Xstrata Plc - annual report 2007

Business Review | Principal risks and uncertainties

The risks set out below represent some of the principal uncertainties and trends which exist in Xstrata’s business and which may have an impact on our ability to execute our strategy effectively in future. Further information about Xstrata’s risk management processes and controls is provided in the Corporate Governance Report on pages 110 to 120 of this report.

Commodity price volatility

Xstrata’s revenue and earnings are dependent on prevailing prices for the commodities it produces. Commodity prices are determined by the supply of and demand for raw materials and are closely linked to global economic growth. Demand for commodities is increasingly driven by the industrialisation of developing economies in Asia, in addition to demand from OECD countries. Xstrata produces and sells both exchange-traded commodities and commodities where prices are negotiated on longer-term contracts. Commodity prices for all products, and particularly for exchange-traded commodities, may fluctuate widely and may have a material impact on financial results. The impact on Group earnings (EBIT) of movements in the price of each of Xstrata’s commodities is set out in the EBIT Sensitivities table in the Financial Review. Commodity price trends and commentary on the outlook for each of Xstrata’s commodity markets is provided in the Markets section of this report.

We manage the risk of commodity price fluctuations through maintaining a diversified portfolio of commodities and typically do not implement large-scale strategic hedging or price management initiatives. We aim to reduce costs on a continuous basis and maintain low-cost, efficient operations, optimising our portfolio and returns throughout the commodity price cycle. Xstrata maintains a robust financial position and a solid investment grade balance sheet. In 2007, the maturity of Xstrata’s debt was further extended through three major bond issues, further mitigating any short-term financial risk.

Fluctuations in currency exchange rates

Xstrata’s products are generally sold in US dollars, while our operations and operating costs are spread across several different countries and currencies. Fluctuations in exchange rates, in particular, movements in the Australian dollar, Canadian dollar and South African Rand against the US dollar, may have a material impact on Xstrata’s financial results. The impacts of currency exchange rate fluctuations on Group EBIT, together with average exchange rates in 2007 compared to 2006, are set out in the Financial Review.

We manage this risk through maintaining a diversified portfolio of assets across several different geographies and operating currencies. From time to time we may also hedge a portion of our currency exposures to fix costs in US dollars to US dollar revenues in relation to contracted terms. Foreign currency hedging information is provided in the Financial Review. Xstrata’s financial structure, including exposure to interest payments, interest rate changes and amendments to taxation regulations, is regularly reviewed with the assistance of external advisers, to ensure compliance with relevant regulations and to maximise financial efficiency. The Group maintains a robust investment grade credit rating and Group Treasury policy is actively monitored and regularly reviewed.

Climate change

Xstrata operates in a number of jurisdictions in which regulations or laws have been introduced to limit or reduce greenhouse gas emissions. While the precise future impact of the Kyoto Protocol and related legislation and regulation is impossible to quantify at this time, the likely effect will be to increase costs for fossil fuels, electricity and transportation, restrict industrial emissions, impose added costs for emissions in excess of permitted levels and increase costs for monitoring, reporting and accounting. Xstrata is the world’s largest producer of export thermal coal and a number of Xstrata’s operations are intensive users of natural gas, electricity, oil and other energy sources. Significant increases in energy costs or restricted supplies of energy sources due to climate change legislation or other reasons may have a material adverse impact on the Group’s ability to maintain production and/or contain operating costs. Any material decline in the use of coal as a power source as a result of carbon taxes, emissions trading or similar legislation may have a material adverse impact on Xstrata’s financial position. Climate change may also result in weather-related events or other physical threats that may hamper production or damage assets.

Climate change issues are given a high priority by management and initiatives are undertaken to continually improve understanding of the Group’s carbon footprint and to implement initiatives to reduce the carbon intensity of operations and activities. Xstrata’s commodity businesses actively participate in industry and regulatory initiatives to address climate change and associated issues. Xstrata Coal is playing a leading role in actively investing in and advocating government support for research and development projects to reduce greenhouse gas emissions from the use of coal in power generation (“clean coal technology”), together with other coal producers, governments, scientific and academic organisations. Demand for coal is expected to be supported by forecast significant increases in global demand for energy, particularly in developing countries, and by coal’s relative cost position, availability and security of supply. Contingency plans are in place to restore operations quickly in the event of a severe weather event and to address significant risks. Energy efficiency is a high priority for operational management as a significant proportion of the Group’s costs relate to energy consumption (see below and Sustainable Development section, pages 20 to 23).

