The rising oil price in 2016 has lifted BHP Billiton Limited (ASX: BHP) 13% higher this year. That's behind the capital gains of industry peer Santos Ltd (ASX: STO), which is 26% higher, but represents an improvement on BHP's 2015 fall of 38%. However, is BHP a stock which should be avoided?
Finances
BHP's debt levels increased in the first half of the 2016 financial year from US$31 billion to US$36.5 billion. However, its gearing remains conservative at 59% of net asset value, while a cash balance of US$10.6 billion enhances its financial health.
BHP's free cash flow in the first half of FY 2016 of US$1.3 billion was aided by reduced capital expenditure. It fell from US$6.4 billion in the first half of FY 2015 to US$4 billion in FY 2016 as BHP cut back on exploration expenditure by 40%. This policy is likely to continue as BHP expects to invest a total of US$7 billion in FY 2016 and US$5 billion in FY 2017.
BHP's financial standing also improved because of its new dividend policy. It is committed to paying out a minimum of 50% of underlying attributable profit at every reporting period. BHP will also pay additional amounts according to its ability to pay. This provides it with additional financial flexibility and means that dividends are sustainable. It does not need to borrow in order to fund dividend payments or investment in its asset base.
Strategy
BHP's productivity has improved since its productivity drive began in 2012. Since then, it has embedded annualised productivity gains of more than US$10 billion. The divestment of US$7 billion of assets and the demerger of South32 Ltd (ASX: S32) have also improved efficiencies due to BHP's focus on a smaller group of large, low cost, long life assets.
Despite its asset spin-offs, BHP is better diversified than industry peers such as Newcrest Mining Limited (ASX: NCM) and this reduces its overall risk profile.
Cost reductions have aided BHP's profitability. In the first half of FY 2016 it reduced Black Hawk well costs by 30%. Similarly, iron ore and coal unit cash costs declined by 25% and 17% respectively in the first part of FY 2016. BHP expects to reduce costs further next year and this will help to boost free cash flow and earnings.
Outlook
Despite a sound strategy and strong finances, BHP expects a prolonged period of weaker commodity prices as well as higher volatility. This increases its risk profile even though it has a diverse breadth of operations across multiple commodities such as oil, iron ore and copper. It also means that profitability and cash flow could come under further pressure, with cost cutting likely to offer diminishing returns over time.
As a price taker, forecasting its medium term financial performance is highly challenging. Although it may outlast a number of sector peers in a commodity downturn, its risk/reward ratio lacks appeal.
