Should You Be Buying Mining Companies Like BHP Billiton?

Aug.31.12 | About: BHP Billiton (BHP)

BHP Billiton Limited (NYSE:BHP) recently scrapped plans to build the world's biggest open pit copper and uranium mine in Australia. This resulted from worries that a slowdown in the global economy will hurt demand for natural resources.

BHP Billiton, which is the world's largest diversified mining company, said that it was not going forward with the planned expansion of the Olympic Dam. CEO Marius Kloppers said that the current market conditions - including subdued commodity prices and higher capital costs - have led to the decision.

A slowdown in China has put pressure on commodity prices, especially since China is the world's biggest consumer of raw materials. For instance, copper prices have dropped 25% in the last 18 months. As such, capital intensive large mining projects are not making much economic sense right now. BHP Billiton is, therefore, quite rightly planning to focus on less capital intensive projects as it adjusts to the weak market conditions.

General weakness in commodity markets shows up in BHP Billiton's results for the year ended June 30, 2012. BHP's underlying EBIT dropped 15% for the year, while its Attributable Profit fell 21%.

BHP's ADRs are down 8% this year, which is alarming if you compare that to S&P 500's gain of more than 11%. However, BHP is not the only diversified mining company that is out there in underperformance limbo; ADRs of rival Rio Tinto Plc (NYSE:RIO) fell by more than 12% this year; Freeport-McMoRan Copper & Gold Inc. (NYSE:FCX) is down more than 5% this year.

Indeed, these companies have put up a grossly disappointing performance this year. The million-dollar question is whether things will improve for mining companies in the near future. Considering the uncertainty surrounding the global economy, it seems unlikely though; mining companies will continue to face challenges in the near future.

Global Economic Outlook

The economic slowdown in China was partly due to monetary tightening, since policymakers wanted to curb inflation in the wake of an overheating economy. With inflation now under control, Chinese policymakers have hinted at monetary easing to stimulate growth. However, China's growth has also been negatively impacted by the situation in the eurozone, which has been fighting a losing battle with the ongoing debt crisis.

The eurozone is one of the biggest markets for Chinese exports, and any weakness in the one hurts the other. The outlook for the eurozone remains gloomy. The debt crisis in the region has shown no signs of ameliorating; meanwhile, the region has slipped into a recession.

The economic situation in the U.S. has been relatively better compared to the euro zone. Earlier this week, a report showed that the U.S. economy grew at 1.7% annual rate, which is higher than the previous estimate of 1.5%. This is better than the eurozone's performance, but still not good enough. US economic growth is still below potential. More importantly, the labor market in the U.S. remains weak. Then there is the fiscal cliff. If lawmakers in Washington fail to reach an agreement on cutting the fiscal deficit, automatic spending cuts will be implemented. This is likely to push the U.S. economy into a recession.

Overall, the outlook for the global economy in the near term remains bleak. Also, policymakers now have fewer tools to fight a recession than they had in 2009.

Outlook for Commodities

Prices of several commodities fell in 2012 due to the slowdown in the global economy and concerns over the economic outlook.

BHP Billiton expects volatility in commodity markets to continue in the near-term, due to weakness in manufacturing and construction sectors across all key markets. Also, the outlook for commodity prices in the medium term depends to a large extent on the state of the Chinese economy.

BHP Billiton expects the global macroeconomic environment to improve in the first half of 2013 and believes that this recovery will provide support for commodity demand and pricing in the short to medium term. However, looking at the state of affairs right now, BHP Billiton appears to be over-optimistic in its outlook for the global economy.

There is no solution in sight to the eurozone debt crisis. Although Chinese policymakers may implement stimulating measures, weakness in the eurozone and a possible recession in the U.S. will have a negative impact on growth in China. So, it may take longer than BHP Billiton's projections for the global economy to show any signs of improvement.

In such a scenario, demand and prices for commodities will remain weak. The key for mining companies going forward will be to focus on less capital-intensive projects.

Should You Buy Mining Companies?

In the long term, perhaps yes. In fact, if you have a bullish long-term outlook, maybe this is actually a good time to pick up some mining stocks at a good price. But don't expect returns in the short to medium term. The sector does not look too appealing. Considering the macro environment and outlook for commodities, I strongly suspect the sector will underperform the broad market in the medium term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.