than the southern African ones.

In short, the old Billiton assets made zero or close to zero profit.

The rest of BHP Billiton — essentially the old BHP, petroleum, copper, coking coal and of course iron ore — generated nearly $14.5bn of EBIT on $29bn of revenue, an EBIT margin of a staggering 50c in the revenue dollar. Not even Telstra at its monopolistic peak made that.

So why is aluminium doing so badly? Why is it the commodity that time and the China-driven resources boom forgot?

Two reasons primarily. Although it’s worth noting that it wasn’t entirely overlooked. Both BHP Billiton and Rio reported significant price increases for both aluminium metal and alumina.

First, aluminium is perhaps the last “social metal”, where sub-economic production is maintained, especially in China.

That’s the second big thing; aluminium takes BHP Billiton and Rio out of resource extraction into the (very expensive) metal manufacturing business. It would be like BHP Billiton’s petroleum division buying oil refineries.

And this is precisely what made the Billiton buy so much worse. Its main aluminium business was the metal; BHP’s had been alumina. And, unlike Rio, Billiton did not have its own hydro power.

Energy coal is a more complex and interesting issue. It should also be riding the China boom and China’s huge expansion in coal-fired power generation. And to some extent it has. Prices have risen sharply. But not like coking coal.

Of the $80bn in likely capital spending, BHP Billiton has detailed for the next four years, only a tiny sliver of perhaps $4bn will go on aluminium. And that’s primarily to complete committed projects and of the sustaining production sort.

An only slightly bigger sliver of $5bn will go on energy coal in Kloppers’ “carbon-constrained world”. The biggest slice of the spend will be in iron ore, followed by petroleum, base metals and coking coal: all BHP businesses.

The slide in the presentation of BHP Billiton’s great tier-one resources assets was instructive in omission. Olympic Dam, the Pilbara and Bowen Basin coal were listed for Australia, along with Saskatchewan potash — a barbed warning to former target Potash Corp? — in North, and Escondida in South, America. Absent was any reference to Africa and thus the old Billiton”.

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