The BHP bottom isn't near

May 19, 2016 02:00 PM

After a two-year bear market in commodities, some analysts may be looking to the sector to find value. While there are certainly long opportunities out there amid the volatility in commodities, BHP Billiton Limited (formerly BHB Limited) stands out as a strong short opportunity, with more downward left. 

BHP Billiton LTD (BHP) discovers, acquires, develops and markets natural resources worldwide. Its primary commodity interests are in petroleum, coal, potash (as agricultural fertilizer), copper and iron-ore. Formed in 1851, headquartered in Melbourne, Australia, BHP’s global business model has continued to expand with iron-ore extraction as one of the world’s leading producers.

Although, BHP’s diversified commodity interests allow for certain degree of financial hedging from individual commodity fluctuations, the recent drop in iron-ore prices is taking its toll on the company’s earnings, with put options on the short side and higher risk calls. Recent spikes on March 17 and March 30 have generated hope that a continued rally is in the offing. However, any specific global economic correction must be examined in tandem with the macro geopolitical and economic realities. The six-month stockpile of iron-ore in China will continue to push global inventory to its highest supply levels. And while some analysts predict that increased demand for iron-ore will help BHP regain momentum, the 2016 consensus is for a  2.85% decline in demand. There also are other mitigating factors impairing a potential iron-ore’s rebound, making the March rebound in BHP a shorting opportunity. 

China is not the only global factor driving iron-ore demand down, increasing inventory and lowering expectations for BHP. The recent mud and iron-ore dam breach in Brazil, now flowing down the Rio Doce River toward the Atlantic Ocean as a result of BHP Billiton and Vale’s co-venture, has led to an unprecedented environmental and media branding disaster. BHP’s attempt to mitigate the situation with a $262 million payout has not assuaged public anger surrounding the mining operations and future litigation that could rise to upwards of $7.2 billion.

Even an attempt to ignore these aspects— China’s production of iron-ore and the fallout in Brazil — worldwide iron-ore production is forecast to increase. Producers’ efforts to limit production may be insufficient, with iron-ore prices sinking to $30 per metric ton from a high of $60 in March 2016. As a result, BHP’s earnings’ risk will play a critical role in its subsequent dividend yields. Any possible reduction or elimination, forcing BHP to lower its dividends for the first time in 25 years (currently at 1.56 trailing12 months or 6.08%), could see its prices falling into the lower teens.

BHP’s chart has been in a stair-step decline since the second half of 2014 (see “Failed rebound”). A reversal from its January low under $20 recently failed as it hits resistance at $29. This downtrend step has been re-established and a test of its previous low of $18.46 set on Jan. 19, 2016, is likely.

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