A Reuters report that oil giant BP is set to pay more than US$10 billion for BHP’s US onshore oil and gas assets has led market analysts to start pondering what BHP might do with this somewhat unexpected “pot of gold”.

The onshore shale assets in the Eagle Ford, Permian, Haynesville and Fayetteville basins were acquired by BHP at the height of the oil boom in 2011. Largely written off in 2016, they are now being sold primarily in response to pressure from activist shareholder Elliott & Associates. In plans tagged “Value Unlock Plan for BHP” and “Fixing BHP,” Elliott argued that out of a total investment of US$29.2bn, US$19.9bn in acquisition costs and US$9.4bn of negative cash flow, BHP had “destroyed” US$22.7bn of shareholder wealth.

According to Elliott, BHP was not the right custodian of the US onshore assets, as there were no real operational synergies or risk diversification, and BHP didn’t have the cultural mindset or nimbleness to operate in shale oil where rigs are quickly commissioned and often drill for less than two years.

BHP hasn’t confirmed the sale to BP. Its last update to the market said that the process was tracking to plan, with bids due by the end of June and the “potential” for a deal announced by the end of calendar 2018. It also hadn’t ruled out a demerger or IPO of the business.

In the resources business, timing is everything, and BHP seems set to benefit from some “luck” in the sale process. A steady rise in the oil price to US$74 a barrel, President Trump’s corporate tax cut and some successful well trials are helping to lift interest in the sale and raise expectations about the proceeds. So, with BHP set to receive a small windfall, what will it do with the funds?

Capital options

BHP has three broad options for the funds - capital expenditure on new projects or buying assets, to pay down debt, or return the funds to the shareholders.

Under Andrew Mackenzie’s reign as CEO, BHP has been very disciplined with capital expenditure, particularly when it comes to new projects. It currently has four major projects underway with a combined capital expenditure of US$7.5bn over the life of the projects. There are two petroleum/LNG projects (Mad Dog Phase 2 in the Gulf of Mexico and North West Shelf Greater Western Flank-B in WA), the Spence Growth Option in Chile to expand copper production and the excavation, lining and building of infrastructure for the Jansen potash project in Canada. BHP recently announced a fifth project, the US$2.9bn South Flank iron ore project in the Pilbara.

Future growth options include offshore oil in the Gulf of Mexico with Atlantis, copper at Olympic Dam in SA, metallurgical coal at Wards Well in the Bowen Basin in Queensland, copper at Resolution in Arizona and after almost a decade, possibly the production of potash at Jansen. BHP says that “any investment decisions will be made in accordance with our capital allocation framework and fully consider the broader market impact”.

According to Mackenzie, BHP’s return on capital employed (ROCE) which was just 10% in FY17, is forecast to rise to around 14% in FY18 and the company is targeting 20% by FY22. 

BHP has also been working hard to drive cost efficiencies, for example, lowering the production cost of iron ore to US$13 per tonne, and is targeting further productivity gains of US$2bn by end FY19. Debt has been reduced, down to US$15.4bn as at 31 December, with BHP now targeting ongoing net debt in a range of US$10– $15bn. It has guided to capital and exploration spending of US$8bn pa to FY20.

The BHP story is “capital discipline, debt reduction and shareholder returns.”

Unless BHP has a major change in strategy, this means that a fair chunk of the proceeds from selling the US onshore oil assets will be earmarked for shareholder returns. This will most likely translate into an on-market buyback of shares in the UK listed entity (to reduce the discount with the Australian listed entity), and an off-market buyback (at a discount) of shares in the Australian listed entity.

The latter will allow BHP to distribute excess franking credits to Australian shareholders and will prove to be very popular with shareholders, assuming that they can get it done before a Bill Shorten ALP Government changes the rules.  

Do the brokers see any value in BHP?

In a commodity up cycle, the major brokers are supportive of BHP with 7 buy recommendations and 1 neutral recommendation (no sell recommendations). That said, they don’t see a lot of upside with a consensus target price $34.48, just 2.1% higher than last night’s closing price.

Individual broker recommendations and target prices (source: FN Arena) are set out below. Because resource company profits are highly dependent on commodity prices, broker forecasts should be treated with an extra degree of caution because a key input is the broker’s forecast for commodity prices.

In a commodity up cycle, the major brokers are supportive of BHP with 7 buy recommendations and 1 neutral recommendation (no sell recommendations). That said, they don’t see a lot of upside with a consensus target price $34.48, just 2.1% higher than last night’s closing price.

Individual broker recommendations and target prices (source: FN Arena) are set out below. Because resource company profits are highly dependent on commodity prices, broker forecasts should be treated with an extra degree of caution because a key input is the broker’s forecast for commodity prices.

                                                Broker Recommendations

Bottom line

Commodity prices are still in uptrend and if you are long BHP, I think you stick around for the ride. With BHP maintaining a high degree of discipline over its capital expenditure and balance sheet, shareholders will be rewarded with higher dividends and capital returns.

Can share investors seeking exposure to resources find better value elsewhere? Probably. If you place faith in the broker forecasts, the same analysts see 11.4% upside potential with Rio and 24.4% upside potential for Fortescue. The latter is much higher risk, given that it is virtually a pure play iron ore miner.

But the sale of the US onshore oil assets should allow BHP to further reward investors, and while it is probably too late to buy, there is no reason to bail out yet. Hold.