CFO Peter Beaven
22 May 2019
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Welcome to our strategy briefing. I am Peter Beaven, BHP’s Chief Financial Officer.
BHP is well set for the near to medium term. We have a great portfolio; we believe that our commodity markets will be supportive; and we have an agenda underway that will create the next wave of productivity gains.
But the world will be a very different place in 10 to 20 years’ time.
We must be thoughtful about the possibilities – what they create in terms of risks and opportunities for us.
If we stand still, we will not be equipped to prosper in this world. It takes more than 10 years to develop an asset from first discovery to first production, let alone fully extract the value. If we are to prepare the way for the future, we must be ready to act today.
We know we must, first and foremost, extract the most from the current portfolio, and pay great cash returns in the near term.
But today I will be unashamedly discussing the long term, and how we can continue to grow sustainable shareholder value and increase cash returns.
We believe there are several foundational building blocks critical to how we think about creating long-term shareholder value.
- our strategy; and
- our capital allocation framework.
In November last year, we took you through the thinking and processes that sit behind our capital allocation framework.
So today, we will take you through our strategy and elaborate on:
- what our strategy is in order to prosper today and in the future;
- what those future worlds in 10 to 20 years’ time might look like; and
- what implications there are for us.
Like the Capital Allocation briefing, I hope this will enhance the understanding and predictability of our actions. And, of course, provide the opportunity to discuss and debate our approach with you.
As always, please note the disclaimer and its importance to this presentation.
At the most fundamental level, we seek to grow long term shareholder value and cash returns.
We also believe that creating social value is a precondition to the creation of shareholder value. We must do this well to safeguard access to capital, resources and employees, which are all fundamental to our strategy. One will not happen without the other.
Our simple portfolio of great assets in attractive commodities and stable, low-risk jurisdictions are producing excellent returns to shareholders, and have done so across many cycles. Total shareholder returns, since the merger, have averaged 14 per cent per annum (compared with 7 per cent for the S&P 500).
But the changing world – including demand sources, the supply environment, required capabilities, and societal expectations – both challenges and excites us.
At BHP, our focus is clear:
- protect the health and safety of our people and environment;
- maximise cash flow;
- maintain capital discipline; and
- increase value and returns.
To achieve this, we believe a simple and winning strategy in this industry has been, and will be, to have:
- the best culture and capabilities;
- in the best commodities;
- with the best assets;
- underpinned by a strong balance sheet and capital allocation process.
I’ll expand on those points.
We are very deliberate about the commodities we choose.
The current or potential size of the market must be large, as we are a large company. It also lessens the potential single event disruptions that can create significant volatility.
We look for favourable demand – and supply – fundamentals over the long term. We can only grow shareholder value through project options if the market demands these. If not, value is destroyed.
We like commodities where the economic rent accrues upstream near the resource – matching our operational capabilities and creating long-term competitive advantage.
Steep cost curves offer strong margins for low cost assets. There is little point in having a great asset in an industry that has a flat cost curve and allows little rent to accrue to even the lowest cost asset.
And, high cash margins through the cycle allow for low operational gearing, thereby reducing cash flow volatility.
A portfolio of diversified commodity exposures further reduces the impact of price volatility, market concentration and the risk of end use market disruption.
Over a 20-year period, when compared to a standalone portfolio of only Western Australia Iron Ore, our diversification reduces cash flow volatility by around 30 per cent.
We believe that diversified portfolios enable better capital allocation. All companies have excess capital at the tops of cycles, but single commodity companies can have less access to capital at bottoms of cycles. They are therefore more prone to being forced or tempted into investing pro-cyclically.
In an ideal world, having a range of desynchronized exposures and a strong balance sheet gives a diversified company the ability to invest counter-cyclically, and in the right project – the holy grail of value creation in our industry.
BHP is built on a core of scarce, great resources – long-life, low-cost and expandable.
Our ability to create substantial shareholder value above WACC has been built on the acquisition and subsequent timely execution of the highest quality options embedded in these assets, and the efficient operation of our production facilities.
When we have strayed from this, we have not done well.
Resource quality cannot be competed away. And it is very rare that this optionality is fully captured in initial value estimates.
Escondida and our Gulf of Mexico assets are great examples of this. Over their long lives, they have generated returns of around 25 per cent – well above the S&P index over the same period and above initial expectations.
