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Why I think you should avoid BHP Billiton Limited shares

mining equipment

BHP Billiton Limited’s (ASX: BHP) dividend is forecast to increase from $0.39 per share in financial year 2016 to $0.70 per share in financial year 2018. That’s an increase of 80% in two financial years. A key reason for this dividend growth outlook is improved sentiment in the iron ore and oil industries. Their prices have risen by 33% and 39% respectively in 2016. However, uncertainty lies ahead for both commodities over the medium term. Therefore, I’m bearish on BHP’s income appeal.

Iron ore

The price of iron ore has been boosted by increased demand from China. It has imported a billion tonnes of iron ore over the last year. A main cause of this is a surging Chinese property market. Annual house price growth reached over 9% in August. Alongside government stimulus, Chinese demand for iron ore could continue to rise in the short run.

However, China is also taking action to cool its property market over the medium term. It has restricted property sales in a number of cities and more regions could do likewise. Therefore, China’s construction sector may not continue to grow at the same pace as it has done in 2016.

Alongside this is a planned increase in the supply of iron ore. For example, Vale’s S11D project is due to come onstream in 2017 and this will add around 90 million tonnes of iron ore capacity each year. Similarly, the Roy Hill mine could add up to 56 million tonnes to global iron ore capacity over the medium term. This mix of higher supply and slowing demand could push the iron ore price downwards.

Oil

BHP’s earnings and dividend may also be negatively impacted by a lower oil price. Although the price of oil has been boosted by Opec’s recent agreement, the cartel followed this up by increasing production to an all-time high in September. In my view, this does not indicate that a deal to cut production lies ahead in the short run.

However, the market has begun to price in a cut in production of at least 700,000 barrels of oil per day (bopd). Therefore, the oil price could fall if Opec does not finalise the deal to cut production at its next meeting. Alongside this risk is sluggish demand for oil which the International Energy Agency (IEA) says is much worse than had been anticipated earlier in the year.

Outlook

BHP’s new dividend policy to pay out at least 50% of underlying attributable profit each year provides transparency to income investors. It also means that BHP has sufficient capital after the payment of dividends to reinvest in its asset base for future growth or to sustain its operations.  However, its yield is lower than popular income stocks such as Telstra Corporation Ltd (ASX: TLS) and Westpac Banking Corp (ASX: WBC). They yield 6.2% and 6.3% respectively, versus 1.7% for BHP.

Further, BHP offers a lack of certainty in its future dividend payments due to its status as a price taker. It remains dependent upon the price of commodities such as iron ore and oil. Their outlooks are uncertain given the potential for a worsening of their supply/demand imbalances. Therefore, in my opinion BHP lacks appeal as an income stock.

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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.

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