Buy, Sell or Hold: BHP Billiton is Poised to Pick Up Big Gains on the Back of a Global Commodities Bull

Face it, commodity prices are in a secular rally – and there are three big reasons why.

• Loose Monetary Policy
• Growing Demand in Emerging Markets
• And the Congruent Devaluations of Major Currencies

We've already profited from this inflationary trend in the Money Map VIP Trader.  And – just like I did with the broadband revolution – today I am presenting you with a stock that stands to benefit from these developments – BHP Billiton Ltd. (NYSE ADR: BHP).

First, let's talk about policy. Immediately following the 2008 financial crisis, the Group of 20 (G20) countries agreed to stimulate their economies simultaneously.  And, while the emerging economies almost unanimously have already returned to strong rates of growth, most advanced economies are just now turning the corner.

That means any premature action taken by the U.S. Federal Reserve and other central banks around the world – such as the European Central Bank (ECB), the Bank of England (BOE), and the Bank of Japan (BOJ) – to raise interest rates or tighten policy could lead to a potentially devastating deflationary spiral.

That's why these institutions will continue to employ "reflationary" policies – policies that stimulate their economies and inflationary forces. 

Now, as far as demand is concerned, India and China have already roared back from the brink and begun to restock their depleted supplies. Economic activity in these countries, as well as accelerating growth in other emerging markets like Brazil, has resulted in increased demand.

As a result we have seen the prices of commodities zoom up from their financial crisis lows.  Spot prices of iron ore, copper, and coking coal have more than doubled in price. 

Demand for commodities is projected to continue to grow strongly for many years. And tragically, in addition to the standard global demand – which is being fanned by loose monetary and fiscal policies – there is new demand from reconstruction efforts in Chile and Haiti.  These two countries will take years to rebuild.  In Chile alone, the price tag is $30 billion.

Finally, we must consider a very distinct phenomenon: the congruent devaluations of major currencies. 

You see, low interest rates and lax fiscal policies – which demand massive issuances of debt – do not foster confidence in the underlying currency.  So investors tend to diversify their bond holdings away from countries that are undisciplined in their spending.

But what happens when all of the world's major economies pursue such policies?  Well, countries that have lax policies cannot devalue their currencies against currencies of other countries with similar policies.  So, almost imperceptibly, all these currencies lose value against gold, commodities and hard assets. 

That's why savvy investors are gradually diversifying their portfolios into commodities and other assets to guard against inflation.  And this shift has been gradual, even despite some episodic counter-trends, including the recent dollar rebound.

All of this points to continued commodity price increases.  In fact, the largest steelmaker, Mittal Steel USA Inc., floated the notion that steel prices would go up some 21%.  And mining companies have benefited greatly from these trends, since the turnaround last year. 

BHP Billiton Turns the Tables

In fact, BHP Billiton said in its February earnings report that it more than doubled its net after tax profit.  And in doing so, it beat analysts' estimates by 8%!

The catalyst for superlative profits: quarterly price contracts.

But, hear this, they could have done even better, because major miners sell most of their iron ore, coking coal and copper in annual contracts that are renegotiated only once a year.  This has been very good for their customers, steelmakers, for example, that get visibility and pricing certainty.  But the run-up in spot prices means that all three major miners left many billions on the table.

But now BHP Billiton and the others have very strong management teams and are taking unprecedented corrective action. Lead by BHP, they moved away from yearly price contracts to quarterly ones.  This might sound like a small change, but in fact it is a dramatic change in the market structure.

BHP did this only because it sees the trend toward higher commodities prices well ingrained in the global economy in the years to come.  And that perception is shared by its customers, who strongly resisted the move but had to throw in the towel and accept the new pricing practice.

In a market where growing demand is outstripping supply, the investments needed to bring fundamentals back into balance requires much higher pricing.  That rebalancing will take a minimum of three years.

So BHP obtained a 55% increase in coking coal prices, which are likely to go up again in three months.  And once BHP renegotiates a price, the rest of the market then uses that same price in their contracts.

