Description

With dozens of Wall Street analysts covering BP, this company is well known.  But this is the bottom line: BP is a turaround at trough earnings.  Upside in +21% (not including div) and downside in -7%.  It is a way to play inflation, the low valuation of Euro equities; it is a (growing) yield play; a hedge on Middle East conflict, etc.  Indeed, some of these things management cannot control.  So I will try to look at what they can control and how its fundamentals are perceived.  From the outset, the market is overly discounting production upside from the company’s valuable producing assets and long term upside potential.  While uncertainty over BP’s Russian investments (TNK-BP) and the extent of remaining liabilities connected to the Gulf of Mexico oil spill present clear overhangs for investors, I believe BP’s current valuation offers significant value relative to expectations for production growth in 2012 and beyond. 

BP's earnings were down big last week, but most of it was non-cash.  Going forward, the momentum will reflect E&P maintenance levels in the near term. The all-important Gulf of Mexico (GoM) will rebound in 3Q from 2Q lows as many expects restarts; however this will be offset by North Sea shutdowns, leaving production down vs 2Q. That’s OK.  I expect volumes and cashflow to start rising from 4Q onwards and in 2013. Longer-term (>2015), many think BP's upstream portfolio can support 2-3% p.a. growth, but further repositioning is needed – too much US dry gas and not enough LNG, to take one example.  Uncertainty on Macondo and TNK-BP continue to cloud the investment case, however I  would expect a resolution on both issues over the 6 months or so.

BP's substantial earnings miss has led us to many Wall Street analysts to reassess their positive stance on the stock, as it was driven by significantly lower E&P profitability than many had expected. Although unit costs normally rise during the turnaround season, it seems that BP's underlying upstream profitability is being eroded as costs rise versus peers, it delivered unit E&P profitability 33% below its global peers in 2Q 12 vs. -13% a year ago. Given the Street’s  EPS reductions, valuation has fallen, DCF value is now 534p, a 10% reduction from previous levels.  NAV has fallen by a similar amount. Given the risks currently associated with BP, especially regarding the final outcome of the Macondo issues and the value it might receive for the sale of its share of the TNK-BP business, a 10% to 15%% discount to DCF level is warranted for the stock.  The company indicated that 3Q production is expected to be lower than in 2Q due to seasonal turnaround activity and further planned divestments. 4Q production is expected to be higher due to a lower level of maintenance activity and major projects ramp-ups including Atlantis and Mad dog from 3Q12. Full year production is expected to be lower than in 2011 as per previous guidance, we are forecasting 2.324 million boe/d, down 140kboe/d versus 2011, mainly due to disposals.  In the downstream, refining margins are expected to decline in 3Q, in line with seasonal trends and turnaround activity is expected to be lower than in 2Q12. Petrochemicals margins are expected to remain weak. Completion of the upgrade of the Whiting refinery to process more Canadian heavy crude is expected by mid-2013. Capex for the year is expected to be $22bn. Cumulative divestments are expected to reach $38bn at end 2013, unchanged from the last update. Disposals for the quarter were $1.9bn and $24bn since 2010.

 A look at the balance sheet :

BP continues to have a great capital structure; dividends are secure and capex is reasonable.  Net debt at the end of the quarter was $32.8bn compared with $28.1bn a year ago. The gearing (ND/ND+E) ratio was 22% compared with 21% a year ago. Total capital expenditure (organic) for the first quarter was $5.3bn, in line with the last quarter. Asset disposals for the quarter were $1.9bn; the cumulative amount from the start of 2010 currently amounts to $24bn. The quarterly dividend declared for the quarter was $0.08, in line with last quarter.

 Sources and uses of cash flow:

In Company has sold many assets and will continue to do so.  In fact, there were significant asset activity, just in the 2Q1012:  In Angola, Petrobras (PETR4BZ, NC) is currently drilling a pre-salt prospect in Block 26, and the results are expected shortly (BP 40%).  In Namibia, Petrobras has spudded the giant Nimrod prospect (BP 45%), which many estimates at over 4bn bbl gross resources. The drilling to take two months; Awarded 2 new deep-water blocks with 100% interest in Trinidad & Tobago; Force majeure was lifted in respect of its Libyan E&P sharing agreement with NOC effective May 15th.; Announced the sale of its interest in the Jonah & Pinedale operations in Wyoming to LINN Energy for US$1bn is cash, transaction is expected to be completed soon; Announced the sale of its interest in the Alba & Britannia in the UK North Sea to Mitsui for US$280 million in cash. Completion of the deal is expected by 3Q12; First gas from the Seth field located in East Nile Delta in Egypt. The first two wells accessing the western part of the Seth reservoir are expected to reach 170 mmscf/d and develop about 240 bcf of gas. (BP 25%); In the GOM, BP acquired 43 new leases which will be awarded subject to regulatory review; Began FEED for the Shah Deniz project phase 2. The consortium selected the Nabucco West pipeline as the single pipeline option for export to Central Europe and signed a cooperation agreement with the Trans-Adriatic pipeline in respect of the southern route; Start-up of the Galapagos field in GoM. Production capacity is 60kbbl/d. (BP 56%); First oil in the Kizomba Satellite phase 1 project in Angola block 15. Peak project capacity of 100kbbl/d. (BP 26.67%).

Valuation:

BP’s valuation gap has started to close in recent months. BP trades at a 28% discount to our NAV of 592p/sh, vs a 23% average discount to NAV, and at a respective 12% and 8% discount on 2013 P/E and EV/CF. Best case: BP achieves an early settlement of the Macondo legal issues at a cost towards the lower end of expectation; Development and exploration activity resumes swiftly in the US Gulf; Sale of its TNK-BP stake at market value; BP successfully accesses a new high-margin, high-growth upstream region; Crude price continue to appreciate, maintaining a level above US$100/bbl, with refining margins also rising.  Clearly a Macondo settlement would provide scope for BP to raise dividends and start share buybacks.  In Russia, many believes a TNK-BP sale would be positive for BP only if structured as a mostly cash deal, with proceeds used for buybacks and strategic upstream acquisitions.  Target PE multiple: 8.6x; Target Price: $52  Worst case: BP becomes entangled in a long-running legal battle with the US government and contractors over the Macondo liability.  Slow re-entry to the US Gulf, which forces severe delay to its development programme and hence its growth prospects. Crude price slips below $70/bbl due to lower demand growth than forecast, refining margins also remain weak. Low PE multiple: 6.3x generates a price of $38

Catalyst