As you can see on this chart, fully unlocking this value takes decades. And this is why we must think and act in these timeframes.
(Let me remind you, it took 13 years from the discovery of Escondida, to first production… and a further almost three decades to get to where we are today!)
So, if picking the right commodities, acquiring and executing the best options, and operating efficiently are the fundamentals of creating shareholder value… what are the key capabilities we need to create sustainable competitive advantage?
We believe these include:
- the highest standards around environment, health and safety;
- long term market intelligence – to provide foresight into market developments and opportunities;
- resource discovery and acquisition – to replenish our resources and options;
- project development and operatorship – to convert these options to value; and
- capital allocation – to maximise long term value and returns.
Our success also depends on our communities valuing our contribution. We cannot succeed without access to the best resources and people and with fair fiscal terms. And our communities provide these.
The world, and societal expectations, are changing profoundly, and we must respond to these changes – just as we must respond to changes occurring directly in our commodity markets.
Our approach to this is a big topic, so we would like to come back to you with a separate presentation on our social value strategy later this year. For today, I will focus on our portfolio response.
Our portfolio is in great shape today.
Through a series of well-timed divestments and the demerger of South32, we have simplified our business to create a focused portfolio of attractive commodities and high quality assets.
We have generated US$12 billion of productivity gains since 2015. But we know we can still generate a lot more value from our existing assets.
This is the aim of our Transformation strategy, underpinned by:
- World Class Functions, designed to simplify and remove bureaucracy.
- The BHP Operating System, which will embed standardised work and a true continuous improvement manufacturing mindset.
- And Value Chain Automation, which will automate physical tasks, and allow data analytics and machine learning to support better, faster decision making across our entire value chain.
These initiatives contain the greatest source of value for the company in the near term, by some margin.
Notwithstanding the fact that we are confident in the near and medium term, we must also be clear eyed about the fact that our current portfolio also has potential risks, which could materially impact our long-term cashflow and shareholder value. For example, our large and concentrated exposures to geographies and sectors.
But there are great new opportunities being thrown up too. So we need more options in the commodities that we think will be most attractive in the long run. Our shareholders should not miss out on acquiring a share of these new value opportunities.
Before we start to take action, we need to have a view on what the future – in 10 to 20 years’ time – might look like.
To make sense of this we use divergent, but plausible scenarios to create bookends. These are not our base or central case, but create the light and shade necessary to understand what might materially change in the future.
We all know that it is a typical human condition to extrapolate the past to the future, especially when things are going well. This may work – but it may not. We use scenarios to ensure we mitigate this natural response.
Through scenario analysis, we seek to identify:
- the biggest and most durable trends in the external environment;
- signposts to monitor these; and
- the most significant opportunities and threats to our business.
Using these possible future outcomes which are not necessarily our base case, we can stress test our portfolio for its resilience. We can also assess how well placed we are to act on opportunities. This reveals the potential gaps, and we can then form a view on where, and when, we must take action.
Our approach provides important context for the big strategic discussions around future portfolio ‘question-marks’ – such as battery materials, hydrocarbons, potash – and our desired level of exposure to geographies and sectors. 8
So, what are some of the strategic themes we use to test our portfolio?
- This slide presents some of these, which have emerged from our scenarios and hypotheses.
- Electrification of transport – considers the evolution of EVs;
- Decarbonisation of stationary power – tracks the growth in energy supply and renewable power;
- Circular economy – references a world of minimised waste, reuse, redesign and recycling;
- Biosphere – monitors an increased focus on water stewardship and food security in the context of climate change and biodiversity; and
- Licence to operate – envisages a world where developed economies restrict expansion, government intervention limits access to resources, and community attitudes become more challenging.
So overall, how do these strategic themes come together to inform our actions?
As I mentioned at the outset, there is significant uncertainty regarding exactly how the world will change, and these themes will not play out in isolation. The reality will reflect parts of all these themes, and others, and their timing is inherently uncertain.
We can, with a degree of conviction, say that adding options in copper and nickel sulphides (as opposed to laterites) are likely to be a sound investment. Demand will grow and, at the same time, new supply sources will be hard to discover and permit, and will be more expensive to develop. Grade decline is an inherent feature of the existing mines, so that just maintaining existing production capacity is a challenge.