Project development

Continued robust demand for mining products has resulted in significant inflation in the cost of labour, fuel, raw materials and other key mining industry inputs, together with increased lead order times for key items and equipment, skills shortages and infrastructure constraints. As a result, the delivery of major capital projects on time and within budget is increasingly challenging and may result in capital cost overruns, delays to expected commissioning of new production or the inability to replace existing production or meet market expectations of volume growth. Xstrata has a significant pipeline representing over $30 billion of capital investment in major organic growth projects across a number of countries and commodities.

We manage this risk through ensuring rigorous planning and risk management processes are in place both leading up to project approval and through the development process. For example, before approving the significant $3.8 billion Koniambo nickel project in New Caledonia, Xstrata Nickel entered into a one-year renewal phase to identify and manage all risks and costs associated with the project. Xstrata’s commodity businesses have an excellent track record of delivering major capital growth projects on time and on budget, including the successful commissioning of several major growth projects in the past two years in a very challenging cost environment. In addition, Xstrata’s existing capabilities have been complemented and broadened through the retention of a significant pool of project management expertise from the former Falconbridge business acquired in late 2006. Cost control remains a key consideration for any project development. Detailed progress reports are provided on a regular basis for all major projects to the Group Executive Committee and effective project management procedures are a key focus for Xstrata’s Internal Audit function.

Cost pressures due to high inflation in the mining industry

Following an extended period of historically elevated commodity prices and increased activity in the sector, inflation in the price of key inputs into the mining and metals industry is considerably higher than consumer price index inflation in most mining regions, with supply shortages in some cases. In particular the price of consumables including tyres and explosives, contractor labour, fuel and energy has risen steeply, with increased competition for resources and consequent operating cost increases. The inability to source appropriate equipment or very significant increases in the cost of key inputs may impact production and negatively affect operating costs and profitability.

Xstrata recognises the importance of cost reduction as a driver of value creation and as a measure of the quality of our operational management and our stewardship of the assets of our owners. Cost performance is regularly reported to the Group Executive Committee and is an important management performance measure. Real net cost savings are used to determine 50% of the potential award under the Group’s long-term incentive plan; the remaining 50% is determined according to total shareholder returns. Improvements to the operating cost base are achieved through a focus on improving productivity, identifying potential efficiencies and replacing higher-cost assets with new, low-cost production. Xstrata’s dedicated technology business, Xstrata Technology Services, is a world leader in the development of minerals processing and metals extraction technologies to improve efficiency and reduce operating costs. Many of Xstrata’s operations use Xstrata Technology products and these are also marketed commercially to other industry participants. Xstrata’s commodity businesses also invest in the development of lower cost proprietary technologies. In each of the last six years, Xstrata has achieved real cost savings from its operational cost base, outperforming its FTSE100 mining industry peers. In 2007, $253 million of real cost savings were achieved in a very challenging environment.

Shortage of skills and retention of key personnel

The mining industry is currently facing a global shortage of skilled employees across a range of disciplines. The ability to attract, retain or train people with the appropriate skills is critical to Xstrata’s continued success and ability to grow and operate effectively. In addition, Xstrata’s lean management structure places reliance on a number of key people both at the executive and operational level, requiring appropriate retention measures and succession planning.

We aim to attract and retain the best people at every level of our businesses and to provide them with the resources they require to achieve and maintain our operational excellence. We provide industry-leading career development opportunities, well structured employment contracts, competitive remuneration and fair and non-discriminatory workplaces. We believe our devolved management structure and supportive environment for rational risk-taking is an important retention measure, offering unparalleled opportunities for development and entrepreneurial leadership, minimising bureaucracy and allowing every employee to play an active part in our success. Fast track and executive development programmes are in place across the Group and formal succession planning is regularly reviewed.

Health, safety and environment

Xstrata’s operations are subject to extensive health, safety and environmental regulations and legislation, community expectations and to the leading practice standards set out in our Sustainable Development Framework of policies and standards. New or amended environmental, health and safety legislation or regulations may result in increased operating costs or, in the event of non-compliance, the possibility of fines, penalties or other actions which may adversely affect Xstrata’s financial position. Rehabilitation costs, which are generally estimated and provided for over the life of operations and based on the best information available, may subsequently increase, impacting on Group earnings. Any breach of regulations or non-compliance with Xstrata’s own best practice standards in health, safety and environmental performance and community relations may damage our reputation and, as a result, our licence to operate. Performance standards at acquired operations may not meet Xstrata’s expected performance standards.

Our commitment to the principles of sustainable development, which incorporates environmental, economic and social performance, is an integral part of our operating philosophy. Every managed operation is independently audited through Xstrata’s independent Sustainable Development Assurance Programme on a regular basis, to provide assurance to the Board that Group policy and standards are being met or exceeded. Health, safety, environmental and social performance indicators are reported on a monthly basis to the Group Executive Committee and quarterly to the Board. Closure planning, including rehabilitation and ongoing environmental costs, is undertaken prior to investment in new operations and closure plans are routinely reviewed. Acquired operations are assessed for HSE risks and opportunities as part of the integration process and action plans are implemented to address any areas of underperformance. Major improvements have been achieved at the former Falconbridge operations as a result of the programmes initiated to respond to underperformance compared to Xstrata’s leading practice standards.

