2015 has been a tough year for the commodities, as low demand and oversupply have pushed down the prices of most companies in the sector. What’s worse, there seems to be a growing consensus that prices will likely remain lower for longer.
Signs are abound that commodity prices are unlikely to make a rapid recovery. Slowing emerging-market growth, increasing global production of raw materials and a stronger US dollar all point towards further downward pressure on commodity prices.
BHP Billiton (LSE: BLT) has seen the value of its shares fall 44% since the start of 2015, as underlying earnings decreased by 52% in the year. But BHP has taken advantage of its low-cost production base to reduce the impact of lower commodity prices on profits by expanding production.
During the year, petroleum output rose 4%, iron ore production climbed by 14%, whilst copper production was broadly flat. In addition, the company has exceeded analysts’ expectations in cutting costs, which will lessen the impact of declining commodity prices.
Free cash flow generation has been comparatively resilient, having fallen just 26%. And this has meant that BHP has, so far, been able to maintain its progressive dividend policy. It raised its final dividend by 2% to $1.24 per share.
However, BHP’s dividend yield of 10.5% indicates that the market is not confident that its dividend is sustainable for much longer. The outlook for lower commodity prices means BHP is unlikely to match its cash flow needs for capital investment and ongoing dividend payments with incoming operating cash flow.
With earnings set to fall another 58% in 2015/6, its valuations are not cheap either. Although shares trade at a P/E of 9.9, its forward P/E is 24.0.
Rio Tinto‘s (LSE: RIO) dividend is in better shape, as it has a much lower level of indebtedness. Rio’s net debt to adjusted EBITDA ratio is just 0.64x, compared to BHP’s figure of 1.11. Rio’s profitability has also been less hard hit by the slump in commodity prices this year.
But one major drawback of investing in Rio is its much larger reliance on iron ore, which accounts for more than 85% of its underlying earnings. Its overexposure to a single commodity means Rio is more vulnerable to changes in iron ore prices. However, these risks should be offset by its more attractive valuations.
Rio Tinto is expected to see its earnings fall by 48% in 2015, but this still leaves Rio trading at a reasonable forward P/E of 12.1. Rio’s forward dividend yield of 7.1% may not seem as attractive as BHP’s, but it does seem more secure.
In conclusion, shares in BHP and Rio could fall quite a bit further if commodity prices continue to weaken. But, as BHP and Rio are low-cost producers and both have relatively strong balance sheets, further declines in prices would force their less competitive rivals out of the market, lending some support to future prices. And this should mean these two mining giants don’t have too much further to fall.
Unfortunately, the same could not be said for the gas-to-liquids (GTL) energy company, Velocys (LSE: VLS). Velocys, which is using GTL technology to convert relatively more abundant gas hydrocarbons into their more expensive liquid forms, has seen lower oil prices undermine its investment case for converting shale gas into petroleum products.
But Velocys is already adapting to changing business conditions. Many opportunities exist to produce high-value speciality products, such as waxes and lubricants, even with lower fuel prices. In addition, GTL technology can take advantage of low-cost feedstocks, including waste and landfill gases, which have no current use, as they have until now been uneconomic to process.
Shares in Velocys are very volatile, but if its technologies are found to be commercially viable then the potential rewards of investing are enormous, too.
