Does Rising Production Make BHP Billiton plc And Rio Tinto plc Attractive?

In an operational review, BHP Billiton (LSE: BLT) says it increased production by 9% for the nine months ended March 2015. The firm reckons it’s on track to deliver production growth of 16% over two years by the end of this year.

There’s a similar story at Rio Tinto (LSE: RIO). The firm’s recent first-quarter update revealed increased commodity production across most of the resources the company extracts.

Does rising production make these firms attractive to investors now, though? I don’t think it does.

The chiefs think it’s a good thing

BHP Billiton’s chief executive reckons the firm’s strong operating performance, improved productivity and lower costs helps mitigate the impact of subdued commodity prices and thus supports returns for the company’s shareholders.

Rio Tinto’s chief executive says a drive for efficiency in all aspects of Rio’s business reflects in a solid production performance. By making best use of high-quality assets, a low cost base, and the firm’s operating and commercial capability, Rio hopes to protect profit margins in the face of declining commodity-selling prices, which the company reckons will maximise returns for shareholders throughout the cycle.

I can see the logic, and the necessity of their positioning on the issue, however what’s essential for Rio Tinto’s and BHP Billiton’s financial survival now doesn’t automatically equate to those firms making good candidates for an investment in their shares at the moment. In fact, I think an investment now has a 50/50 chance of winning or losing in the short- to medium-term–they are not investing odds, they are gambling odds.

Why so?

We must look at the big commodity producing companies as cyclical firms before anything else. It’s easy to allow a big dividend payout to seduce us, for example, but the investing outcome in the long run depends on what commodity prices do.

BHP Billiton and Rio Tinto produce resources for which they have very little control over output selling prices. The control they do have mostly amounts to either producing or not producing. Right now, commodity prices have fallen from what they were not so long ago. In reaction, both firms chose to increase production to maintain margins–they are earning less for their labours so now work longer to keep up the level of take-home pay.

However, the sums won’t add up if commodity prices fall further from here. If you think that can’t happen, think of the price of oil — few foresaw that falling by more than 50% as it did recently. We don’t need to have very long memories to remember most commodity prices in the doldrums either — 20 years or so? Back then, we had to pay the scrap man to come and collect our old bangers, which meant fly dumping and roadside car burning became rife, making the countryside and urban back alleyways look like a war zone.

Supply and demand

Paradoxically, the supply and demand equation dictates that prices rise when either excess demand or under supply are present. Oil is low right now because of over-supply. BHP Billiton and Rio Tinto ‘need’ prices to rise in order to make larger profits but both are charging towards ramping up production. Perhaps they both see escalating demand on the horizon? Maybe, but I think buying shares in highly cyclical firms such as these is too difficult to get right mid-macro-economic cycle such as now.

I want to see their share prices on the ground and trodden in before I’ll even consider a speculative punt on catching the next up-leg. They can keep their fat dividends. A 50% or so share-price decline could wipe out any gain from dividends just like that anyway. Can you imagine that happening from here? I certainly can.

BHP Billiton and Rio Tinto do not top my list of attractive dividend candidates, as you may gather. Investing to harvest dividends is not the simple stock market solution it might appear to be. Success in dividend investing features in a particular wealth report produced by our analysts at the Motley Fool. It's a solid read and helps guide past some of the hard-to-spot pitfalls of the game. There's a copy with your name on it if you click here.

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.