BHP's divestment of its non-core metallurgical coal assets in the Blackwater and Daunia mines has captured the market's attention, as the process ostensibly draws to a conclusion.
The rationale behind the divestment is sound given the asset-specific challenges as well as the broader industry headwinds for the metallurgical coal markets are anticipated to experience as a whole. This poses an interesting conundrum for potential bidders, with the evident risks counterbalanced by the potential upside as a result of sudden, unexpected externalities that could affect market supply; as we saw in thermal coal markets following the Russian invasion of Ukraine.
TailwindsThe metallurgical markets are experiencing headwinds with steel demand softening as a result of diminishing and more focused monetary and fiscal stimulus on a global basis. Governments are no longer investing as aggressively into 'nation building' infrastructure projects as we have seen over the past 3 years; instead taking a more focused approach with an emphasis on encouraging uptake of renewals as best evidenced by the Inflation Reduction Act in the US. It is likely that steel production will gradually transition over time towards the greater adoption of 'coal-free' steel production technologies such as Electric Arc Furnaces (EAF) over the present conventional Blast Furnaces.
Meanwhile, China which produces and consumes the lion's share of steel, and by proxy metallurgical coal; is experiencing a rapidly cooling housing market. Despite strong government incentives to lend into the housing market, our analysis concludes that there has been a considerable fall in consumer appetite for housing as an investment class as well as a reduction in bank appetite to lend for investment in housing as an asset class. We anticipate that this in turn will lead to a fall in new starts, potentially further softening steel demand.
Post-Covid, government intervention over immovable assets, such as natural resources, has been increasing. A large proportion of global metallurgical coal production is produced in Queensland, and the state government's enormous rise in royalties against election promises represents an unquantifiable risk going forward; so much so, that the Japanese government has disclosed they do not view Queensland as an investable jurisdiction.
The rise in Queensland's royalty rate has lifted the cost curve for these producers with industry experts expecting the 90th percentile cost curve for premium coking coal to be circa AUD$250/t on an all-in basis. We anticipate that this will depress the returns of mines that are able to produce lower-quality metallurgical coals such as semi-soft coking and PCI coals.
Portfolio assessmentBlackwater and Daunia are the lowest-quality metallurgical coal assets within the BHP portfolio; producing a blend of lower-quality coking coal products that are sold at a discount to the premium PLV coal index. The sale of these assets will vastly improve BHP's residual portfolio of metallurgical coal assets, and we believe would be an enormous value accretive process, over and above the notional sale value.
Blackwater is a longer-life asset with a highly automated, high-cost profile making it a difficult operational proposition for any potential acquirer. Daunia is a difficult deposit geologically and has the additional challenge of a relatively short mine life.
BHP's desire to sell these assets does not negative the strategic value of these assets. From media accounts, the sale process has been hotly contested to date; with a range of ASX-listed companies and foreign entities reportedly expressing strong interest. This is to be expected given the deficit of investable, producing metallurgical coal assets available for sale. However, bidders do have challenges in terms of putting together an acceptable offer given the limited appetite for bank financing in the sector as well as the present, very modest valuation of listed coal players.
For instance, a listed player who is trading at 2-3x trailing cashflows would be hard-pressed to acquire these assets for more than their present valuation multiple; given it would be a value-destructive exercise for their existing shareholders.
This is coupled with the fact that BHP, as a good corporate citizen, would likely want these assets in the hands of a responsible steward with a demonstrable track record; as well as alleviating concerns of future potential liabilities. This diminishes the pool of potential buyers considerably, not taking into consideration the opinions of the 3 levels of government that overlay these assets.
BHP as one of the pre-eminent mining company exposures globally, has a strong mandate to enact ESG best practices. These assets, by their very nature in terms of the products produced, are at odds with this objective.
We consider more onerous enactment of ESG factors to be a material negative externality and risk going forward for mining companies. It is impractical for any acquirer to ignore this potential existential risk, and that accordingly will be factored into any transaction price by a bidder.
Ultimately, BHP is fighting with RIO for investor dollars and is underachieving in terms of relative valuation. Much of this can be explained by the very proactive fashion in which RIO has aligned itself to investing in future-facing metals such as lithium. BHP whilst making this transition, has opted for more pedestrian and conventional exposures to copper and nickel; whilst holding onto lower quality, non-Tier 1 assets.
Accordingly, it's important for BHP to view the situation holistically. In our opinion, the majority of the value to be extracted will be from the improved perception of BHP and the consequent value re-rate, rather than the headline price for these assets.
For instance, a 1% fluctuation in the market price for BHP represents a move in market valuation >AUD$2 billion. A clean divestment of these assets is likely to drive quick and material value accretion via a re-rate of BHP's stock price.
Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author may hold shares in companies discussed.