Chief Executive’s Report

Despite the sudden and severe impact of a global banking crisis that dramatically slowed economic growth from the third quarter and led to a precipitous fall in commodity prices, Xstrata’s businesses achieved a highly creditable result in 2008, generating EBITDA of $9.7 billion, 11% lower than the record profitability achieved in 2007. Earnings per share of $4.90 were 13% lower than the prior year. The impact of markedly lower commodity prices in the final quarter was largely offset by the benefit of record thermal and coking coal and ferrochrome contracts settled during the year, together with robust copper prices for the majority of 2008.

A strong operating performance at Xstrata’s coal, alloys, nickel and zinc operations, the successful integration of the acquired Tahmoor and Resource Pacific coal operations and Jubilee nickel assets, the commissioning of the Perseverance zinc mine and Elandsfontein PGM operations led to record production across a number of the Group’s key commodities. Copper volumes increased by 16% in the second half compared to the first half, when lower grades and a number of one-off operational difficulties reduced volumes.

The successful commissioning and ramp up of new, lower cost production and a number of productivity improvements, in particular at Xstrata’s zinc and coal operations, mitigated ongoing inflationary cost pressures and achieved real cost savings of $184 million. At Xstrata Alloys, the Lion ferrochrome smelting complex and Bokamoso pelletising plant contributed greater than expected improvements in energy efficiency and ore consumption. These proprietary, industry-leading technologies continue to show their worth, as further efficiency savings are set to mitigate the adverse impact of standing charges in 2009 in respect of idled capacity, which currently represents some 80% of annual capacity.

Cost deflation in respect of major input items has lagged the severe decline in commodity prices but is beginning to accelerate, in particular for fuel, raw materials and contract labour, and will contribute to greater operating cost savings in 2009. The impact of a stronger US dollar against the major commodity-producing currencies is also expected to provide a significant offsetting benefit to lower prices in 2009.

Rapid supply-side response to market conditions

Economic growth projections in the main OECD countries were already being reduced during the first half of 2008, but dramatically declined in the wake of the financial crisis in September. Failing banks resulted in a severe tightening in money supply and liquidity continues to be very constrained. The consequence has been rapid de-leveraging and destocking across the world economic system, with the US, UK, Japan and Euro-zone economies falling into recession and growth rates in the developing economies moderating significantly.

Since the financial crisis in September 2008, the majority of LME commodities have traded at ultimately unsustainable levels at or below their marginal cost of production.

It is striking and important to note that the mining industry has responded to this sudden reversal in fortunes with far greater speed and to a greater extent than in previous economic downturns. Restricted access to capital, in particular for junior mining companies or marginal producers, has further contributed to the prompt closure of unprofitable operations and the curtailment of exploration and development of new growth projects. Consolidation of the sector has undoubtedly also played its part, with a smaller number of major producers acting responsibly and rationally in the face of extraordinary financial market conditions and weak demand for commodities.

The response from nickel producers has perhaps been the most rapid and significant, with over one-fifth of global supply suspended or closed to date and further cutbacks expected. One million tonnes of zinc or 9% of planned zinc production has been idled or closed. At the same time, significant proportions of ferrochrome capacity and 24 million tonnes or 13% of planned coking coal production has been removed from the traded market as cutbacks continue to be implemented in response to weak demand from steelmakers.

In the copper market too, previously planned global copper production in 2009 is expected to be reduced by at least 9% or 1.6 million tonnes due to production cutbacks and suspensions and the ongoing impact of mine underperformance at a number of major copper operations. Perhaps even more noteworthy is the likely impact on longer-term supply growth, as announced cancellations or deferral of growth projects have removed over 2.8 million tonnes of new copper supply over the next four years, introducing significant future constraints.

While near-term market conditions remain very challenging, the swift reduction of existing production and the suspension of loss-making operations will limit oversupply and ultimately result in a more balanced market as demand starts to increase from current depressed levels.

