Coal operating costs and asset values, not royalties, should be priorities for BHP’s new CEO

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When BHP announced Brandon Craig as its new CEO, his predecessor Mike Henry was lauded for his strategic vision and, among other strategies, upgrading its coal business. 

IEEFA’s analysis of BHP’s financial reports highlights that the Queensland coal division has delivered an improved price outcome. This is largely due to reducing the discount BHP incurs on its metallurgical coal sales to the hard coking coal (HCC) market price, from 11% in FY2018-19 to just 1% in FY2025-25. (The reduction reflects improvements in the quality of BHP’s coal.)

Despite this, BHP’s latest financial results highlight a continuing decline in financial returns, with an effective zero return on investment. As a result, the mining giant has announced cost-cutting measures, including the closure of its Mackay Skills Academy. BHP blames changes to Queensland’s royalty regime in 2022 for the closure and the company’s declining overall financial performance.

IEEFA’s research tells a different story. It found the impact of the expanded price tiers on which Queensland’s coal royalties are calculated (from three to six) was significantly less than that claimed by the industry – analysis which still holds. Meanwhile, BHP’s operating costs have increased, particularly due to regional labour cost pressures.

Consequences of coal upgrade strategy

BHP’s strategy to upgrade its Queensland coal assets through sales of coal assets held by its BMA joint venture with Mitsubishi has resulted in a significant decline in its equity share of coal sales since FY2015-16 (by almost 60%). However, asset values reported by BHP have only decreased by about 20% (Figure 1). 

The outcome of this combination is that BHP is maintaining a significantly higher asset value per unit of production, which has increased by 84% over the period. Given that asset values affect depreciation, this would be expected to reduce return on investment rather than operating costs.

Operating costs, however, will be affected as fixed operating costs are spread across falling volumes. 

Operating costs rise substantially

IEEFA’s analysis shows BHP’s operating costs have increased significantly since FY2017-18 (Figure 2). While the expanded coal royalty regime has contributed to an increased proportion of the price, it is still only 15%, up from 10% in FY2017-18. This is far exceeded by the 28 percentage point increase in operating costs – the overwhelming driver of BHP’s declining coal earnings, not royalties.

The surge in operating costs has left BHP with just 17% of the price to cover depreciation costs and investment return (compared with 50% in 2018). Combined with the 84% increase in asset value per unit of production, a return on investment of close to zero is to be expected. This is not a function of the change to the royalty regime.

IEEFA’s analysis therefore finds that the key contributors to the deterioration of BHP’s Queensland coal assets’ financial performance are:

• Operating cost inflation
• High asset values per unit of production increasing unit depreciation costs.

Changes to the royalty regime do not appear to be a significant contributor, notwithstanding BHP’s (and the coal industry’s) strong opposition to the changes.

Private royalty regimes

Commercial sales of coalmines often include provisions that could be considered private royalties as they allow for increased payments based on future price outcomes. 

For example, the 2023 sale of BMA coal assets to Whitehaven included a provision for contingency payments based on certain price triggers. Whitehaven must pay BMA 35% of total revenue above AU$200 per tonne, based on the applicable exchange rate. That is, BHP essentially imposed a ‘deferred consideration’ ‘contingency payments’ 35% (effectively a royalty) above AU$200/t on Whitehaven for a three- year period. This is higher than the marginal state royalty rate of 20% that applies at AU$200/t.

Such provisions undermine BHP’s statements suggesting higher state royalty payments deter investment.

Costs and asset values more pressing for BHP

BHP’s deteriorating financial performance appears to be predominantly a function of cost inflation combined with high asset values and declining production, not a changed royalty regime. This conclusion is strengthened when private, commercial royalty provisions imposed by BHP in its asset sales are compared with the state regime.

While upgrading its coal assets has improved price outcomes, BHP’s management should prioritise cost and valuation issues rather than rail against a royalty regime whose impact is marginal at best, as this analysis and BHP’s own commercial arrangements suggest.