BHP Billiton Limited (ASX: BHP) has risen by 12% in 2016. That?s behind iron ore peer Fortescue Metals Limited (ASX: FMG), which is up 161% year to date. However, it?s higher than Rio Tinto Limited?s (ASX: RIO) gain of 4% in 2016. In my view, BHP Billiton?s risk profile is unappealing due to an uncertain outlook for commodity markets.
Although BHP is a well-diversified resources company, the commodities it mines have proven to be highly correlated. During the downturn of recent years, the prices of oil, copper and iron ore fell dramatically. Therefore, I question the value in terms of…
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BHP Billiton Limited (ASX: BHP) has risen by 12% in 2016. That’s behind iron ore peer Fortescue Metals Limited (ASX: FMG), which is up 161% year to date. However, it’s higher than Rio Tinto Limited’s (ASX: RIO) gain of 4% in 2016. In my view, BHP Billiton’s risk profile is unappealing due to an uncertain outlook for commodity markets.
Although BHP is a well-diversified resources company, the commodities it mines have proven to be highly correlated. During the downturn of recent years, the prices of oil, copper and iron ore fell dramatically. Therefore, I question the value in terms of risk reduction of BHP’s diversified operations.
The outlook for commodities such as iron ore and oil is relatively downbeat. For example, iron ore is forecast to fall to US$35 per tonne by 2020 due to rising industry cost cuts and an increasing reduction in demand for steel from China. Further falls in iron ore are expected between 2020 and 2025, due to an increase in substitution from scrap as China’s stock of steel matures.
Similarly, the oil price is forecast to fall to below US$40 per barrel within the next four years. This is largely due to productivity improvements and falling costs in the US shale industry which have lowered the marginal cost of production. In my view, the end of the China-driven commodity boom has not fully unravelled. This could cause BHP’s profitability to disappoint over the medium to long term.
One advantage of BHP versus other resources stocks is its financial standing. Its debt to equity ratio of 61% indicates that its balance sheet can accommodate greater leverage. BHP believes that its current level of net debt is the peak of the cycle and expects it to fall over the medium term.
BHP is targeting a reduction of 12% in unit costs in financial year 2017 and total productivity gains of US$1.8 billion excluding the savings from reduced petroleum production. This follows productivity gains of US$437 million, as well as free cash flow of US$3.4 billion in the 2016 financial year.
Further, BHP has an asset base which includes a number of the world’s largest mines. This provides it with scale advantages over rivals. BHP’s cost curves in iron ore and LNG are at the lower end of their respective industry cost curves. However, over-investment during the commodity boom when capital costs were high compared to today has reduced the overall impact of operating cost advantages in my opinion.
BHP Billiton’s geographic diversity and balance sheet strength reduce its risk profile. However, it remains a price taker with a narrow economic moat. The commodities it produces are positively correlated and therefore provide little downside protection during a commodity downturn. In my view BHP lacks investment appeal, particularly when compared to these three blue-chip shares.
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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.