4QFY10 was a record event
Most production periods for the large diversified miners have one or two areas of weakness which is only to be expected. Where it counts, in its high margin businesses, BHP Billiton had a solid 2Q10 (4QFY10) and a good twelve months with lots of production records.
The Petroleum division had a consecutive annual production record, largely because of record output from the Gulf of Mexico. Iron ore has kicked goals ten years in a row; the Samarco operations in Brazil had a record quarter and a record year. North West Shelf oil and gas and Hunter Valley coal had record annual production, and elsewhere records were broken in nickel and alumina.
The market seeks a guide to the world economy from each quarterly, or half year report, particularly from BHP Billiton and Rio Tinto. The views of the CEOs from these firms are assumed as the bellwether indicator for what lies ahead. BHP did not have much to say in the recent quarterly other than to say the company was still cautious about the world economy. BHP is concerned that, as governments adjust fiscal settings, demand for raw materials will slow.
There is certainly some truth in the latter point because a high taxing Democratic Government in the U.S. will achieve the opposite of the desired outcome of businesses investing to grow the slice of the pie and a reduction in the numbers of unemployed.
When we look at a table of annual changes in industrial production, with the exception of less than a handful of countries, there is clearly a global recovery taking place. We know that world trade bounced sharply in 1Q10, mainly because of strong surge in activity in March. A 25% increase in trade dragged had a profound and positive impact on the Australian Reserve Bank Commodity Price Index.
In Australia, BHP’s share price has outperformed the ASX 200 index in the last few days. The watered down MRRT is fading into the background, but not for long if Labor wins the election on 21 August 2010 and the Australian Greens control the Senate. The Australian Greens would like to impose a higher tax of 60% on the miners. So it’s not surprising that some pundits are questioning the possibility of a secret deal between Labor and the Greens, in return for the Greens giving second preference to Labor on the how to vote on handouts.
The likelihood of a double dip recession is fading into the distance. An increase in world trade next year will at the very least support commodity prices at around current levels, and this is good for corporate cash flows.
“In a relative sense, BHP is the most expensive play in its peer group; and so it should be it’s by far the largest mining house in the world and deserves a premium rating.”
We know that the best time to buy the miners is close as possible to the bottom of the business cycle when gloom and doom prevails. The time to sell the major miners is before the peak of the cycle. It does not hurt to buy in a tad late or exit a tad early. The aim is capture most of the price appreciation because nobody buys major miners for yield.
Although the Australian Liberal Party is clawing back support, the coming election is going to be a very close run election. An upper house controlled by the Greens might make business conditions difficult with far higher energy costs for all.
With so much uncertainty regarding the outcome of the Australian election we think the appropriate course of action is to HOLD BHP Billiton, and Rio Tinto. With a little more data in hand, and a positive outcome from an election, we would seek to revise our recommendations on the major miners to BUY again.
SHARE PRICE CHARTS AND COMMENTS:
Turning to the charts, BHP touched a recent low of $58.38 during early July and has rebounded strongly since. The move higher saw a break above both the 50 (green line) and 200 (red line) day moving averages, which is bullish. Currently, BHP has found support at the 200 day moving average, which suggests we will see a continued move higher, with overhead resistance at the April 5th high of $83.20.
The weekly chart reveals the breach of the uptrend line in place since late 2008, which is an indication of the weakening uptrend. The 39 week moving average (green line) is currently providing resistance but looks as though it will be broken. The weekly MACD remains negative, however is slowly moving closer to the zero line, which could result in a change of trend back to the upside.
STATE OF PLAY
The following table shows production statistics for what we feel are currently the key drivers of BHP Billiton’s performance. Iron Ore and Coal prices are the main drivers behind the company’s profit and cash flow which is why Labor and the Greens want to increase the tax paid on the Australian operations.
Petroleum
Before the end of this year the price of oil will likely back-up to around US$80 per barrel. Global gas prices are still under pressure and some industry views are that gas prices might be under pressure for several years.
Never the less petroleum is an excellent high margin business. Other miners have to drown their sorrows when the price of energy soars, but not so BHP Billiton because Petroleum Division comes into its own helping offset the pain.
Drilling wells in the Gulf of Mexico is suspended for six months following the BP tragedy, but is sure to begin again because of America’s thirst for oil. Even BHP has to face the problem of declining field production so it is important that its program in the Gulf of Mexico is not impeded for long.
The best of the petroleum businesses is currently crude oil and gas liquids. Production increased in the 12 months thanks to new production in Australia, Pyrenees, and strong performance from Shenzi in the Gulf of Mexico.
To help stave off the inevitable decline in production of petroleum, the company has a number of projects coming on-stream in 2011 and 2012. In 2011 the company has 45% of a gas project in Trinidad and Tobago starting in 1H11 with initial production of 280 million cubic feet per day.
BHP has a 32.5% to 50% interest in the Bass Strait, Kipper gas/gas liquids project. Production is scheduled to begin in 2011 at 10,000 barrels per day of condensate and 80 million cubic feet of gas.
The Turrum gas/gas liquids project is also in Bass Strait. BHP has a 50% interest in this project which is also start production in 2011 with 11,000 barrels per day of condensate and 200 million cubic feet of gas.
The total capital required for the last three projects is around US$1.3 billion. Large sums of capital are also being spent at the North West Shelf which includes North Rankin B Gas (BHP 16.67%) which is scheduled to produce 2,500 million cubic feet of gas per day in 2012.
Copper
Copper is our favourite base metal. The reason for this is that we believe that supply will struggle to keep pace with demand in the future. We have constantly pointed out the London Metal Exchange stocks of copper are falling on a daily basis, and if that trend continued, the price would bounce. This is what happened during the week ending Friday 23, 2010; the price of copper rose 7.5% to US$3.17 per pound.
