The 3 Biggest Risks Facing BHP Billiton

Published in Company Comment on 23 November 2012

What should investors in BHP Billiton (LSE: BLT) be worried about?

Global mining giant BHP Billiton (LSE: BLT) (NYSE: BBL.US) is a business with very definite attractions. A £104bn FTSE 100 (UKX) constituent, last year the company earned a pre-tax profit of $23bn on revenues of $72bn. (Note: yes, mixed currencies.)

And with margins like that, no wonder this defensively positioned business is popular with many investors. Better still, with its shares changing hands today at 1,948p, the company is rated on a price-to-earnings (P/E) ratio of 11, and offers income investors a forecast dividend yield of 3.9%.

But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in BHP Billiton adversely impact investors' wealth?

In this series, I set out to answer just these questions. My starting point: BHP Billiton's latest annual report, where the company's directors are obliged to address the issue of risk.

Risk management

One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.

The good news? As you'd expect from a business of BHP Billiton's size and calibre, the company has in place a risk-management policy, a system of regular reviews and a number of high-level committees tasked with monitoring the risks that the business has identified.

But what, precisely, are those risks that the company faces?

Read the small print, and BHP Billiton identifies no fewer than 13 risks as having a significant prospective impact on the company's financial performance. They range from government and political engagement to climate change, and from a shift in currency exchange rates to commercial counter-party failure.

So let's take a look at three of the biggest.

Falling Chinese demand

The Chinese market has become a significant source of global demand for commodities. In 2011, notes BHP Billiton, China represented 61% of global seaborne iron ore demand, 39% of copper demand, 40% of nickel demand, 43% of aluminium demand, 48% of energy coal demand and 10% of oil demand. The danger is obvious. As BHP Billiton itself puts it:

"Sales into China generated $21.6 billion or 29.9 % of our revenue in the year ended 30 June 2012. A slowing in China's economic growth could result in lower prices and demand for our products, and negatively impact our results."

What can BHP Billiton do to counter this risk? Not a lot: what happens to the Chinese economy is very much out of its hands. But the company is clear that successful risk management can be a source of competitive advantage, and points to the carefully developed natural diversification in its portfolio of commodities, geographies, currencies, assets and liabilities as a key element in its risk management approach.

The commodity cycle

Fairly obviously, BHP Billiton is in the commodities business, which -- as most savvy investors recognise -- is subject to the commodity cycle, over which prices rise and fall as supply and demand fluctuate. As the company puts it:

"The prices we obtain for our oil, gas, minerals and other commodities are determined by, or linked to, prices in world markets, which have historically been subject to substantial volatility. The ongoing uncertainty and impact on global economic growth, particularly in developed economies, may adversely affect future demand and prices for commodities."

Once again, what can BHP Billiton do about the commodity cycle? Nothing. But it can do its best -- as it has done -- to lock in long-term contracts and trading relationships, and spread its activities over as wide a set of commodities as is practicable, to avoid overexposure to the extremes of any one cycle.

Environmental compliance

Mining has an unarguable environmental impact. And there are also safety, health and corporate social responsibility issues to throw in. Compliance today is a costly and complex business compared to the more relaxed standards of yesteryear, and there's little doubt that the regulatory regime is set to get tougher, not more lax. As BHP Billiton puts it:

"The nature of the industries in which we operate means that many of our activities are highly regulated by health, safety and environmental laws. As regulatory standards and expectations are constantly developing, we may be exposed to increased litigation, compliance costs and unforeseen environmental rehabilitation expenses."

How is this risk dealt with? Routinely, BHP Billiton makes financial provisions for operational closure and site rehabilitation. In addition, it is aware that its employees face dangers and health risks from occupational exposure to noise, silica, manganese, diesel exhaust particulate, fluorides, coal tar pitch, nickel and sulphuric acid mist, and does its best to minimise these.

Community actions are also targeted on fulfilling the company's corporate social responsibilities by providing skilled employment opportunities, decent salaries and wages, paying taxes and royalties, and community development programmes, which include a commitment to invest 1% of pre‑tax profit in community programmes.

Risk vs reward

Two superstar investors who are well used to weighing risks are Neil Woodford and Warren Buffett.

On a dividend reinvested basis over the 15 years to 31 December 2011, Neil Woodford delivered a return of 347%, versus the FTSE All-Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.

Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.

So click here to download this free special report profiling the investment logic behind eight of Mr Woodford's  largest and most successful current picks.

And click here to discover which beaten-down British share Warren Buffett has been buying of late -- and why he bought it, and the price he paid.

> Malcolm does not own shares in any company mentioned here.

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