Just as I predicted in the Money Map VIP Trader, BHP moved to quarterly contracts, dragging the entire contract market along with it.

You know that the trend is deeply ingrained when the strongest and most conservative buyers of commodities, like POSCO (NYSE ADR: PKX) and Nippon Steel Corp. have agreed.  The Chinese steelmakers will follow suit or be left in the untenable position of having to buy their iron ore and other commodities in the spot market, without any guarantees of long-term supplies.  Relying solely on the spot market is inviting disaster, like it was for the electric utilities in California a few years back.

A Chinese Inflation Trap?

China, as we all know, does not allow market forces to set the value of its currency.  The government intervenes heavily.  That creates a short-term trade advantage for Chinese exports, but it also creates a long-term "lose-lose" scenario.

Markets first take advantage of artificially cheap Chinese goods and services, and then they take advantage of artificially discounted asset prices by buying real estate, equities, etc.  These massive inflows into the Chinese currency inflate its monetary base, overheat the economy and eventually result in inflation.  The resulting inflation eventually negates the trade advantage of an artificially undervalued currency.

So if the Chinese policymakers do not act soon enough to control inflation, they will be left with an eroded trade advantage and ingrained inflationary expectations, which are very difficult to get rid of.  Beijing now is facing the dilemma of whether to allow its currency to revalue or introduce restrictive measures in order to curb growth. 

The winning alternative is to allow the currency to revalue.  And this alternative is being seriously considered, especially since major trading partners, including the United States, are very upset about China's currency policy.

Now, should a revaluation of the Chinese yuan occur as I predict, it will increase the purchasing power of the Chinese and lead to higher commodity prices in U.S. dollars.  The Chinese have already started making the transition from an export-led economy to a consumer-led economy.  Some 90% of China's 2008 economic growth came from the consumer sector. 

But this should help BHP greatly as well.

As the leading diversified mining company in the world BHP is a great play, ready to deliver very strong profits in years ahead, starting today. Its financial strength and product and geographic diversification greatly reduce the risks inherent to the highly cyclical mining business.  They have strong pricing power in iron ore and coking coal.  The current commodity trends should also boost its operations in nickel, energy coal, manganese, oil and natural gas.

In addition, BHP has a joint-venture with rival Rio Tinto PLC (NYSE ADR: RTP) that combines the two companies' iron ore mines, rail, ports and workforces in the Pilbara region.  That venture is projected to save a combined $10 billion. And we will see those benefits starting in the second half of 2010.

BHP's stock is trading at thirteen times forward earnings, which is at a discount to the market multiple.  And this is despite of the fact that most analysts' projections do not factor in the type of price gains that I am envisioning.  Technically, the stock is in a long-term, powerful "cup-and-handle" pattern, above both its 200-day and 50-day exponential moving averages. 

Recommendation:  Buy shares of BHP Billiton Ltd. (NYSE: BHP) at market (**).  Make sure that you add some more if you see a correction later in the year towards the 200-day moving average.

(**) Horacio Marquez owns no interest in BHP Billiton Ltd.

[Editor's Note: Horacio Marquez knows how to make a market call. It was Marquez who told investors that lithium was going to be big – a year before other "experts" made the same call. Now Marquez has isolated the major profit opportunities being created by the possible broadband breakdown – a situation that the news media is only just now starting to understand. To find out all about those top profit opportunities, check out this new report.]

News and Related Story Links:

• Money Morning:
  Historic Agreement Ends 40 Year Old Iron Ore Benchmark as Miners Get Short-Term Pricing Contracts

• Money Morning:
  Guilty Plea by Rio Tinto Execs Shines Light on Complexity of China's Iron Ore Market

• Money Morning:
  Buy, Sell or Hold: Buying Into Brazil by Betting on Vale (NYSE: VALE)

• Money Morning:
  Iron Ore Negotiations Reach an All-Too-Familiar Impasse

• Money Morning:
  With Rio Tinto's Snub of Chinalco, Aussie Backlash Against China's New Capitalists Continues to Escalate

Join the conversation. Click here to jump to comments…