Commodity Stocks For An Imminent Recession

by: Ry Frank

When BHP Billiton (NYSE:BHP) reported its results for the six months to December 31, 2011, it reported a decline in net income of 5.5% on the year-on-year basis to $9.9 billion and short of the consensus estimate of at least $10 billion...the decline was attributed to the decreased production, which is affected by heavy rains and some minor labour problems in the copper division.

The global economic problems particularly in Europe also contributed to the decline in profits as lower demand for a number of BHP products led to softer prices. The company showed record net income of $10.5 billion for the same period in the previous year on the way to an 86% increase to $23.6 billion in the previous fiscal year. Revenue rose by just under 10% to $37.48 billion and return on capital remained at the high level of 28%. Despite the fall in prices, profitability levels were sustained by the highly profitable iron ore business and this is a strength that BHP shares with one of its major competitors Rio Tinto (NYSE:RIO). BHP also announced a dividend of $.55 a share up from $.46 per share in the previous year.

I am often amazed by how many people regard BHP as a mining or a metals company when it is in fact probably the most diversified of the giant commodities companies in the world. It mines for and extracts gold but also smelts alumina. It deals with carbon both in the form of coal and in the form of diamonds. It is also in the oil and gas exploration business. It operates in geographical locations as diverse as South Africa, Chile, Indonesia, Mongolia, Colombia, Gabon, Ecuador, India, Australia, Liberia and many others. And it is in the top 200 of the Fortune Global 500 companies.

Recently you would have seen a lot of media coverage about BHP and the global iron ore business. Iron ore is a large slice of BHP's business and much of the news has to do with China, which is a large consumer of iron ore for its gigantic steel requirements. There is a broad expectation that the GDP growth in China is going to slow down this year and consequently the demand for iron ore is expected to fall. To be sure, this will hurt BHP but let us take a quick look at its competition. The largest iron ore producer in the world is Vale (NYSE:VALE) of Brazil, and the world market is pretty much dominated by Vale , Rio Tinto and BHP. Vale has invested a fortune in the "Capesize" vessels and "Valemax" vessels, which can transport huge quantities of iron ore. However, China, by far its biggest customer, only permitted one port entry before banning the entry of ships over 300,000 tonnes into Chinese ports. Rio Tinto managed to increase production by about 10%, but this disappointed the market, which was expecting a larger increase.

The company that has been the worst affected is Anglo American (OTCPK:AAUKY), which has invested billions of dollars in an iron ore mining project in the province of Minas Gerais, Brazil. This is Anglo-American's biggest project of any kind by far and it has now been forced to suspend work on the project because a Brazilian judge has suspended its license. It is likely that the project could be snarled up in legal problems for a long time to come.

What of the future prospects of BHP itself? The iron ore continues to be of importance in determining revenue and profits and production from the Pilbara iron-ore mines is at record levels. It is unlikely that Chinese demand will continue to be strong and prices may well keep dropping but because of the efficiency and the cost effectiveness of the company's mining operation, it should be able to retain a high level of profitability. BHP said for every $1 a tonne change in the iron-ore price, its net profit for the 2012 year would change by $US95 million. Last year, BHP acquired Petrohawk Energy, the U.S. producer of gas from shale for just under $15 billion. Petrohawk has now reported a loss of $55 million in the three months to March 31, compared with a loss of $29 million a year earlier. Gas prices in the U.S. declined and, if they continue to remain weak, BHP could well be considering a write-down in the value of gas assets of as much as $5 billion, according to some analysts.

It is rumored that BHP is planning another major acquisition and the target is Walter Energy (NYSE:WLT), a coal producer based in Birmingham, Alabama. In addition to producing coal, Walter also has a subsidiary that extracts natural gas from coal fields. I consider this unlikely, however, as BHP seems to be cutting back on capital expenditures like its Escondida copper mine operations until the international commodity markets have stabilized. However, the acquisition would be a sensible long-term move to bolster a key business area. It also seems that BHP is having labor problems again at the gigantic Escondida copper mine in Chile. The company has claimed that production is unaffected and this means that global copper prices are not likely to be affected.

If you are looking for a good global commodity play, BHP is an excellent candidate because of its strength and diversity. This also ensures that it is not a China centric stock, and the 3% dividend yield is attractive. Despite the rumored slowdown, the company has done well out of China and the cut back on its ambitious expansion plans should preserve financial resources and strengthen the balance sheet. The real question is whether or not you should be looking at commodity plays at this point of time. In my opinion, the decision should be deferred until there is more clarity on the global outlook. If you have an existing holding in BHP stock, by all means hold on with the expectation of better returns in the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.