There is a much big issue we have to tackle today. Alan Kohler framed it well over at the Business Spectator. He asks, “Is BHP is a proxy for the Great Australian Question of 2008: will Chinese industrialisation and urbanisation offset the coming global slowdown caused by the bursting of the credit bubble?”
The trade we mentioned yesterday-long commodities and short the U.S. dollar-was described in today’s Financial Times as “The Big One.” It’s the trade everyone made to hedge against inflation and still profit. But is the Big One done?
The liquidation of the short-dollar/long-commodity trade raises a simple question: what’s going to lead the market when it turns up next? Typically, the sector that led the last bull market hardly ever leads the next one. There are lots of reasons for this. But the simple one is that conditions for expanding earnings are never as good as they are when things are as good as they’ve ever been (as they tend to be at the height of a boom.)
Financials have been pounded harder than resources. But as an investor you have to wonder which sector is closer to the bottom, and which can grow earnings more quickly. Which brings us back to BHP Billiton and the composition of its earnings before taxes and interest (EBIT).
The company’s profits from operations increased by 22% from US$20.1 billion to $24.2 billion in the last year. But the big driver of that increase was the $6.5 billion contribution to underlying earnings from price increases in commodities (coal, iron ore, oil). By contrast, increased production volumes delivered only $1.8 billion dollars to underlying earnings.
Why does it matter? Well, it means the company’s profitability is being driven by sky-high resource prices not increases in production. If resources prices-especially for coal and iron ore fall-then the share would be in a for a serious re-valuation.
Of course, we don’t expect a sudden decline in thermal coal and iron ore prices. China’s demand for steel should survive the turmoil from the on-going financial meltdown in the U.S. These are two imperial economic ships passing in the night.
However, it’s obvious that if BHP Billiton is going to deliver stellar earnings growth next year, it’s going to have to buy someone else’s production (Rio Tinto) or increase production volumes without incurring cost blowouts. It could always count on resource prices rising faster than costs. But that’s the sort of strategy that makes for a nasty earnings surprise.
So is the Big One still the Big One? Is this a blip in the resource trade? Or a sinkhole?
Nothing is too big to fail. Were the dinosaurs too big to fail? Was the Titanic too big to sink? Institutions come and go the same way whole species and civilisations do.
But we reckon BHP Billiton and the Australian resource boom will be a lot longer in the tooth before we have a serious discussion of the end of the boom. However we also reckon the way to invest in it is to find world-class energy and mineral assets whose shares don’t already have a steep earnings premium.
Markets and Money