While demand for batteries will drive lithium and, to a lesser extent, cobalt demand, we also believe that abundant supply of the former, and substitution of the latter, reduces the attractiveness of these commodities for us. 9
Steel production growth is expected to remain marginal, and increased recycling and long term slower growth in infrastructure will challenge even these low possible growth rates. Our iron ore and metallurgical coal assets, being low cost, will likely continue to offer attractive margins and returns. But cost curves are also likely to flatten compared to today, and the end markets will remain concentrated on China (although less so for metallurgical coal).
Energy demand will rise as populations grow and living standards increase.
Hydrocarbons demand is expected to be tempered by increased renewables in the energy mix. Thermal coal should remain a large market – but over time we expect it to plateau and then decline, as headwinds strengthen.
Field decline in oil will ensure that new capacity will be required, notwithstanding demand destruction due to EVs. New discovery trends are not strong. It is likely that attractive rent will continue to be available for well-placed assets.
Clearly there is a growing market for gas in the medium term. But there are abundant new supply options and a possibility that gas is bypassed as a transitional fuel to renewable energy in emerging markets in the longer term.
The world will consume more food and will demand a higher quality. Competition for land is intensifying. And mitigating historical unsustainable land and water use in certain regions will be a challenge.
Demand for potash should continue to grow in line with established historic trends. However, there is today material existing latent potash capacity. We expect this existing latent capacity will be utilised by the middle of next decade given this demand growth. This is likely to cap prices in the near term. Thereafter, new greenfields projects will be required.
So what options do we have to react to this? You may have seen this slide before – it shows some of the risk, return and optionality characteristics of a selection of our future options.
We absolutely recognise the need to balance, at all times:
- return on capital employed;
- cash returns to shareholders;
- value growth; and
- minimising underlying cash flow volatility.
It is vital, therefore, that we always have options in different quadrants of this matrix. An unbalanced portfolio overweight with long-term options will penalise near to medium-term returns to shareholders. While a portfolio with only near-term, low-risk options, will jeopardise long-term value and dividend growth.
So, assuming the projects pass the Capital Allocation Framework tests, strategically our options make sense.
- Copper via Olympic Dam expansions, Resolution, Ecuador or Oak Dam.
- Finding and developing more nickel resource in Western Australia.
- Developing oil projects in the US and greater Gulf of Mexico, and Canada.
- Investing in gas close to ullage in existing downstream LNG facilities, as it can provide a relatively quick payback.
We have options in copper and oil, but we need more. And we are interested in adding more nickel sulphide resource to our portfolio. So we should continue to add exploration options in these areas.
We do not need to do M&A. But we never discount it as a way to acquire great resource bases, especially early in the life of a project when the optionality is not necessarily fully understood or valued.
We are unlikely to add significant new capacity in iron ore or metallurgical coal beyond productivity tonnes. We should squeeze the maximum value out of the existing invested capital. 11
Our energy coal exposure is just 3 per cent of our asset base. But it is made up of two very high quality mines which generate high margins. Our focus will be on maximising value to shareholders, whether we are long term owners or not.
Jansen makes sense on a strategic level. It creates a high-margin, long-life asset, with multiple, basin-wide, expansion opportunities. But as existing excess supply capacity will only be utilised by the middle of next decade, so first production from Jansen could only arrive in that time frame. The end markets represent significant diversification from current exposures.
But this is a large investment and the first stage has to pass the risk-return hurdles in the Capital Allocation Framework. And that has not yet happened.
As always, we will be guided by our Capital Allocation Framework. It demands that investments in these projects will always be compared with cash returns to shareholders.
We will not invest in markets that do not require additional capacity. But we must be prepared to invest counter-cyclically.
We may conclude that we like the commodity and the resource characteristics, but the individual project does not pass the Capital Allocation Framework test.
So it is both our strategy and our Capital Allocation Framework that govern what we do.
So to conclude.
Our fundamental aim is to protect and sustainably grow shareholder value and cash returns, as well as social value for our communities, over the long term.
Our strategy is built on growing our exposure to highly attractive commodities and world-class assets, and continuing to develop and invest in the leading capabilities and culture in the natural resources industry.
Our strong balance sheet and capital allocation processes are key enablers of this strategy. They allow us to invest in the right projects at the right time.
BHP is well placed today, and will be for the next 10 years, due to our world-class capabilities, assets, options and strong balance sheet.
But we must think well beyond the next decade, so we can continue to grow cash returns to shareholders and be even more successful in the long term.