Commodities

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

If there's any big mining deal that should be happening right now, it's a takeover of Freeport-McMoRan by BHP Billiton.

Most large resources companies pick either solids (mining) or liquids (oil and gas). BHP and Freeport are rare in keeping a foot in both camps. They also share an optimistic view of the long-term outlook for Freeport's key assets, copper and petroleum.

The fact a deal isn't happening is one of those odd omissions reminiscent of Sherlock Holmes's dog that didn't bark:

``Is there any other point to which you would wish to draw my attention?"

``To the curious incident of the dog in the night-time."

``The dog did nothing in the night-time."

``That was the curious incident," remarked Sherlock Holmes.

The attractions of a deal for BHP are obvious. It would easily become the world's biggest copper miner, leaving current leader Codelco in the dust. The Australian company would end up with control of all three of the world's biggest copper pits -- Escondida, Grasberg and Morenci -- and its output of the metal would more than double overnight.

Even so, with 3.5 million metric tons a year of production it would still only account for about 15 percent of the world's copper supply -- a small enough proportion that Chief Executive Officer Andrew Mackenzie could hope to evade the competition concerns that scuppered BHP's 2010 attempt to merge its iron ore assets with Rio Tinto's.

Big Copper
A combined BHP-Freeport would be easily the world's biggest copper producer
Source: Bloomberg Intelligence, company reports

The companies' oil and gas assets are also a neat fit. Both have extensive operations in the Gulf of Mexico's Green Canyon region and the southern U.S.'s Haynesville shale. BHP is keen to increase its petroleum exposure both on and offshore in the U.S., Tim Cutt, the president of BHP's petroleum unit, told an investor conference last September. A Freeport takeover would fit the bill nicely.

A further advantage comes from the asset mix. BHP's earnings are currently tilted toward capital commodities that are used just once, with iron ore and coal accounting for about 45 percent of Ebitda last financial year . Given that medium-term steel demand may already have peaked, shifting the portfolio away from that sector by doubling down on copper and petroleum would be wise.

It would also make sense for Freeport, whose debts are dragging it dangerously close to the plughole. Its 3.55 percent 2022 bonds are trading at 55.3 cents on the dollar and the cost to protect its debt from default using credit-default swaps is 1,802 basis points. Those are zombie apocalypse levels: Lenders wanting to insure against nonpayment would have to post $4.4 million of cash upfront for every $10 million protected.

Not at Any Price
The price of Freeport-McMoRan's 3.55% bonds due in 2022 has plummeted
Source: Bloomberg data

Freeport has alternatives. It could shave off some stakes in its better copper mines, as it demonstrated last week by selling a 13 percent share of Morenci to Sumitomo Metal for $1 billion. It's also offered Indonesia about 11 percent of its Grasberg-owning local unit for $1.7 billion, according to that country's government, and is considering options for its oil and gas business.

The problem with all that is that Freeport combines a pretty runty petroleum business with one of the world's premier copper portfolios. The few buyers out there will want the latter rather than the former, leaving Freeport shareholders with the dross not the diamonds. Beggars, especially in this market, can't be choosers.

BHP seems a much more attractive suitor. By offering its stock, it could even save cash while framing the deal as a way for Freeport shareholders to retain the upside from any long-term recovery in commodity prices. An all-stock deal that offered Freeport shareholders a 25 percent premium would deliver BHP investors a return of about 20 percent this year and next, assuming $300 million of synergies, according to Bloomberg's merger calculator.

Buddy, Can You Spare a Dime?
BHP's net debt has never yet topped $30 billion. Now is hardly the time to start
Source: Bloomberg data

There's just one problem with the whole scenario. While Freeport's $8 billion market capitalization looks like a modest appetizer next to BHP's A$86 billion ($61.7 billion), its $20.4 billion in net debt would be harder to swallow. Still, indigestion has a habit of going away after a time, and while net debt-to-Ebitda at a combined company would rise to about 2.8 times in 2016, it would drift below 2 times by the 2018 fiscal year, according to consensus analyst estimates. That's not much worse than the standalone BHP: 

Gearing Up for Success
Net debt-to-Ebitda at a merged BHP-Freeport wouldn't be unmanageable
Source: Bloomberg consensus analyst estimates
Note: Chart shows fiscal years. BHP has June year-end, Freeport has December.

That seems pretty manageable by conventional standards, but these aren't conventional times. BHP's shareholders are nursing a 43 percent share price decline over the past 12 months and praying that Mackenzie won't cut their dividend at Tuesday's half-year results, as rival Rio Tinto did earlier this month. Credit investors are already facing possible downgrades to lower, if still investment-grade, ratings from Moody's and Standard & Poor's, so could do without taking on Freeport's junk-rated liabilities. All sides would like BHP to do nothing more dramatic than hunker down until the current storm passes.

Still, it's on gutsy deals like this that great companies are made. The rewards for BHP look transformational, while the risks seem transient. If Mackenzie's not considering a transaction, you can take that as another sign of how dire the outlook for commodities has become.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Coking coal counts as a capital commodity because of its use in steelmaking; thermal coal is more of an operational commodity. BHP Billiton's mines are geared toward coking coal production and demand for thermal coal is in any case threatened by cheaper renewables and global action on climate change.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net