BHP Billiton Ltd.'s (BHP) strength in its balance sheet means the metals giant faces a capital allocation issue.

Its deep pockets allow it a choice of paths to grow, but BHP must remain selective when it comes to acquisitions and stick to its traditional strengths of organic growth and smaller purchases - leaving aside its failed, $68 billion attempt to take over Rio Tinto PLC (RTP).

The next smart move could be in the chemicals sector, but it may not be the obvious one. Talk has surfaced of a bid for Potash Corp. of Saskatchewan Inc. (POT), but a smaller company could be a better bet.

Given Potash's $30 billion market cap, the size of such a deal could prove a problem and hamstring BHP's ability to court Rio again if it chooses to do so.

The company certainly has the means to be a buyer in this market. It posted record net operating cash flow of $13.3 billion last quarter. Its ratio of debt to earnings before interest, taxes, depreciation and amortization - a metric used to asses the probability of defaulting on issued debt - stands at a low 0.46, which hints that BHP could take on more debt.

Last month, the company raised $3.25 billion via the debt markets. The bulk of its $11.2 billion outstanding debt is not due until 2012, and Moody's rates it A1 with a stable outlook. BHP has said specifically it doesn't want to risk its credit rating in making acquisitions, increasing the likelihood for smaller deals.

BHP's traditional M&A strategy has been to acquire smaller players, allowing it to steadily grow operations while maintaining a low debt load. This strategy has paid off. In the last 10 years its shares have outperformed its acquisitive rival Rio Tinto by nearly twofold.

 
   New Market

That brings us back to potash.

BHP entered the potash market with a $254 million acquisition of Anglo Potash Ltd. in May 2008. Prices for potash, a resource primarily used to formulate fertilizers and cement, are negotiated with farmers who need to meet demand for crops used for food, fuel and animal consumption. If BHP is looking to expand its presence here, a more nimble move would be to acquire a smaller player with a footprint in the space.

Agrium Inc. (AGU) fits the bill with a market cap of $6.3 billion, Ebitda margins of 21.5% as of last quarter and shares that trade at a lower earnings multiple than Potash: 7x 2010 earnings versus 8.8x for Potash.

The profiles of Potash's and Agrium's growth and profitability are similar, according to InFinancials' GPRV analytics, but the key difference lies in risk, where Agrium scores much better than Potash and its peer group due to its lower debt load and lower volatility.

BHP is looking to diversify its business segments by expanding in potash production, and in March it announced plans to build the world's first new potash mine in 20 years. The Canadian project is still awaiting approval by environmental authorities.

A BHP spokesman, declining to comment on market rumors or potential acquisition targets, said: "We have, however, clearly stated our interest in acquiring tier-1 assets if they become available at the right price."

BHP is looking to capitalize on growing potash demand, currently forecast to be around 3% to 4% annually, and expand in a more stable earnings stream. While demand has been hit during the economic slowdown, along with other commodities, potash is protected by the basic demand for fertilizer and food.

BHP's main businesses are such base metals as copper, which account for 32.7% of operating profit, and such petroleum products as crude oil, which account for 22.7%. But commodity demand has waned over the past year, and oversupply concerns in both the oil and copper markets have taken a toll on the underlying futures prices. Crude oil is down 52% from a year ago, and copper has fallen nearly 50% over the same time period.

Even oil demand from China has taken a hit, with the China Petroleum and Petrochemical Engineering Institute now forecasting a 4% to 5% annual rise in demand from 2010 to 2015 - down from 14.5% in 2006. Crude oil inventories recently hit an 18-year high in the U.S., according to the U.S. Energy Information Administration.

Typically, decreasing commodity prices put pressure on a company's margins, forcing it to reconsider or abandon future projects. As of year-end, BHP reported an operating margin of more than 41% and a net margin of nearly 26%, both exceeding industry averages.

(Kevin Nichols is a columnist for Dow Jones Newswires on the energy, industrial and auto sectors. He has more than seven years experience as an analyst and trader on Wall Street and was formerly an executive in the proprietary trading unit at an investment bank. He can be reached at +1 (201) 938-2417 or by email: kevin.nichols@dowjones.com. Dow Jones Newswires is enhancing its news, commentary and analysis for the investment banking community, and is providing it on this service temporarily. To ensure continued access to the best of Dow Jones news and opinion on companies, sectors and deals for bankers and research analysts, please contact investmentbanker@dowjones.com.)

(TALK BACK: We invite readers to send us comments on this or other financial news topics. Please email us at TalkbackAmericas@dowjones.com. Readers should include their full names, work or home addresses and telephone numbers for verification purposes. We reserve the right to edit and publish your comments along with your name; we reserve the right not to publish reader comments.)