One of the challenges of investing in mining companies is that, by definition, they are price takers. This means that their profitability is largely dependent upon the price of the commodity they mine. And while many investors may make a prediction as to where commodity prices are headed, the reality is that doing so accurately is very challenging.
However, mining companies can derisk their operations to a degree by diversifying. That's why BHP Billiton Limited (ASX: BHP) has proven relatively popular among investors, since it provides exposure to a range of commodities including oil, iron ore and copper. That's even after a major disposal which saw a number of non-core operations spun-off into South32 Ltd (ASX: S32).
In theory, then, BHP should offer a lower risk profile than a pure play mining company such as Newcrest Mining Limited (ASX: NCM). That's because Newcrest is a gold mining business and while it is Australia's largest gold miner, it is reliant upon the price of just one commodity rather than a handful as is the case with BHP. And as we have seen with other mining companies such as Rio Tinto Limited (ASX: RIO), a fall in the price of one commodity (iron ore in Rio Tinto's case) can cause a major fall in profitability and the company's share price.
However, investors may argue that Newcrest's exposure to gold is less risky than BHP's diversified portfolio of operations. That's because as has been seen in recent years, commodity price falls can occur at the same time, with a slowdown in demand and a rise in supply of oil, iron ore, and copper causing their prices to fall and BHP's profitability to tumble.
Further, the gold price can act as a useful hedge against a weak outlook for the world economy. It is still seen as a store of wealth by many investors and so with the outlook for Europe and China in particular being uncertain, the gold price could rise yet further following its 25%+ increase year-to-date. And with the US Federal Reserve being dovish, competition from interest-producing assets could remain low and fuel gold's rising price further.
In terms of their internal operations, both BHP and Newcrest have made major improvements in recent years. I was impressed with Newcrest's recent update, since it showed a reduction in costs and a rise in production. Newcrest's all-in sustaining cost per ounce dropped by 4.5%, while production rose by 2.6% – in other words the 'jaws' of revenue and costs moved in the right direction.
Similarly, BHP's production in 2015 increased in the double-digits for a number of its segments including iron ore. And with it continuing to invest heavily in its long term capacity, BHP may be able to maintain or even grow market share to create a more dominant business. Its cash flow indicates the potential of the company to continue to do so, with it having free cash flow of around USD$5.4 billion per annum over the last three years even after spending over USD$16 billion on capex per year.
So, in the long run both BHP and Newcrest could continue to dominate their respective fields.
Although the former is more diversified, the latter mines an asset which is viewed as a store of wealth by investors across the globe. And with the economic outlook being uncertain, Newcrest could continue to outperform BHP in the short term.