Political and community

Xstrata’s operations and projects span 18 countries, some of which have more complex, less stable political or social climates and consequently higher country risk. Political risks include changes in laws, taxes or royalties, expropriation of assets, currency restrictions or renegotiation of or changes to mining leases and permits. Similarly, communities in certain regions may oppose mining activities for various reasons. Any of these factors could have an adverse impact on the Group’s profitability in a certain geographic region or at certain operations. In South Africa, these risks include the ability to convert existing mining licences to “new order” mining rights under the Mineral and Petroleum Resources Development Act and Empowerment Charter.

We perform a thorough risk assessment on a country-by-country basis when considering our activities and investments and regularly review political, regulatory and social risk to ensure that these risks have been properly identified and are within acceptable levels. We aim to work closely in partnership with local communities for mutual benefits, earning and maintaining a social licence to operate. We further manage this risk through maintaining a broad geographic spread of assets, ensuring that political risk is spread across a number of territories. Investment terms and joint venture or other partnership agreements are reviewed to ensure fairness and reduce the risk of renegotiation. Xstrata maintains a transparent and open relationship with regulators and local, regional and national government bodies and closely monitors compliance with legislation and with the leading practice standards set out by the Group’s sustainable development framework. In South Africa, Xstrata is one of the only major mining companies to have satisfied black economic empowerment ownership requirements under the MPRDA and is on track to achieve employment equity, procurement, social development and other targets by 2009 as set out by the Charter.

Integration of acquisitions

Xstrata has grown primarily through the successful completion of a number of large-scale and smaller acquisitions and through the subsequent improvements made in the performance of businesses acquired. Acquisitions and investments in joint ventures will continue to be an important part of our strategy. Acquisitions and investments involve a number of risks, including the risk that businesses acquired are not integrated effectively or that anticipated cost savings or synergies are not realised.

Xstrata has developed and refined an effective and proven integration process over the past six years, which includes rapid risk assessments of acquired operations and the swift implementation of management and reporting structures. The Group has a strong track record in effectively integrating large-scale and smaller acquisitions and investments into Xstrata’s corporate structure. For each transaction, acquisitions have been quickly and effectively integrated, realising operational, financial and strategic improvements and greater than expected cost savings or synergy benefits, as with the major acquisition of Falconbridge in 2006 and again with a number of smaller, bolt-on acquisitions in 2007.

Energy and water supply

Access to a secure supply of electrical energy at a reasonable cost and sufficient water are critical considerations for the continued operation and future growth plans of Xstrata’s operations. Energy supply is subject to constraints in some regions and the cost of energy is, in general, rising. Fresh water supply may be restricted and limits imposed, particularly in arid regions with a significant number of domestic and industrial users.

We manage this risk through implementing energy efficiency plans across the Group and developing energy efficient technologies, for example Xstrata Alloys’ proprietary Premus technology which reduces the energy consumption of ferrochrome smelting by over 20% compared to conventional processes. Long-term energy contracts are negotiated to reduce dependence on spot markets and we seek to diversify power sources and identify alternatives. All operations are required to implement and regularly review a water management plan to reduce fresh water use and maximise on-site water storage and re-use. Storage facilities and usage is regularly monitored, particularly in high-risk areas and, where appropriate, water management strategies are determined to address potential shortfalls or water quality issues.

Operational risks and reserves and resources

Xstrata’s operations may be impacted by a number of circumstances including natural disasters, unexpected geological or technical difficulties, labour disruptions, environmental or safety incidents, causing increased costs, lower production or the suspension of operations. Similarly, the Group’s strategy of “near-mine” exploration, partnerships with junior exploration companies and the acquisition of new resources may not succeed and existing reserves may not be replaced or increased. Reserves and resources information also relies on a number of estimates and assumptions which, if materially inaccurate, could impact on our financial position and asset values.

Our strategy of leveraging existing operations for “near-mine” exploration and of partnering with junior exploration companies results in a more focused approach to exploration, reducing the risks inherent in large-scale greenfield exploration programmes. A number of extensions to resources and reserves were confirmed at Xstrata’s operations in 2007 through this approach. Xstrata’s operational management identifies and manages the risks inherent in mining operations through a comprehensive risk management programme. The Group Reserves and Resources Policy ensures business unit reporting is consistent and that reserves and resources information is compiled by appropriately qualified people and is externally reviewed before publication.