The supply of copper concentrates is extremely tight. Smelters have to run at full capacity otherwise they become incredibly inefficient and high cost. When the concentrates are in short supply the prices that smelters charge for turning the concentrate into copper metal fall; and vice versa.
In recent times some smelters have charged nothing to treat a concentrate other than the normal smelter deduction which might be 1% off the concentrate grade; for a concentrate grading 28% copper, the payable metal value is 27%.
The other charges that smelters have are for smelting and refining. These charges might normally be US$80 per tonne to smelt the concentrate and US 8 cents per pound to refine the copper. The costs have not just fallen, they have plummeted.
The sorts of smelting and refining charges in vouge at the moment are US$15 per tonne as a smelting charge and US 1.5 cents per pound for refining. This is not the sort of situation that emerges during a recession, but is one that is highly supportive of strong demand for the most important industrial metal for increasing industrial output.
The other reason that we like copper is for the very long term. Even if world growth in consumption slows to 3% per annum, demand will double in 24 years. 2034 might sound a long way off but it means that 17 million tonnes of new copper will be needed, and production at existing mines must be maintained at existing levels.
It takes 10-12 years to find and develop a large copper deposit. The reality is that the world will need the equivalent of at least 68 new mines producing 250,000 tonnes of copper per annum by 2034. It will be very difficult to achieve that sort of increase in production.
BHP is actively exploring for copper in Chile and Zambia., but it might be easier to have tilt at one of the copper producers like Antofagasta perhaps?
It was entirely expected that BHP’s copper production would be lower in FY2010. Like many of the world’s major copper mines, the average grade is falling. Lower ore grades were experienced at Cerro Colorado and Antamina and making life more difficult was the outage at Olympic Dam in South Australia and industrial action at the Spence mine in Chile.
Escondida had a strong quarter but declining grade is expected to drop production by 10% in 2011. BHP owns 57.5% of the Escondida mine Chile which produced a total of 448,100 tonnes of copper in concentrate in FY10, which was an increase of 7.3% over FY09. Escondida also produces a tad over 170,000 tonnes of copper cathode per annum.
We are particularly concerned about any falls in the output of copper because higher prices will probably offset falls in volume.
Marketing
BHP Billion has largely moved away from benchmark pricing and instead prices for iron ore, manganese and coal are more closely linked to market prices. This is a good when demand is strong and prices are rising, but if and when prices fall the sword will cut both ways.
Let’s take the spot price of iron ore, 62% iron, CFR North China. It was not many weeks ago that the price was around US$180 per tonne, now it is UA$129 per tonne. Domestic steel prices in China are at least US$100 per tonne below a global benchmark price. Stocks of steel and iron ore built in China and weighing on the spot price is higher production from domestic mines.
The situation in China with regards iron ore seems fluid and over recent days the Chinese traders have been reported taking long positions again. Recent spot trades from India have been reported at an equivalent price of US$140 per tonne CFR China.
The worst might be over for iron ore prices but there is a question of might happen to short term contracts in the event that the spot price falls below the contract price.
In the long term the world will probably be over supplied with iron ore from Africa and Brazil. The high prices for iron ore that the Australian Labor Government is relying upon for its budgetary purposes will not last for ever.
The outlook long term for copper is a completely different matter and BHP Billiton needs more exposure to it. It’s copper which makes Xstrata particularly attractive; Xstrata has the highest leverage of the diversified miners to the red metal.
Value
BHP Billiton is running second place to Rio Tinto in terms of which company is touted as the preferred investment by leading stockbrokers. However, both companies are expected to outperform the broader equity indexes.
Turning to the consensus forecasts we note that Rio is trading on lower earnings multiples than is BHP, not that BHP is expensive, because it is not.
The consensus price earnings multiples for BHP Billiton are 10X for 2011, and 9X for 2012 and 2013. The cash flow ratios are 8.5X for 2011, and 7X for 2012 and 2013; 7X or below is good value and above 9X expensive.
The consensus price earnings multiple for the large cap diversified and metal company sector is 6.2X for 2011; and the cash flow ratio is 4.5X.
In relative sense, BHP is the most expensive play in its peer group; and so it should be it’s by far the largest mining house in the world and deserves a premium rating.
At this point in the business cycle BHP Billiton will remain firmly HELD in the Portfolio. We look forward to considering changing our recommendation to BUY; but not before the results of the forthcoming Australian election is known.
DISCLAIMER
Fat Prophets has made every effort to ensure the reliability of the views and recommendations expressed in the reports published on its websites. Fat Prophets research is based upon information known to us or which was obtained from sources which we believed to be reliable and accurate at time of publication. However, like the markets, we are not perfect.
This report is prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore discuss, with their financial planner or advisor, the merits of each recommendation for their own specific circumstances and realise that not all investments will be appropriate for all subscribers.
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As at the date at the top of this page, Directors and/or associates of the Fat Prophets Group of Companies currently hold positions in Avexa (AVX), Evolution (EVN), Cerro Resources (CJO), Energy Action (EAX), Mt Isa Metals (MET), Telstra (TLS), Woodside Petroleum (WPL), ANZ (ANZ), Austar (AUN), Carsales.com (CRZ), Gold Road (GOR), IOOF Holdings (IFL), Magellan Financial group (MFG), Paladin Energy (PDN), QBE Insurance (QBE), Platinum Australia (PLA), Datasquirt (DSQ), Hodges Resources (HDG), Newcrest Mining (NCM), Oil Search (OSH), Zambezi Resources (ZRL), Auroa Minerals (ARM), Billabong (BBG), Pioneer Resources (PIO), Runge (RUL), Westpac (WBC). These may change without notice and should not be taken as recommendations.