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Expanded Purchase Recommendation: July 2013
The Turnaround Letter recommended this large-cap oil & gas stock in July 2013:
BP Plc (NYSE: BP)
1 St. James’s Square
London, SW1Y 4PD
One American Depository Share of BP represents six ordinary shares.
BP was founded in 1909 as the Anglo-Persian Oil Company. It wasn’t an easy process, as the founders had nearly completely run through their fortunes when at the last minute in 1908, they became the first to discover oil in the Middle East. BP has witnessed and survived much turmoil in the Middle East ever since. They were early pioneers in Alaska’s Prudhoe Bay, and they made the first commercial oil discovery in British waters. Via its 1998 acquisition of Amoco, it was the first foreign oil company to explore the Chinese mainland.
In April 2010, the company was rocked by an explosion on its Deepwater Horizon drilling rig in the Gulf of Mexico which killed 11 people and spewed large quantities of crude oil into the waters of the Gulf. The explosion also rocked the company’s stock price, which had been rebounding after the 2008 financial crisis, sending it to the low 30’s. The company has been fighting a series of legal and public relations battles stemming from the explosion ever since.
The BP story cannot be told without a review of the unfortunate and deadly 2010 explosion of the firm’s Gulf of Mexico Deepwater Horizon rig that was operating in the Gulf of Mexico’s Macando field that lies off the coast of Louisiana. The blowout took the lives of 11 workers and led to untold damages to the ecosystem. Investors responded by selling the stock off from its April 2010 high of 60.57 by more than 55% to 27.02.
BP has settled many of the legal problems emanating from the Deepwater Horizon explosion. In November 2012, an agreement was reached with the US government to resolve all federal criminal claims that included a $4 billion payment over five years. They also reached a settlement with the US Securities and Exchange commission that included a civil penalty of $525 million. The largest financial commitment was the establishment of a $20 billion trust fund that, with the 2012 contribution of $4.9 billion, is fully funded. Since May 2010 BP has paid out about $9.5 billion to individuals and businesses. As a result, the total cumulative charge, net of recoveries, for the Horizon event totaled $42.2 billion at the end of the first quarter.
Having made substantive progress on legal problems emanating from the Deepwater Horizon explosion, litigation in the U.S. is in the middle of a multi-stage trial. At the same time, management is seeking to persuade the US Environmental Protection Agency to lift a temporary suspension that is preventing the awarding of new federal contracts. While the range of possible adverse litigation outcomes is wide and the renewal of federal contracts is uncertain, we believe that BP is now financially strong enough to weather the worst-case outcomes.
To prepare itself for the financial repercussions, BP initiated a plan to downsize in a way as to build its financial resources and improve profitability. Since 2010, BP has divested approximately $40 billion of non-core assets. The have sold about one half of their ‘upstream’ installations and pipelines and about one third of their wells; they’ve retained, however, roughly 90% of their proved reserves base and production and gained access to new exploration projects and upgraded assets.
All the while, BP has reduced debt and raised its cash holdings from $8 billion at the beginning of 2010 to $19 billion at the end of 2012. A focus on higher margin exploration and production activities has helped maintain profitability and allowed management to reinstate and then raise the dividend.
In March, BP extricated itself from an investment in Russia that had evolved into an ongoing headache and distraction. A 1997 $571 million investment in what was then Russia’s fifth largest oil company led in 2003 to a 50/50 joint venture with a group of Russian investors called TNK-BP. Though lucrative, BP reporting that from a roughly $8 billion initial investment they’ve receivedsome $19 billion of dividends, shareholder discontent, board distractions and conflict with the Kremlin were just not conducive to BP’s goals of streamlining and better controlling operations. On March 21, BP completed the sale of its interest to Rosneft, a state owned oil firm that is Russia’s largest oil producer. BP received $27.5 billion in cash and Rosneft shares (net cash inflow of $11.8 billion) in a transaction resulting in a 19.75% interest in Rosneft. This transaction reduced BP’s risks while letting it keep a significant profit stake in valuable Russian oil and gas fields.
As we discussed last month, we think that many of the large integrated oil companies are good investments at the present time. It is interesting to note that in 1981, the world’s oil reserves were estimated to be 700 billion barrels. But while having used 800 billion, estimated reserves in 2011 had risen to 1,650 billion barrels. The oil industry has had several transformative times in its history, including a number of geopolitical events such as the Arab oil embargo of the 1970’s. At the outset of major oil developments, international oil companies dominated the market, but in time national oil companies emerged to take greater control of resources. At the same time, much of the easiest to access oil has been developed, thus ushering in an era of greater cooperation required to unlock oil & gas found in more challenging environments. As a result, capability rather than exceptional scale is a key to future growth.
