Why I Would Buy BHP Billiton plc Over BP plc

Here’s why I prefer mining giant BHP Billiton (LSE: BLT) to oil supermajor BP (LSE: BP):

Lowest Cost Producer

Like Saudi Arabia is for oil, BHP is a global low cost producer of metals. The mining group is the lowest cost large-scale producer of iron ore (yes, BHP is lower cost than even Rio Tinto), with all-in sustaining costs estimated to be $29 per tonne, more than a third lower than current spot prices. What’s more, cash costs are more than 70% lower than current spot prices.

Being at the very low-end of the cost curve, BHP benefits from strong underlying margins and is highly cash generative. Underlying EBITDA margin is 40% for BHP in the second half of 2015, compared to less than 10% for BP. What’s worse, BP is actually loss-making in exploration and production, with a RC (replacement cost) loss of $728m in the fourth quarter of 2015

So, it is of no surprise that BHP continues to increase production, even as rival CEOs, Andrew Forrest of Fortescue Metals Group and Ivan Glasenberg of Glencore, criticise its expansion plan as “reckless” and “damaging” to the industry. This is because lower commodity prices in the meantime may actually help BHP in the long term, by forcing out higher-cost rivals. With marginal producers reducing production, this should lend support to higher prices in the longer term.

Capital investments have fallen more sharply in the mining sector than it has in the oil & gas sector, with a one-third reduction from its peak in 2012. This compares to a smaller and much later cut of 20% from a 2014 peak, in the oil & gas sector. However, on the upside for the oil & gas sector, the outlook for global energy demand has held up better.

Free Cash Flow

After slashing its dividend by 74% earlier this year, BHP may not offer much in terms of dividends. It has a prospective dividend yield of just 2.9%, substantially less than BP’s 8.0% yield. But, at least BHP is fully covering its dividends with earnings and free cash flow generation. There may even be cash left over to finance acquisitions on the cheap.

BP, on the other hand, is barely able to finance its capital spending plans, with the company likely to generate little or no free cash flow this year. And, that’s before we worry about its expensive dividend policy. Along with selling up to $5bn in existing assets, BP would likely need to borrow an additional $2-3bn this financial year.

With oil prices likely to stay below $60 per barrel (its estimated free cash flow break-even level) for many more years to come, I can’t expect BP will avoid a dividend cut for long. Its exchange-traded dividend futures seem to agree, with a 17% and 40% dividend cut being priced in for 2016 and 2017, respectively.

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