Why a bet on BHP Billiton Limited is a huge risk to take

BHP Billiton Limited (ASX:BHP) is highly leveraged to the prices at which its commodities trade.

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Speculating on the future of commodity prices is a dangerous game to play, yet that is essentially what investors are doing when they buy shares of the miners themselves.

Unless you've been living under a rock for the last few years, you'll know that the prices of numerous commodities have come under enormous pressure. This has mostly been the result of a decline in global demand as China's economic growth has continued to wane, combined with an increase in supply from producers around the world.

The costs involved with producing resources are enormous, and must be covered by a high level of income generated by the sale of those commodities to various purchasers around the world. In other words, the miners rely on higher prices to increase that revenue, or else they operate on extremely thin margins with the bottom line – or the group's overall profit – bearing the impact.

That is exactly what has happened most recently to some of Australia's biggest, and most widely-held companies. For the 2015 financial year, BHP Billiton Limited (ASX: BHP) reported a 22.2% decline in revenue and a 51.6% decline in its underlying net profit. Rio Tinto Limited's (ASX: RIO) underlying net profit also fell 43% for the year.

Shares of both companies have been severely affected by the downturn, down 31% and 20% over the last 12 months, respectively.

Should you buy BHP Billiton?

BHP Billiton Limited has long been considered Australia's safest mining stock. To a large extent, I would tend to agree considering its low cost operations and its high level of diversification.

However, although BHP Billiton has diversified its operations, all four of its primary commodities – being iron ore, copper, coal and petroleum – are under enormous pricing pressure, and have been for a long stretch of time. This is why the miner's earnings fell in 2015, and it's also why the shares are down so heavily this year.

Like all other miners, BHP Billiton is highly leveraged to the prices at which its commodities trade. With BHP's shares trading near a seven-year low price, many investors believe now is a great time to buy, but that really depends on whether commodity prices have bottomed out yet.

Given the uncertainty regarding China's future economic growth, I don't believe they have just yet. Iron ore and oil in particular are expected to continue falling over the next few months which could put a serious dent in BHP's and Rio Tinto's 2016 earnings. With so many other shares on sale right now, that's just not a bet I'd be willing to make.

Motley Fool contributor Ryan Newman has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. You can follow Ryan on Twitter @ASXvalueinvest. 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.

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