In the medium term, the current shortage of capital and poor short-term visibility are leading to substantial capital expenditure reductions by major and junior miners to defer or forgo growth projects. Further delays to new production capacity to replace ageing mines with declining grades and increasingly difficult mining conditions are sowing the seeds of future undersupply and significant price increases across a number of commodities, once global industrial production and demand for commodities resume their longer-term growth trend.

Substantial global fiscal stimulus packages

The mining industry’s response to the sudden downturn in global economic conditions has been matched by government-led actions to attempt to restart growth, improve liquidity and secure the global banking system. In total, over $1.7 trillion of fiscal stimulus packages have been announced to date in major commodity-consuming regions including China, Japan, Europe and the US. A very significant proportion of this total – for example, more than 70%, or $400 billion, of China’s total investment – has been earmarked for metals-intensive infrastructure investment and is consequently expected to bolster demand for commodities.

Together with looser monetary policy to encourage industrial production and economic growth, these measures are expected to begin to ease economic conditions in due course.

Xstrata’s response to the sudden downturn

Our businesses have acted promptly and decisively in response to sudden lower demand for key commodities and conserved cash during a period of heightened uncertainty by:

• suspending or closing higher cost or unprofitable production;
• aligning production with reduced demand;
• redoubling efforts to drive down operating costs and tightly control working capital; and
• substantially reducing discretionary sustaining and expansionary capital expenditure.

back to top >

Suspension of marginal production

Xstrata Zinc and Teck Cominco closed the joint venture Lennard Shelf zinc-lead operation in Western Australia in early August in response to ongoing lower zinc prices in what now appears to have been a prescient decision, given the financial meltdown in September.

Faced with the confluence of depressed nickel prices and record oil prices during 2008, Xstrata Nickel acted swiftly to suspend its Falcondo ferronickel operation in the Dominican Republic in August before placing the operation under care and maintenance in early December. Falcondo has traditionally been a swing producer and, while the decision to suspend an operation is never taken lightly, ceasing production in a timely manner avoided over $85 million of operating cash losses at this operation in the second half. At Sudbury, Xstrata Nickel accelerated the closure of the Thayer-Lindsley and Craig mines, which were approaching the end of their useful lives.

A number of other operations remain under review and I am confident that our management teams will continue to take prompt action to improve the operating cost profile of our operations and ensure that our businesses remain financially robust throughout the economic cycle.

Aligning production with demand

The sudden deterioration in economic conditions had a particularly strong impact on the steel sector, affecting demand for all commodities used in stainless and carbon steel production. In response to weaker demand for ferrochrome, the Xstrata-Merafe Chrome Venture progressively suspended 17 ferrochrome furnaces in South Africa, representing approximately 80% of annual production capacity, prioritising lower cost, energy efficient production from the Lion and Lydenburg Premus smelters.

Coking coal demand has similarly declined in line with lower steel production. Xstrata Coal’s Oaky No 1 mine in Queensland, Australia, suspended longwall operations as it came to the end of a section. A development unit has been installed to ensure the mine is able to respond quickly when market conditions improve.

Production at McArthur River Mine was reduced to an annual rate of 2 million tonnes of ore per annum, from 2.5 million tonnes per annum, in line with deteriorating market demand for McArthur River’s bulk zinc-lead concentrate from ISF smelters.

Operational changes of this nature, especially the closure of operations, unfortunately but inevitably result in impacts on Xstrata’s employees and contractors, as operations seek to ensure they have the appropriate workforce structure for prevailing market conditions. We have sought to minimise the impact of operational restructuring or closures on our workforce and avoid compulsory redundancies to the extent possible, including through offering early retirement schemes or alternative positions within the Group, or by not filling vacant positions. Overall headcount, including contractors, has been reduced by 5,500 positions to date.

