Description

Recommendation - Buy BP (either BP US ADR or BP/ LN).

About two years ago I pitched XLE long.  The thesis was fairly simple: Energy was the biggest re-open trade post COVID, Value had been decimated over the preceding decade, and OPEC was finally functioning like a cartel.  There were also other idio factors like companies becoming more shareholder friendly by not goal seeking max growth and return of capital via dividends and buybacks.  And we also had a nice 2022 Putin gift.  For a more complete narrative, please refer to my XLE write-up on 2/10/2021.

There is a similar narrative taking shape specifically for BP, and it has the potential to be the best performing global major of 2023.  Before I dive into BP, I will also say that I am still bullish energy, and if we indeed have a soft landing (as the market is pricing in over the last month + today’s FOMC reaction), then oil is going back above $100.  2022 was characterized by both simultaneous manipulation of both oil supply and demand.  The Chinese suppressed oil demand with lockdowns and Biden inflated oil supply with SPR releases.  Both of those are over.  The only thing that can derail oil right now is massive demand destruction by Powell… but all the signals are flashing to contrary (fed fund futures, 2yr UST, 10yr UST, DXY, QQQ, etc.)

BP, along with most European energy stocks, are basically orphans.  Imagine trying to sell ribeye steaks at a Vegan convention.  It’s a tough sell.  When oil exploded above $100 following the Russian invasion of Ukraine, the European governments thought it best to punish their own energy companies with windfall taxes.  Funny how European problems (lack of energy security) can only be solved with European solutions (more taxes, which invariably leads to further curtailment of supplies).  I mean even Joe Biden is finally realizing the folly of this – just today news came out that he is likely going to approve ConocoPhilips Alaska Project. 

The other piece of news out today was the WSJ article, “BP’s CEO Plays Down Renewables Push as Returns Lag”.  I think this is very big deal for a few reasons.  For a very long time, the European majors have been following a strategy of ESG appeasement.  Appeasement didn’t work in WW2 and it isn’t working now.  BP or Shell isn’t going to get the green leftists off their back just because they are pouring billions of dollars into renewables like wind.  This was basically Dan Loeb’s thesis when he tried to go activist on Shell in the fall of 2021.  You have two competing constituencies – those who want to enjoy above cycle returns on fossil fuels for a lot longer than most people think is possible, and those with ESG mandates that prefer to take the moral high ground by locking in crappy returns on renewable investments.  When you try to please both constituencies at the same time, you end up pissing off both.

This is exactly why European energy stocks have broadly lagged their US counterparts.  For the last 2 years, the obvious trade has been long XLE, OIH, XOP, etc.  Now I think that might change… at least for BP.  You see, BP right now offers you an insanely cheap stock…. 3x EBITDA, 5x EPS and upwards of 15% cash return yield (dividends + buybacks).

Compare that to XOM or CVX which are 6x EBITDA, 10x EPS and 7-8% cash return yield.

The valuation disconnect is so vast, you are getting massive margin of safety.  Additionally, we just got handed a catalyst in the WSJ article.  BP announces earnings next week (2/7/23) and if they pivot away from renewable energy investments and prioritize more cash returns, the stock had to re-rate or else if gets even cheaper.

Ok, lets assume I am wrong, and still nobody cares. Well, I think there is an additional angle here.  BP has $150bn EV and it’s a no-brainer acquisition for CVX or XOM.  I think the reason that CVX announced a $75 billion buyback last week is because 2023 is the year for monumental M&A among majors and they need to be ready to support their own stock if their stock derates on a mega deal.  CAPEX has become a dirty word, but there has been a laundry list of M&A over the last 6 months where the E&Ps have done deals and have bragged about the FCF per share accretion – any their stocks have been rewarded.  Its much easier to underwrite accretion / dilution math on a M&A deal than trust the IRR’s that management teams tell you when they start punching holes, etc.  So you don’t have to be a CFA charterholder to understand that CVX buying BP is massively accretive with the current valuation disparity.  Separately, I think the whole honeymoon phase with US Shale is over.  Capital efficiency is declining and I think there is a real desire to grow non-shale sources of oil production that enjoy lower decline rates with longer production tails.  So I think its more reasonable for CVX to consider M&A that advances that goal and that means targets like BP or HES and not simply a Permian producer.

So to summarize the bull case:

• BP dials back renewables spend and further increases capital returns on 2/7/23 earnings update
• BP is the cheapest stock in the sector with a 15% cash return yield.
• BP has idio positives in 2023: LNG volume growth as projects come online + big GOM project coming online (Mad Dog)
• Macro tailwinds: China re-open and Powell soft landing
• Legit take-over target that only gets 15% cheaper if I am wrong

Risks:

• Hard landing destroys oil demand
• China does not re-open
• Europeans find new ways to go full retard.

Catalyst

• BP dials back renewables spend and further increases capital returns on 2/7/23 earnings update
• BP is the cheapest stock in the sector with a 15% cash return yield.
• BP has idio positives in 2023 (LNG volume growth as projects come online + big GOM project coming online – Mad Dog)
• Macro tailwinds: China re-open and Powell soft landing
• Legit take-over target that only gets 15% cheaper if I am wrong