Description

BP (BP) $21.06

12/24/20

Summary

BP is one of the world’s major oil companies. Energy companies in general have fallen out of favor among investors for several reasons including both the shift towards factoring environmental costs and benefits into the investment decision process and the shift towards less capital intensive, higher growth businesses. My own investment process has shifted away from commodity industries, yet my concern about the risks building in stock market valuations and the economy at large led me to examine cost-effective ways to protect my portfolio.

I believe BP is uniquely positioned to help protect and grow capital over the next few years. As such, it is an oil stock for investors who hate oil stocks.

Background

We stand at an interesting crossroads at the end of 2020 with much to be optimistic about and much to be concerned with. While the vaccines make the end of the pandemic visible, the vitals of the economy are being elevated by artificially cheap capital which has helped drive frothiness in stock market valuations for certain sectors that is reminiscent of the Internet 1.0 bubble that ended in 2000.

Oil presents an interesting opportunity for two reasons:

·       Oil prices are suppressed largely due to the reduction in economic activity due to the pandemic and therefore there is an implicit growth optionality to oil prices as the pandemic recedes and demand increases.

·       Oil being priced globally in US Dollars provides an effective and inexpensive hedge to continued weakness in the US Dollar resulting from the rapid expansion of money supply by the Federal Reserve in response to the pandemic.

The stock of an oil company that has scale, a low-cost position, decent balance sheet and effective management provide an additional opportunity in that the valuations of these stocks are very reasonable and should benefit if there is a rotation out of growth towards value stocks.

BP presents as a unique opportunity among oil companies for several reasons:

·       BP has announced a process to transform from an oil company to an energy company over the next 20 years. This involves divesting certain petroleum assets and investing in cleaner and renewable energy sources.

·       BP has a collection of assets including retail and emerging market exposure that should enable them to make significant progress on these goals.

·       Their legacy oil assets are substantial and provide a secure means to fund this transition.

·       Ultimately, there is the potential for a long-term upward rerating of trading multiples as BP is perceived as part of the solution to the environmental concerns tied to carbon-based energy sources instead of simply part of the problem.

·       BP owns 19.75% of Rosneft, Russia’s largest oil company (and 50% + 1 share owned by the Russian government). Rosneft is an advantaged low-cost oil producer that trades at a depressed valuation because it is Russian. BP’s stake is worth almost $13bn (18% of BP’s market cap).

What is Changing?

In 2020, BP announced a change in strategy to be led by a new CEO. The new strategy pivots towards low carbon energy, making a 10-fold increase in low carbon investment by 2030, with up to an 8-fold increase by 2025.

The legacy hydrocarbon business will focus on decreasing capital intensity and maximizing efficiency. Production declines of 40% are expected by 2030.

Oil is likely to remain a significant global energy source throughout this century. BP’s transitioning away from less capital efficient hydrocarbon programs and towards renewables, bioenergy and hydrogen has financial benefits as well as return on average capital employed is expected to increase from 8.9% in 2019 to 12% - 14% in 2030. Reducing geopolitical risk – and the resulting price volatility – may warrant a further increase in trading multiples.

BP has a substantial retail presence globally which will be an asset in this transformation. For example, they currently offer EV charging in China, which comprises half of the worldwide installed base of EV’s.

The capital plan for the transformation involves $25bn in divestment from 2H20 – 2025, half of which has already been completed. $14 - 16bn per year of capital investment (compared to $21bn in 2018 & 2019) for 2021-2025 inclusive of $5 – 7bn per year of low carbon/sustainable investment. Operating efficiencies of $2.5bn/year by end of 2021 and a goal of $3 – 4bn/year by 2023. These combinations should yield both increased profit and capital efficiency on the hydrocarbon business (targeting $6/boe production costs in 2025 vs $7/boe in 2019 and capex of $9bn/yr in 2025 vs $13bn in 2019) while expanding the scale of the sustainable energy business. The dividend was cut to $0.21/year (1% yield) to help finance the transition. Once the divestments have lowered net debt below $35bn (vs $47bn current), 60% of excess free cash flow will be directed towards share repurchases.

