Oil price weakness a major headache for BHP Billiton

Since BHP Billiton (LON:BLT) relies on its oil division for 29.6% of its EBITDA, the uncertain outlook for oil leaves me negative on its medium-term future. Hopes were raised regarding the oil price last month when OPEC declared that it had struck a deal to freeze output. Brent rallied in the aftermath and many investors became increasingly bullish about the medium-term prospects for black gold. However, the deal has not yet been finalised and even if it is, sluggish demand for oil could keep its price at sub-$50 per barrel in 2017.

No deal

OPEC’s agreement to cut oil production from 33.7 million barrels of oil per day (bopd) in September to between 32.5 and 33 million bopd is not a done deal. It will meet again this month to decide which members will cut production and by how much. This, then, is where the uncertainty begins, since a number of OPEC members are likely to insist that their production stays as it is, or even rises in the coming months.

For example, Iraq is likely to ask for exclusion from the list of countries which will cut production since it needs cash from the sale of oil to fight IS. However, this would mean other OPEC members bearing the brunt of cuts, since Iraq is the cartel’s second biggest oil producer. Similarly, Iran has stated repeatedly that it is seeking to raise production to pre-sanction levels. If it is allowed to do so, it will mean other OPEC members will be forced to cut production even further. In my view, this seems unlikely and the oil price could come under pressure due to rising supply in 2017.

The value of a deal

Even if OPEC does agree on a cut in production, I’m not convinced it will make a huge difference to the oil price. Since OPEC’s production reached a record 33.7 million bopd in September, there may need to be a more sizeable cut in order to end the glut of supply which has plagued the oil market in recent years. In fact, the International Energy Agency (IEA) said recently that demand growth for oil has been sluggish and that it did not expect supply and demand for oil to balance until at least part way through 2017.

One reason for this is that non-OPEC supply of oil is forecast to remain stable at around 57 million bopd through the remainder of 2016 and into 2017. Although OPEC supplies around 41% of the world’s oil and therefore has a significant impact on the oil price, non-OPEC producers such as Russia and the US will also heavily influence the price of oil over the medium term. With costs of production falling across the globe, the oil market is increasingly becoming a free-for-all where anybody who can produce oil sells it for whatever price can be achieved. In my view, this means that a cut in OPEC’s production may not have as great an impact as it would have done in previous years.

BHP Billiton

Although BHP is predominantly a mining company, its petroleum division contributed 22.3% of revenue the last financial year. Therefore, a lower oil price could act as a drag on its overall financial performance.

BHP is a well-diversified business and it produces a long list of commodities such as iron ore, copper and coal. However, in the last two years BHP has invested more in its petroleum division than in any of its other divisions. For example, capex in BHP’s petroleum division was $7.5 billion over the last two years versus $6.6 billion for copper and $3 billion for iron ore.

This investment follows the $20 billion spent by BHP on US shale assets in 2011. BHP’s intention of becoming a major oil and gas producer is logical given the uncertain outlook for demand in the iron ore and coal industries. Therefore, BHP’s petroleum division could become even more important to its overall performance in future years, which makes the prospect of a falling oil price even more relevant to its medium term outlook.

Sustainability

Although BHP’s earnings may be put under pressure from a falling oil price, it remains financially sound and able to cope with even a prolonged downturn. For example, BHP has become increasingly competitive in recent years, with its petroleum division reducing unit costs by 30% in 2016. Alongside this, BHP has a debt to equity ratio of 61%.

While BHP’s financial standing may not be in doubt, the reality is that its profitability would be negatively impacted by a falling oil price. This could cause BHP’s valuation to fall over the short to medium term. BHP has a forward P/E ratio of 19.7 using 2017’s forecast earnings, which indicates that its shares are expensive at a time when a pure play oil and gas stock such as BP has a forward P/E ratio of 14.2.

Outlook

In the long run, the price of oil could rise as the current imbalance between demand and supply narrows. However, in the short to medium term I believe that the oil price could come under severe pressure. The chances of an OPEC deal to cut production may not be as high as the market currently anticipates, since agreement is yet to be reached on which countries will cut production and by what amount. Even if there is a deal to reduce production, non-OPEC production could mean that the current supply glut continues well into 2017 and keeps prices pegged back.

Although BHP is financially sound, it has a high valuation which could be trimmed over the medium term. Its reliance on its petroleum division may be increased by weak demand for iron ore and coal. Therefore, given the uncertain outlook for oil, I believe that BHP is a stock to avoid.