Despite the current period of uncertainty and significant change at our operations, I am very pleased that Xstrata’s businesses have continued to achieve significant improvements in safety performance. The frequency of total recordable injuries recorded across the Group improved by 18% in 2008 compared to the previous year, with particularly strong reductions in injuries at Xstrata Alloys, Xstrata Copper and Xstrata Zinc.

back to top >

Operating cost reductions

The current economic climate has provided additional impetus and urgency to our management teams’ ongoing efforts to pursue every opportunity to reduce costs. We have long recognised that year-on-year cost efficiencies are an important measure of our operational excellence and this is borne out by Xstrata’s track record of sustainable cost reductions on a real basis every year since the initial public offering in 2002. Our approach to costs has always been to progressively optimise productivity and efficiency without sacrificing the longer-term growth potential of our operations and this remains a key objective. I firmly believe that Xstrata’s devolved management structure provides a critical competitive advantage in this area. Operational management teams are incentivised and have the authority to implement innovative, localised initiatives to enhance efficiency that together amount to significant, cumulative savings, without the burden of centralised decrees and programmes that ignore the realities of individual operations.

Xstrata Zinc’s recently announced series of measures to optimise its Mount Isa operations offers one example of the initiatives currently under way throughout the Group. Xstrata Zinc aims to achieve substantial reductions in operating and cash costs while increasing metal production at Mount Isa. Handlebar Hill open pit mine will be placed into care and maintenance, while production from the large-scale Black Star open pit operation and higher grade George Fisher operation at Mount Isa will increase by 35% and 13% respectively. Together, with stockpiled ore from Handlebar Hill, this will enable an optimised throughput at the expanded zinc-lead concentrator of 7.3 million tonnes, 20% higher than in 2008, with improved recoveries and increased operational efficiencies. This strategic operational change will result in a 23% increase in zinc metal output and a 17% increase in lead metal output over 2008 levels. Planned capital expenditure at Mount Isa will also be reduced by 83% without impacting the integrity of our operations and further cost savings will be achieved through reducing and deferring the movement of waste material at Black Star by 40%.

In total, operating costs at the Mount Isa zinc-lead operations will be reduced by $135 million or 32% in 2009. Taking into account the increase in metal output and reductions to capital spending, cash savings are expected to represent over half a billion dollars in 2009, excluding any beneficial impact from the stronger US dollar against the Australian dollar. This exceptional result is to the credit of Xstrata Zinc’s operational management and demonstrates the entrepreneurial approach being taken across Xstrata’s businesses to reduce costs and improve productivity.

Similarly, at Xstrata Nickel, the accelerated closure of higher cost operations at Sudbury, together with energy efficiency improvements and low-capital capacity increases at Nikkelverk is targeted to reduce C1 cash costs at the combined Sudbury and Nikkelverk operations by over 30% in 2009 compared to 2008, excluding foreign exchange impacts. This substantial cost improvement includes the transformational impact on the cost profile of the Sudbury complex expected from the commissioning of the Nickel Rim South operation later this year. When fully commissioned, Nickel Rim South will more than replace the lost metal volume from the closed mines, contribute significantly higher by-product credits and offers substantially lower cash costs through the application of bulk mining methods.

back to top >

Substantial reductions in planned capital expenditure

Xstrata’s businesses have developed a significant pipeline of greenfield and brownfield organic growth options that can be progressed as market conditions allow and provide a significant source of future production growth and value creation. Total capital expenditure rose to $5 billion in 2008, including $3.4 billion of expansionary capital expenditure to progress key growth projects and commission new, lower cost production including the Perseverance zinc-lead mine in Canada and the Elandsfontein PGM mine and concentrator in South Africa. However, total expenditure fell below previous guidance for the full year, as Xstrata’s businesses acted quickly in the final months of the year to reduce and defer discretionary capital expenditure in the light of the financial crisis and lack of visibility into near-term economic conditions.

During the current period of depressed commodity prices and low visibility into near-term economic conditions, Xstrata’s focus is to optimise cash by reducing capital spending, while preserving the value of its significant suite of growth options. An ongoing review of all capital expenditure projects has resulted in almost $3 billion of capital expenditure deferrals or reductions for 2009, reducing anticipated capital expenditure for 2009 by approximately 45% relative to previous guidance to $3.4 billion. Forecast expenditure comprises $1.2 billion of essential sustaining capital expenditure and $2.2 billion of expansionary capital expenditure, of which some $500 million relates to projects due to commission in 2009, including the Goedgevonden thermal coal mine in South Africa and the Nickel Rim South project in Canada. Those elements of Xstrata’s extensive growth pipeline which have been deferred remain available to be accelerated at the appropriate time and when market conditions allow.

