COLUMN - What is the point of BHP? John Kemp

A train car waits in line at the Potash Corp's Cory mine site near Saskatoon August 19, 2010.

-- John Kemp is a Reuters market analyst. The views expressed are his own --

By John Kemp

LONDON (Reuters) - BHP Billiton's hostile bid for Potash Corp of Saskatchewan is the culmination of the consolidation and portfolio strategies the company has pursued for more than a decade, transforming the bulk mining industry.

But it crystallises troubling questions about where BHP is headed, and whether the industry's increasingly concentrated structure is the right one to deliver massive investments in new capacity needed to meet booming emerging-market demand for industrial raw materials and farm products over the next few decades.

As shareholders, regulators and governments review the bid -- and BHP's troubled but not yet extinct proposal for an iron-ore joint venture with Rio Tinto -- there are four questions they and the company's customers should be asking Chief Executive Marius Kloppers and his team:

PORTFOLIO MANAGER

Why is BHP using proceeds from high iron ore, copper and oil prices to back a bid for a producer of potash and phosphates, rather than investing them back in its core businesses or returning them to shareholders?

The company says acquiring Potash will diversify its revenue streams. In particular, it will move BHP away from reliance on energy products and industrial raw materials to give it exposure to growing demand for farm products.

But if BHP's shareholders want to diversify, portfolio theory suggests they can do this for themselves by buying Potash shares directly. Instead it looks like BHP management is trying to become a portfolio manager or replicate a broad-based mining index all by itself.

Some observers will argue BHP should return excess capital to shareholders and let them decide how to invest it to meet their investment objectives -- whether in fertiliser, solar power, infrastructure companies or government bonds.

MARKETING AND PRICING

What benefits would BHP management bring to unlock greater value from Potash's assets than the company's existing management?

BHP is not explicitly claiming synergies from the deal (the most common justification). The company says the deal "leverages BHP Billiton's global capability and experience in building, operating and expanding mining operations" but that seems a thin rationale for a $39 billion acquisition. It is not clear how BHP would run Potash's assets any better than current managers.

BHP's real advantage is its experience extracting more value from raw materials through innovative and aggressive marketing and pricing.

In iron ore, BHP was the leading evangelist for shifting from negotiated prices under long-term contracts to pricing linked to the spot market. With Rio Tinto, it has been very aggressive in price negotiations, as its Chinese customers can attest. There are rumblings BHP would like to achieve a similar switch in alumina [ID:nLDE6741G9].

If the offer succeeds, BHP would bring the same strategy to fertiliser. It has already signalled it would seek to withdraw from the system of annual contracts negotiated through joint marketing organisations. BHP clearly thinks the current cozy arrangements are ripe for a shake up, and that as a low-cost producer Potash would gain most from the fallout.

So the bid is really a gamble BHP can unlock more value through a radical change in the industry's pricing system. The question is whether Potash management (which should know its own industry better than BHP) has already considered this and rejected it, or whether as an outsider BHP can bring a new perspective and expertise developed in other markets to revolutionise a sleepy fertiliser business.

MARKET POWER CONCERNS

BHP says the bid is "consistent with [its] strategy of developing, owning and operating a diversified portfolio of large, low-cost, long-life, expandable, export-oriented, Tier 1 assets". Another way of putting it is to say the company specialises in owning low-cost assets in industries with few substitutes, protected by high entry barriers (capital intensity, geological and regulatory) giving it substantial pricing power.

Bulk commodities such as iron ore, thermal coal and alumina fit this model perfectly. So does potash and phosphorous mining. In its 2009 business review, Potash lists "substantial barriers to entry" among its key strengths, noting "economically mineable deposits are rare, capital costs are high, and lead times are long".

Potash argues "Building a conventional 2-million-tonne mine in Saskatchewan would require an estimated $2.8 billion Canadian dollars in upfront capital, excluding investment in roads, rail, utilities, port facilities and other infrastructure outside the plant gate. From the start of production we believe it would take at least seven years to achieve full production capacity".

Concerns about the major mining companies' pricing power in iron ore and the potential ability of low-cost producers to maintain it against the threat of entry by exercising price leadership and sequencing new investments surfaced in the review of BHP's abandoned bid for Rio Tinto in 2008, and have emerged even more strongly in the current review of the proposed production joint venture between the two companies.

The Australian Competition and Consumer Commission (ACCC) has postponed a decision on the joint venture four times to give the parties more time to respond to the customer concerns flagged up by market inquiries and set out in the Commission's own Statement of Issues.

Iron ore (and copper) consumers are likely to be disturbed by BHP's bid for Potash. In a competitive market, high prices for iron and copper should be signalling and financing more and faster investment in production; instead BHP is borrowing money to buy a fertiliser business. Many will argue this confirms their view BHP's profits are the result of an over-concentrated industry with substantial entry barriers.

In a way, BHP's bid for Potash is an acknowledgement it cannot expand much more in its core businesses without running into regulatory objections or moving up the cost curve (something the company wants to avoid). It is much easier to buy a ready-made dominant position in another industry (one where BHP has negligible production at the moment so it will not be subject to the same merger clearance problems).

WHAT ABOUT NEW CAPACITY

Mining executives are united in their view high prices are needed to finance massive expansion in capacity for a range of raw materials needed to meet expanding emerging market demand in the coming decades. But how will this deal help boost investment and output?

The deal will not directly add a single tonne of potash or iron ore production. At a time when the industry needs to expand, the deal takes equity out of the sector and replaces it with debt. While that may improve returns to shareholders, it runs counter the view that the recent financial crisis was caused by too much leverage.

It also seems to ignore the fact at least one major mining company (Rio) suffered a near-death experience during the crisis and downturn because it was carrying too much debt.

BHP's bid crystallises a sense something is wrong with the structure of bulk mining. Leading firms have more incentive to focus on pricing and marketing strategies to unlock value and use soaring profits to go drilling in other parts of the stock market, than expand production to meet forecast demand and eventually lead to lower prices for customers.

For BHP's shareholders, the key question is whether the company should be acting as portfolio manager on their behalf. For regulators, the question is whether there is enough competitive pressure in bulk mining and whether the industry's structure is providing the right incentives for investment or if there needs to be an intervention.

(Editing by Keiron Henderson)