Business | Mining

Core ores

The metals crunch is forcing miners to reconsider the merits of diversification

AT THE pinnacle of the mining industry sit two Anglo-Australian companies, BHP Billiton and Rio Tinto, which are to iron ore what Saudi Arabia is to oil: the ones who call the shots. Their mines in Pilbara, Western Australia, are vast cash cows; with all-in costs below $30 a tonne, they still generate substantial profits even though prices have slumped from $192 a tonne in 2011 to about $44. They have increased iron-ore production despite slowing demand from China, driving higher-cost producers to the wall—an echo of the Saudis’ strategy in the oil market.

But whereas Rio Tinto has doubled down on iron ore, BHP also invested in oil and gas—in which it has nothing like the same heft—at the height of the shale boom. Their differing strategies are a good test of the merits of diversification.

The China-led commodities supercycle encouraged mission creep. Many companies looked for more ways to play the China boom, and rising prices of all raw materials gave them an excuse to cling on to even those projects that were high-cost and low-quality. Now the industry is plagued with debts and oversupply.

On February 16th Anglo American, a South African firm that was once the dominant force in mining, said it would sell $3 billion of assets to help pay down debt, eventually exiting the coal and iron-ore businesses that it had spent a fortune developing. That would leave it with a core business of just copper, diamonds and platinum. The day before, Freeport-McMoRan, the world’s largest listed copper producer, was forced to sell a $1 billion stake in an Arizonan copper mine to Sumitomo of Japan, to help cut debts racked up when it expanded into oil and gas. With Carl Icahn, an American activist investor, agitating for a shake-up, analysts say its energy assets could follow—if there are any buyers.

When BHP reports half-yearly results on February 23rd its misadventure in American oil and gas will be of particular concern because it has put the world’s biggest mining firm in the shadow of Rio for the first time. Since BHP merged with Billiton in 2001, its share price has outperformed Rio’s (see chart); it made an unsuccessful bid to merge with its rival in 2007. Yet in the past year its shares have done worse. Analysts expect that next week it will cut its annual dividend for the first time since 2001, thereby breaking a promise to raise the dividend year by year. Though Rio ended a similar “progressive dividend” policy this month, it did not cut the 2015 payout.

BHP’s dividend yield began to soar relative to Rio’s in late 2014 so a payout cut should not be a surprise. But shareholders, especially those in income funds that depend on mining-industry returns, will be kicking themselves. They could have diversified their own portfolios, putting more money into oil majors like Exxon Mobil, whose payout is considered more secure, rather than have BHP expose itself to oil and gas on their behalf.

Paul Gait of Sanford C. Bernstein, a research firm, says that because of BHP’s weak position in oil, it is suffering from the same cost pressures that it is inflicting on its competitors in iron ore. He calls it “nemesis to their hubris. They are in oil what they are attempting to destroy in iron ore.”

BHP argues that its strategy enhanced shareholder returns during the good times, and that no one expected oil and metals prices to collapse with such synchronicity. It says its business mix is no stranger than that of an oil company like Exxon Mobil, which is into the refining and marketing of oil products as well as the exploration and production of crude. Its underperformance against Rio has also been the result of a mining accident in Brazil in November. Rating agencies worry that a big fine could put further strain on its balance-sheet. “We just have to be patient. Cycles are an inherent part of the business,” an executive says.

BHP’s long-held belief is that by strengthening its oil and copper businesses it enjoys a longer cycle than if it were more exposed to iron ore and coal. In China, for example, demand for steel, and thus for iron ore and coking coal, has been central to the country’s building boom. But as it grows richer, it will need more copper for electric cables, and petrol for its growing fleet of cars.

Such arguments were more compelling when Chinese growth seemed unstoppable. But Konrad von Szczepanski of the Boston Consulting Group says the downward leg of the supercycle has eroded the case for diversification, pushing firms to reconsider strategies last used in the 1990s: focusing on single commodities in which they have the cheapest, best-quality ores.

Whatever they do, mining companies will now be required to demonstrate that the assets they have are high quality and capable of generating cash even in hard times. The trouble is that as they attempt to focus, as Anglo American is doing, there is no guarantee they will be able to sell their non-core assets for a high price. Acquirers, as one analyst puts it, only want the family silver, not the dross.

This article appeared in the Business section of the print edition under the headline "Core ores"

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