The intent is for earnings to grow by $1bn by 2025 vs. 2018 which would take EBIT to $24bn in 2025.

Valuation

At $21.06, BP’s valuation is an unloved stock that has been largely overlooked by investors in the market euphoria of the last 8 months. Market cap has fallen -43% and enterprise valuation is down -25% YTD. Brent Crude ($51.29/bbl) is only down -25% YTD in comparison, while Henry Hub natural gas prices ($2.76/MMbtu) are up 34% YTD. Refining margins are off sharply YTD due to reduced end product demand due to COVID-19 and likely offer the greatest potential for upside to BP in 2021 as the pandemic recedes.

For a company of this size and complexity that sells a commodity product, there are lots of moving parts. The most deliberately constructed dcf becomes instantly worthless the moment that OPEC changes direction. As such, I tend to think of valuation more directionally than precisely.

Oil prices can rise (perhaps significantly) in the near term on either increased demand as the pandemic subsides or dollar weakness, or some combination thereof. There is a reasonable argument to be made that these changes could be large and rapid given how much supply has been shut in during 2020. Historically, production tends to rise to meet demand and shale economics have shown that there’s always capital looking to drill as prices rise. Long term, there may well be societal restrictions in the form of regulations that restrict drilling in order to reduce atmospheric carbon. This should result in prices remaining elevated (and possibly increasing) as the demand for oil falls. Regardless, oil will remain a significant energy source for most of this century even in the most optimistic green transition scenarios.

Consensus estimates are for oil to remain bound in the $50 - $60/bbl range for the next few years and for BP’s revenues to grow from $197bn in 2020 to 258bn in 2022. Revenue growth is tempered by divestitures, but profitability is forecast to increase to EBITDA of $34bn in 2022 vs $18bn in 2020. This would still represent declines from 2019 levels of $278bn revenues and $37bn of EBITDA and reflect divestitures completed and expected.

BP currently trades at roughly 5.0x EBITDA on 2021 consensus expectations. If BP can hit consensus expectations through 2022 and market sentiment (towards BP) remains flat, a 5.0x EBITDA multiple on expanded 2022 figures would be enough to lift the stock 49% in a year to $31.31.

However, there are several catalysts that could boost BP’s results or investor’s perception (trading multiples) over the next two years that would result in the stock price far exceeding the base valuation. Oil prices could expand by demand or by USD weakness, investor rotation from growth to value, investor perception of BP’s strategy. While the last two are hard to quantify, the sensitivities of BP’s EBIT to energy metrics are known. Each $1 full year change in the Brent Oil price has a $340MM impact; each $0.10 full year change in the Henry Hub natural gas price has a $60MM impact; and each full year $1/bbl change in refining margin has a $500MM impact. If Brent moved to year end 2019 prices, EBIT would rise by $5.6bn. If refining margin returned to year end 2019 levels, EBIT would rise by $3.3bn. There is lots of room for recovery.

The primary risks are that prices collapse further which does not seem to be likely in the near term given the expected recovery from the pandemic, the reduction in supply during the pandemic, and the need for Petro Nations for cash. I do not see much additional risk in the sustainable programs since it is expansion of proven technologies and products and the risk profile seems lower than with hydrocarbons, thereby lowering the risk profile of the enterprise.

In summary, I see lots of ways to win with BP, and limited downside risk. In addition to its merits on a security basis, the addition of BP provides an inexpensive (albeit imperfect) hedge in a higher growth/higher valuation portfolio.

Side note: For investors that may want to reduce oil exposure, there is the possibility of shorting shares of Rosneft against the BP position. This would be easier done by trading both in the UK where 1 ROSN.LN share would be shorted for every BP.LN share. 

Catalyst

Positive catalysts include increased hydrocarbon pricing/margins driven by increasing global demand as the pandemic recedes, increased oil price driven by weakening dollar. Stock price rerating possible through, increased energy pricing outlook, market rotation from growth to value, and/or investor perception of BP's strategy to transition towards carbon sustainability.