BHP: It's Hammer Time

This week should prove to be an interesting one for those who follow metals and mining companies. BHP has two things on the corporate calendar for February 6: First, its earnings report; second, it will either need to put up or shut up with regards to a Rio Tinto (RTP) acquisition.

Earnings are expected to be $9.62 billion for the half year that ended Dec. 31, which is up 5% compared with the same time period in 2006. But many analysts aren’t making forecasts because of possible conflicts of interest – half the street is advising either BHP or Rio Tinto about the endlessly discussed potential merger. Rio Tinto is scheduled to announce its earnings the following Wednesday, with analysts expecting $7.2 billion for full year 2007 – down 1.4% from 2006.

How the stocks respond to all this is anyone’s guess. After all, if “everyone” got it right, the market would be boring. In this case, it’s difficult to separate the two events because all news stories lead back to the possible takeover. We’ve reported on this before – but here’s the 30-second review:

In November, BHP offered to buy Rio Tinto in a 3-for-1 share deal. Rio Tinto turned them down, saying that the offer vastly undervalued RTP, and has continued to turn them down. It seemed that the market agreed, as RTP’s stock price rose above the offer’s valuation. In December, Rio Tinto requested that the UK Takeover Panel give BHP a deadline for a formal bid. They did—February 6 - so on that day, BHP will either need to submit a formal bid or go away for at least six months. To make matters even more interesting, Friday (February 1), Alcoa and Aluminum Corp. of China announced the acquisition of 12% of Rio Tinto.

This isn’t the only mining merger that is in the news – Companhia Vale do Rio Doce (RIO) from Brazil is getting ready to make a possible bid for Xstrata PLC (XTA.LN). These are just the tip of the acquisition iceberg. For the past year, news of attempted and completed acquisitions have regularly been in the headlines and driving stock prices.

Why does that matter?

BHP, RTP and Commodity Performance

BHP is a huge company ($192.09 billion) with mining interests all over the world. It operates in petroleum, aluminum, base metals (copper, silver, nickel, zinc, lead), stainless steel materials, iron ore, manganese, coal (metallurgical and energy) and diamonds and specialty products.

Rio Tinto is almost equally as large, with a market cap of $130.68 billion. Its primary products are aluminum, copper, diamonds, energy products, gold, industrial minerals and iron ore.

If the merger comes to pass, the resulting gargantuan would end up cornering 38% of the iron ore market, 6% of the copper market and become the world’s largest coal supplier. Needless to say, commodity investors need to take note.
Now, a rational investor (and all evidence aside, that’s what I consider myself) would think these two commodity giants would perform like the commodities they produce.

But do they?

The chart below compares the performance of five different publicly traded commodity investments.

• BHP Billiton stock (BHP – the blue line)
• Rio Tinto stock (RTP – the red line)
• The iPath’s GSCI Total Return ETN (GSP – the green line – representing a broad-based, energy-focused portfolio of commodity futures)
• The StreetTRACKS GoldShares ETF (GLD – the yellow line – representing the price of gold bullion)
• The Powershares DB Base Metals ETF (DBB – the grey line – representing an investment in aluminum, zinc and copper futures)

Over the last year, BHP and Rio Tinto have performed primarily in lockstep – moving up together, moving down together. The only time they really diverge is in response to news of the proposed merger.

Similarly, GLD and GSG have been running together, which makes sense given the way oil prices and gold prices have been climbing. It is only lately, with oil prices going down because of the threat of recession and gold going up because of those same fears, that the two have started to separate from one another.
DBB is in a whole other world.

Obviously, commodities and commodity stocks are not the same thing.

It gets even more interesting if you dig into the actual correlations, which we show in the table below.

As expected, BHP and RTP are highly correlated at 0.85. You might expect a strong correlation between these mining companies and the base metal commodities they produce, but you’d be wrong. BHP and DBB have almost no correlation: 0.067. Rio Tinto is actually negatively correlated to DBB at -.17.
Interestingly, the two companies are much more closely correlated to gold (GLD) and the energy-heavy GSP, with correlations between 0.82 and 0.93.

Curious Correlations BHP RTP GSP DBB GLD BHP 1.00 RTP 0.85 1.00 GSP 0.85 0.93 1.00 DBB 0.07 -0.17 -0.24 1.00 GLD 0.67 0.82 0.93 -0.38 1.00

What’s going on here? Well, one possible explanation is petroleum. GSP is heavily weighted in energy (74%) and roughly 16% of BHP’s earnings come from their petroleum group. For the past year, at least, BHP has traded more like it’s in the energy business than the metals business.

That’s speculation, but here’s a fact. Companies and commodities are simply different kinds of investments. Buying a commodity like gold gets you … a lump of metal. The price goes up or down according only to how the market values that rock. Nothing that rock does is going to influence its price.

Buying a commodity future like the Base Metals ETF (DBB) gets you exposure to the commodity plus some exposure to the forces of backwardation and contango.

But buying stock in a company gets you more than the products they produce. You are investing in how the company is run, from the decisions its CEO makes to its safety record and employee morale. (You don’t think accidents cost money or that employee morale can have a big effect on production and the bottom line? Read a mining company annual report.) You’re also investing in the company’s hedging and leveraging decisions – all of which distorts the tie between commodity price and stock performance. Investing in a mining company is not directly investing in a commodity.

And in the case of BHP, you’re making a big investment in how well they manage the Rio Tinto decision, the China card and public perception.

But, investing in a company is the only way, at least for now, to get exposure to certain commodities. With no commodity-based pure-play for coal or steel (at least until April '08), investing in companies that produce those products – like BHP and RTP – is the only way to play. And besides, at least for the past year, BHP gave a better return than DBB, plus exposure to coal and steel that isn’t available with DBB.

Should be a fun week.