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Tuesday, August 18, 2009

I Like BHP Billiton, But It May Be Due for a Big Pullback

About 3 months ago, I was advised by a long-term friend to take a look at BHP Billiton (BHP) as "the best single way to play the Resource space". He further went on to talk about the dynamic growth that they had experienced, and how brilliant the management was. Upon taking a closer look at it, he had some good points.

First, the breadth of BHP's business is impressive, as it covers just about all key aspects of the Resource world:

1) Base Metals (Copper, Zinc, Lead, Iron Ore, Nickel and Cobalt)

2) Coal (Metallurgical and Thermal coal)

3) Magnesium

4) Oil and Gas

5) Aluminum

6) Rough Diamonds / Titanium

7) Potash (New Venture)

All they would have to do is to throw in Fresh Water, and they have most of the world's needs covered. However, I started wondering if they had holdings and weightings in each in resources that will truly benefit from when the economy recovers. I've given a quick over view of each resource, and where it may go in the short term (less than 2 years) and in the longer term (2+ years).

I'm not an Engineer or Chemist, nor do I cover these materials as well as some. I don't tend to factor in things that you can't prove/predict when I write, such as hoarding of materials by some countries or how speculators may drive up and down prices for reasons not related to their fundamentals....there are people who are a lot smarter than I, when it comes to each of these metals.

Base Metals (32% of 2008 Profit)

- Most Base metals have a high correlation to Industrial Production. Copper is heavily used in Piping/wiring for Houses, Industrial Circuits/machinery and Plumbing for Indsutrial uses. Zinc is used heavily in Steel/Brass production, as well as in batteries. Lead has tons of uses, ranging from use in boats, to batteries to Electrical solder.,,,,you get the drift.

- Most of these metals are extremely sensitive to economic conditions and were very punished during the Economic downturn. However, most of them have a direct correlation to the expansion in the BRIC / Emerging markets arena, and should fare well in the longer term. In the very short term, I would expect a sharp pull-back on some of them, as the run since the beginning of 2009 has been almost too good.

Coal (8% of 2008 Profits)

- BHP put an announcement out on June 10th this year, announcing that prices for Met Coal could fall by close to 60% by the end of the year. This is mostly due to the strong drop in demand for Steel.

- Thermal Coal prices are up from their February Low, but are well down from their high in August 2008 (well over 50% down). They should have some strong legs in 2010, namely due to China's increasing development of Coal-fired plants

- Overall, either Coal Product won't be a short-term catalyst for BHP, however, I would expect that they will be much more profitable starting in 12-18 months when demand picks up.

Manganese (6.5% of 2008 Profits) and Iron Ore (19% of 2008 Profit)

- Although Maganese has other uses (such as Electrical), these two metals are closely enough linked (at least from a Financial standpoint), that I have linked them together. Both of these metals are used to make materials (Iron/Steel) that are used in Heavy Machinery, Construction, Automobiles and other projects.

- These metals are both extremely economically sensitive. They both should see continued growth in both the short term and the long term (short term based mostly on the eventual implementation of much of the EU/US Stimulus projects, as well as the continued Infrastructure growth in the BRIC countries in the longer term).

Oil/Gas (23% of 2008 Profits)

- If you've read any of my past articles, you no doubt know that I am a long-term bull on both Oil and Natural Gas. This differs a lot from my short-term thoughts, however.

- Oil should remain strong for most of 2009, with some significant upticks in 2010, in line with the economic return of the US Consumer in mid to late 2010. Natural Gas, on the other hand, has a different problem, in that much of the current weakness was not all related to the Economic downturn, but rather a nice spike in the amount of available resources. This extra production will not be absorbed quickly, and even when demand returns with the Economic upswing, the price may not rise until late 2010 or even 2011. Longer term (past 2012), the sky looks bright for both Oil and Natural Gas, as we may start to see returns to 2007 prices and even beyond.

- Watch for my next article, which will be on the future of Natural Gas.

Aluminum (6% of 2008 Profits)

- Is there anything in this world that is not made from Aluminum, with a range of uses from Automobile to Construction materials to Baseball bats to Paint to Foil?

- Aluminum has seen a nice spike since the start of 2009, mostly due to an increased feeling that the economy has seen its worst (Note - I'm not going to take sides on whether China is hoarding).

- I suspect that this rally has been overdone in the short term, so expect a pull back, especially if Q3 earnings for Fortune 500 companies aren't as rosy as what people seem to think they will be. As well, it's hard to say whether Obama will continue the Cash for Clunkers plan, which undoubtedly help to increase Auto production (and the demand for Aluminum) beyond where it would have normally been at this stage of the economic downturn/recovery.

In short, I do like BHP (it is my largest holdings), although due to its volatility, it isn't the easiest stock to own. I think that its most recent run (it has almost doubled since its low in February) means that it will be running out of steam shortly, and may be due for a big pull back. I think you may be able to get it again in the low 50s (for the ADR in NY), and maybe even below $50.

At $50, it would be a great entry point, as it would be trading at about 10x expected 2009 Earnings, and would yield over 3%. With the expected growth in China, and an economic recovery in the rest of the world, this one may return back to its former highs of $90+ within 18 months, so you would be looking at close to a double, when you factor in the dividend.

Disclosure - I am long BHP as one of my largest holding's.

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