COLUMN-Reliance on cost-cutting the real BHP story: Clyde Russell

Wed Aug 20, 2014 2:22am EDT

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Clyde Russell is a Reuters columnist. The views expressed are his own.

By Clyde Russell

LAUNCESTON, Australia, Aug 20 (Reuters) - BHP Billiton's plans to spin-off unwanted assets may have received a tepid welcome from investors, but the real news from the mining giant's results is the limits to cost-cutting.

Delving into BHP's results presentation on Tuesday shows the company has been successful in cutting expenses, with a 12 percent cut in cash costs at the flagship Western Australian iron ore operations, while the Queensland coal business recorded a 24 percent drop.

BHP said its productivity-led volume and cost efficiencies were $2.9 billion in the year to end June 2014, beating its target by $1.1 billion.

Given the company's net income for the period was $13.4 billion, the $2.9 billion in savings represents about 22 percent of the profit, which certainly looks impressive.

The problem comes when you start to look at the savings achieved, the potential for further cost-cutting and the likely trajectory of commodity prices.

BHP said it produced a record 225 million tonnes of iron ore in the 2014 financial year, which resulted in revenue of just under $23 billion, or roughly 34 percent of the group's total revenue.

The miner said it achieved a realised iron ore price of $103 a tonne for the year, which was 6 percent below the prior financial year.

However, Asian spot iron ore .IO62-CNI=SI prices have fallen 31 percent this year to $93 a tonne on Tuesday, and the consensus is that they will remain below $100 for the foreseeable future as big miners such as BHP, Anglo-Australian rival Rio Tinto and Brazil's Vale ramp up output even as Chinese demand growth weakens.

Put another way, a tonne of iron ore is currently $41.20 a tonne less than it was at the start of the year, while BHP's cost cutting resulted in a saving of about $3.53 a tonne over the year to end June.

BHP's presentation also provides a useful calculator of the impact of price changes in commodities on its expected profit for the year to end June 2015.

Every $1 drop in the price of iron ore wipes $135 million off net profit after tax.

The company plans to increase iron ore output to 245 million tonnes in the 2015 year, a gain of 20 million tonnes.

But the extra revenue generated from this output boost seems likely to be overshadowed by the lower profits from a weaker iron ore price.

If BHP achieves a selling price of $96 per tonne for iron ore in the current financial year, which is the consensus forecast price for 2015 in a Reuters poll of analysts, this means a drop of $7 a tonne from the 2014 financial year.

This translates to a loss of $945 million in net profit after tax in the 2015 financial year, and this is just for the iron ore division.

DIMINISHING RETURNS FROM OUTPUT BOOST?

Looking at revenue, the 225 million tonnes of iron ore produced in the 2014 financial year yielded $23.175 billion, using BHP's realised price of $103 a tonne.

If 2015 output is 245 million tonnes, and the realised price is $96 a tonne, it will result in $23.52 billion in revenue, a gain of just $345 million on the prior year.

In this case, iron ore risks becoming another coal, where miners pursue output gains in order to lower costs, but in the end the resulting supply surplus just depresses prices even more, resulting in a no-win situation for producers.

It's not just iron ore. If the price of crude oil drops by $1 a barrel, BHP's profit goes down by $50 million. For copper a decline of 1 U.S. cent per pound knocks off $30 million, and in metallurgical coal a fall of $1 per tonne means $30 million lower profit.

Of course, the opposite is true insofar as profits will rise by the same amounts assuming that commodity prices increase.

But while there may be some recovery in iron ore, coal and copper prices, the risks are that on average they will be much the same to weaker in the 12 months to end June 2015 compared to the same period a year earlier.

This means that BHP will only be able to boost profits by cutting costs further, and by limiting capital expenditure.

Both of these are possible, even likely, but the question has to be can BHP, and its rivals, cut costs as fast as commodity prices have fallen?

The Australian-listed shares of both BHP and Rio Tinto have diverged this year from iron ore, after years of fairly close correlation. (See graphic) [link.reuters.com/few62w ]

BHP's share price is up 4.2 percent from the end of last year to Tuesday's close, while Rio Tinto's is down by 3.5 percent.

This means they have both significantly outperformed the 31 percent drop in iron ore, and perhaps much of the credit for that can be attributed to their cost-cutting and capital spending reductions.

But both are now in their longest period of divergence from the iron ore price since the Asian spot iron ore index was launched in 2008.

For this divergence to persist the lower cost-structure for the miners would have to be sustained, and that may prove to be a bridge too far for both BHP and Rio.

Disclosure: At the time of publication Clyde Russell owned shares in BHP Billiton and Rio Tinto as an investor in a fund. (Editing by Richard Pullin)

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