Acquisitions

Through our acquisition of Jubilee Mines nickel operations in January, Xstrata Nickel has gained access to dwindling nickel sulphide growth opportunities. Our coal team was also able to further its strategy to consolidate major coal complexes through the acquisition of the Resource Pacific coal assets in February 2008.

On 1 October 2008, Xstrata announced that it would not proceed with the proposed acquisition of Lonmin announced in August, due to the risk posed by the requirement to refinance a significant portion of the necessary acquisition facilities within one year. Instead, we increased our stake in Lonmin to 24.9%, providing a significant interest in one of the world’s leading platinum producers.

We are confident that the long-term fundamentals on which our investment cases in respect of these acquisitions were based remain sound and that these acquisitions represent value-accretive transactions of long-life operations that will deliver substantial returns to shareholders over many years. However, with the benefit of hindsight, we may have been able to secure these assets at a lower cost and at a time of less financial stress.

back to top >

Securing an appropriate capital structure

The early actions taken by our commodity businesses to mitigate the impact of prevailing economic conditions are being matched by a number of proactive initiatives undertaken to secure Xstrata’s capital structure. While the Group did not take up the acquisition facility associated with the Lonmin transaction, we did proceed with a new $5 billion club facility with a broad group of relationship banks to refinance and extend significantly the tenure of the Group’s existing debt and provide further headroom. In January 2009, the facility was increased by an additional$459 million to approximately $5.46 billion.

As a result of these actions, Xstrata benefits from substantial headroom and no significant debt refinancing requirements until 2011. Net debt of $16.3 billion at the year-end represented gearing (on a net debt to net debt plus equity basis) of 40%.

Nonetheless, it is clear that, while appropriate for market conditions experienced in the first three quarters of the year and indeed in the past few years, in the aftermath of an unprecedented financial crisis, Xstrata’s absolute level of debt is now perceived as a potential constraint on the Group, given the uncertainty that exists over the near-term outlook for commodities.

Our announcement of a 2 for 1 rights issue to raise £4.1 billion (approximately $5.9 billion) excluding costs, will provide a significant injection of capital, mitigate the risks presented by the current uncertainty and remove this potential constraint. The proceeds of the rights issue will be used to repay bank debt. Specifically, we will pay back in full the drawn amount under the Group’s recently increased $5.46 billion revolving facility, with the balance used to repay in part the drawn balance under a $4.68 billion revolving facility.

Following the rights issue, Xstrata’s net debt will reduce to approximately $12.7 billion and gearing will reduce to just under 30%, at the lowest end of our long-term target range. Including the net proceeds from the rights issue, the combined impact of the actions taken by the Group to conserve cash and reduce operating and capital costs will add over $7 billion, providing Xstrata with a substantially strengthened balance sheet at a time of heightened uncertainty.

Glencore, Xstrata’s major shareholder with an interest of 34.5%, has provided irrevocable undertakings to take up its rights in full, and the remainder of the rights issue will be fully underwritten. The issue of new shares will be subject to shareholder approval at an extraordinary general meeting to be convened by early March.

back to top >

Acquisition of Prodeco

The planned rights issue, together with Glencore’s ongoing support for Xstrata has provided Xstrata with an opportunity to acquire Glencore’s world-class, cash-generative Prodeco coal operations in Colombia for a consideration of $2 billion. The addition of these premier operations into the Group will consolidate Xstrata Coal’s global leadership in thermal coal and strengthen its strategic position in Colombia, from which it supplies both the European and US markets.

The Prodeco operations comprise the La Jagua and Calenturitas mines, which benefit from the potential to almost double production from current production of 9 million tonnes per annum of premium quality, export thermal coal. Prodeco also controls its own infrastructure, in the form of export port facilities, a 40% share in a railroad rail facilities and proprietary rolling stock. Xstrata Coal management has detailed operational experience at these assets, with one of Xstrata Coal’s senior operational managers having recently held the position of Chief Operating Officer of Prodeco and the acquisition represents a highly attractive addition to our industry-leading thermal coal portfolio. As a related party transaction, the acquisition will also be subject to shareholder approval.

