Commodity prices have tumbled to new lows in recent weeks, following weak market conditions and uncertainties with China’s economic outlook. Recently, iron ore and oil prices have been particularly hard hit, but the prices of almost all commodities have also been affected. Investors had long anticipated a slowdown in the Chinese economy, but China’s growth seems to be decelerating much faster than many analysts had previously predicted.
It’s very difficult to predict the bottom in commodities prices, but the worst of the declines seems to be behind us. If prices continue to fall further, higher-cost producers with weak balance sheets would be driven out of the market, which would lend support to prices. With this in mind, now may be the perfect time to buy the shares of the low-cost and low-debt producers.
BHP Billiton (LSE: BLT) saw its underlying earnings per share for the year ending 30 June fall 51.6% to $1.207. Although BHP missed analysts’ expectations on earnings, the firm did show steady progress with increasing production and reducing costs. Free cash flow generation has been relatively resilient, having fallen just 26% to $6.3 billion. This enabled net debt to fall 5% to $24.4 billion, but the more substantial fall in profitability meant its net debt to EBITDA ratio rose from 0.85x to 1.11x.
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Capital and exploration expenditure fell 24% to $11.0 billion, and management expects further cuts will enable capex to fall to $8.5 billion by 2016, and $7.0 billion by the following year. BHP’s management said it remains committed to its progressive dividend policy, and raised its final dividend by 2% to $1.24 per share.
With commodity prices having fallen further in August, its 2015/6 financial year is set to be much tougher. But, BHP should be able to weather the downturn in commodity prices. With an EBITDA margin of 50%, BHP is one of the lowest cost producers in the sector.
Rio Tinto (LSE: RIO) is much more focussed on iron ore, which accounts for 87% of its underlying earnings (iron ore accounts for 58% of BHP’s underlying earnings). The outlook for iron ore is less attractive than the outlook for most base metals, as the supply of iron ore has been growing much faster than most commodities and demand for the metal is much more heavily exposed to China.
With lower iron ore prices, Rio is unlikely to meet its capital investment needs and ongoing dividend payments with operating cash flow. But, as Rio is one of the least indebted miners, with net debt of just $12.5 billion, and a net debt to EBITDA ratio is 0.64x, Rio is not in an immediate danger of risking its investment grade credit rating by financing its dividend with increasing leverage.
Anglo American’s (LSE: AAL) 7.7% dividend yield reflects the consensus view that the miner is in a much more difficult position. Its balance sheet is much weaker, with net debt of $13.5 billion, and its net debt to EBITDA estimated to be 1.99x. It is also a higher cost producer, with EBITDA margins of 25% in the first half of 2015.
Anglo American’s diamond business is the real gem of the group, and it accounts for 30% of the group’s underlying earnings. Diamond prices have fared much more resiliently, with prices falling just 5% over the first half of 2015. Demand for diamond jewellery remains robust, and the US is the largest market, accounting for 40% of global demand.
Although Anglo American benefits from a unique diamond business, its higher leverage and higher cost of production means its dividend is at much greater risk. Lower commodity prices would put greater pressure on Anglo American’s free cash flow, because of its lower margins. This should mean that there is a very real possibility that its dividend could be cut within the next 12 months. If its dividends is cut, shares in Anglo American could have much further to fall.
