Last week, the Big Australian, BHP Billiton Limited (ASX: BHP), took another tumble on the ASX – down to around $28.50 from a high of nearly $40 in August 2014. That's a significant drop in value. Why is this so?
One of the major factors is the decline in its Standard and Poor's rating from stable to negative and its placement on S&P's ratings watch list. Let's take a look at what caused the ratings change.
Iron ore and coal prices are low – the spot price for iron has halved over the last year and many analysts aniticipate that the long-term prices will settle around $50-$55 per tonne (at the beginning of this month it was $60 per tonne). There are some suggestions that BHP and Rio Tinto have flooded the market in an effort to gain more market share, squeezing junior miners out of the market and attempting to be the last man standing. But that strategy looks to be changing.
BHP has flagged that it will take a "slower path" to reach its output target of 290 million tonnes a year. Iron ore producers around the world are looking at reducing production – Brazil's Vale announced it will cut production by up to 30 million tonnes and it looks likely that other international producers will follow suit if commodity prices do not rise.
However, for BHP, higher production does not necessarily correlate to higher profits. At current prices, the profit per tonne for iron ore is only a few dollars and whilst iron ore is not the only contributor to income, it represents almost 40% of its overall commodity revenue. Australian operating costs in the mining industry are high by world standards – all contributing to a lower bottom line.
The closure of BHP's nickel mine in Ravensthorpe in WA and the subsequent sale of the mine for considerably less than its book value resulted in write-downs in 2009 of $3.6 billion. In 2012, BHP announced it would not be proceeding with the expansion of Olympic Dam in SA in the face of slowing commodity prices and global economic growth. There are significant capital expenditures tied up in such projects that may never be recovered.
BHP's largest market, China, has a slowing economy at present and it is anticipated that as its building industry slows, its demand for iron ore will both diminish over the next few years and be sourced from lower cost producers globally. In addition, China is aiming to achieve 40% self-sufficiency by the end of 2015, although it will still be a major customer for the higher quality iron ore produced in Australia, because the iron ore produced in China is of a poorer grade.
Coal is another major income source for BHP, representing around 15% of commodity revenue. The factors mentioned above in relation to iron ore are also affecting the market for coal and the outlook for thermal coal is bearish. In addition, as countries around the world come to grips with the changes that they must make to address climate change, technology for power generation will improve. The demand for fossil fuel power generation will diminish – and as a result, so will BHP's markets.
At a recent conference on risk considerations in portfolio management, speakers commented on the increasing trend for investors to divest perceived "risky" assets such as those in coal-reliant resource companies.
Foolish takeaway
BHP continues to be upbeat in its reporting and pays high dividends – but for many, this could be seen as unsustainable in the face of falling cash reserves. The continued outlook for BHP is not, by any means, as rosy as it once was. That's why S&P is keeping a close eye on the Big Australian – and we are, too.