However, Xstrata and Glencore failed to reach full agreement on an appropriate valuation of the Prodeco assets and, as a result, the transaction agreement includes a call option, under which Glencore may buy back the Prodeco assets from Xstrata at any point up to the first anniversary of the closing date, for a total cash consideration of $2.25 billion, plus the net balance of any cash invested by Xstrata and any profits accrued but not distributed to Xstrata. The call option agreement ensures that, should the option be exercised, Glencore will pay a repurchase price that adequately compensates Xstrata’s shareholders for the option granted. In my view, these arrangements are fair to both parties and at the same time facilitate an orderly rights issue process, which is to the benefit of all of Xstrata’s shareholders.

In light of the rights issue, the Board has decided not to declare a final dividend for 2008. The total dividend for the year is therefore 18 US cents per share, paid as the interim dividend on 10 October 2008. The Board intends to resume dividend payments to shareholders at the earliest opportunity, while seeking to maintain a prudent capital structure against the backdrop of the macroeconomic climate and the Group’s cash flow, capital requirements and dividend cover.

The primary objective of our announcements today is to ensure that Xstrata remains financially robust during current challenging market conditions and going forward, given the lack of visibility into near-term economic conditions. However, looking through the prevailing period of uncertainty to the return of a more benign environment, the capital raising also provides the Group with an enhanced platform from which, at the appropriate time, to initiate the next stage of Xstrata’s growth.

A number of opportunities are beginning to emerge as a result of the dislocation of market values from underlying company valuations and the distressed or forced sale of attractive, cash-generative assets or projects. Once visibility into the outlook for commodity prices and cash flows improves, Xstrata will continue to use its proven ability to identify and execute acquisition opportunities, seeking to improve the strategic positioning of its business units and the Group as a whole.

We will continue to take a highly disciplined approach to growth. Shareholder value and a prudent approach to funding and capital structure will remain our primary considerations. Xstrata remains fully committed to maintaining an investment grade balance sheet throughout the economic cycle.

back to top >

Outlook

The financial crisis has produced a marked lack of visibility into short-term economic activity, and as such, the outlook for 2009 is uncertain. Investment in infrastructure is set to increase during 2009 and 2010, reflecting the significant stimulus packages announced by many major governments which prioritise commodity-intensive investment in many cases.

Notwithstanding prevailing near-term market conditions brought about by the financial crisis, the long-term positive trend for increased demand for metals and energy remains intact, driven by the ongoing industrialisation of developing economies and the urbanisation of over 20 million people per annum in China and India and over 65 to 70 million people globally at current rates. Long-term positive demand trends of this nature result in higher average commodity prices than historical averages in real terms, as new supply struggles to keep pace with increasing demand from emerging economies.

At the same time, current market conditions will exacerbate future supply constraints, as inventories are depleted by curtailments to existing supply and exploration investment and growth projects are deferred or cancelled.

When OECD economies return to a growth phase, the impact of synchronised demand growth from developed and emerging economies, coupled with greater commodity supply constraints, has the potential to lead to a rapid increase in commodity prices and demand, resulting in substantial cash flows and margin expansion for those metals and mining companies which have weathered the current challenging conditions.

Previous downturns have shown that companies that act quickly and decisively to secure their future emerge strongly from difficult economic conditions, with an improved competitive position. The rights issue, together with the proactive initiatives being undertaken by management and the addition of the cash-generative Prodeco assets, will ensure that Xstrata maintains a robust financial position throughout even an extended period of uncertainty, providing a strengthened position from which to pursue growth and value creation upon the inevitable return to growth of global economies.

Xstrata continues to operate a suite of cash-generative operations across a broad range of geographies, with excellent growth potential and a strong competitive position in each of its key commodity markets. Against a background of strong medium- to longer-term fundamentals for the Group’s products and near-term actions to secure Xstrata’s financial position, I am confident that the prospects for Xstrata remain very encouraging.

Mick Davis

Chief Executive

back to top >