Expansion of natural gas reserves is another important market dynamic; burgeoning supplies of natural gas due to better recovery methods has increased the world’s supply in such a way as to keep some pressure on oil prices. And though the market economics of many renewable energies are not viable in large scale, they are finding political support in development nations. Even so, under the International Energy Agency’s most aggressive climate policy scenario that would most aggressively limit the growth in temperature and greenhouse gases, oil and gas would still make up 50% of the energy mix by 2030. With a bit of a pullback of its commitment to renewables, BP is well positioned to participate in the long-term demand for these basic carbon fuels.
Rising populations and increasing industrialization, particularly in emerging markets, should be accompanied by rising real incomes that should lead to persistently growing demand and consumption. Some restraint may be witnessed in economies evidencing structural shifts toward less energy-intensive activities, but Management expects energy demand to increase by as much as 36% between 2011 and 2030, with nearly 93% of the growth to occur in non-OECD countries. Though expecting investments in natural gas, oil will remain BP’s principal focus along with selective investments in downstream activities, such as refinery operations.
So we think that the current environment is good for large integrated oils. And BP trades at a considerably lower valuation than its peers. For example, BP stock currently trades at a forward P/E of 7.3 and a price-to-book value of 1.0, compared to Exxon-Mobil’s P/E of 11 and P/B of 2.4 and Chevron’s P/E of 9.5 and P/B of 1.6.
In the wake of Deepwater Horizon, management set out to reorganize BP by refocusing its activities to concentrate on higher margin exploration and production activities. The central themes were laid out in 2011 in what the company refers to as its 10-point plan. The plan is designed to make BP a simpler, stronger company that highlights its strengths and concentrates on high value-added projects, both upstream drilling and exploration and downstream refining and marketing. Management identified roughly $38 billion of assets that it anticipated to be disposed of by the end of 2013, a milestone that they achieved a year ahead of schedule.
An effort to focus on its strengths (exploration, deep water, giant fields and gas value chains) is evidenced by management’s plans to commit about three fourths of its capital expenditures on upstream drilling and exploration. In 2012, BP was active in 28 countries, and since 2010 they’ve accessed about 400,000 square kilometers of new acreage, roughly the size of California and more than twice what they’d accessed from 2000 through 2009. Going forward, management has identified Angola, Azerbaijan, the North Sea and the Gulf of Mexico as the four most promising areas to meet the goal of achieving higher margins.
Strong margins will be key to maintaining financial strength, including supporting the dividend and stock buyback program. The dividend was restored in 2011 and currently the stock pays 5.2%, well above its peer group. Due in large part to the cash flow received from the completion of the sale of its interest in TNK-BP, management received approval to begin a share buyback program expected to return up to $8 billion to shareholders over the next 12-18 months. The balance of the TNK-BP proceeds will be used to pay down debt. Both actions help to compensate you if you have to wait a while for the market to get more comfortable with BP’s prospects.
BP, as a leading integrated oil and gas company, operates across all stages of the hydrocarbon value chain, from exploration & development to delivery systems and refineries. They provide customers with fuel for transportation, energy for heat and light, lubricants to keep engines moving, and the petrochemicals products used to make everyday items as diverse as paints, clothes and packaging.
The company is organized into two main business units: Upstream and Downstream. In renewables, BP’s investments and activities are focused on biofuels and wind. They also operate an emerging business segment that invests in a broad range of energy projects and technologies. And they also hold a nearly 20% interest in Rosneft, Russia’s leading oil company.
BP considers its strengths to be acquiring access and searching for hydrocarbons, particularly in deep water environments; managing large scale and complex fields with resources believed to exceed 500 million barrels of oil; value added activities in moving gas from field to customer; and reliable and efficient downstream operations across fuels, lubricants and petrochemicals.
The upstream segment is responsible for oil and natural gas exploration and field development and production. Midstream activities, a subset of the Upstream segment, involves the ownership and management of crude oil and natural gas pipelines, processing facilities and export terminals, LNG processing facilities and transportation and a natural gas liquids (NGLs) extraction business. BP also markets and trades natural gas, including liquefied natural gas, power and natural gas liquids. Management’s focus is on areas that play to the company’s strengths, particularly exploration, deep water, gas value chains and giant fields.
In 2012 upstream and midstream activities took place in 28 countries including Angola, Azerbaijan, Canada, Egypt, Norway, Trinidad & Tobago, the UK, the US and other locations within Asia, Australasia, South America, North Africa and the Middle East.
BP’s downstream segment is the product and service-led arm of BP, focused on fuels, lubricants and petrochemicals. It is responsible for the refining, manufacturing, marketing, transportation, and supply and trading of crude oil, petroleum, petrochemicals products and related services to wholesale and retail customers. The downstream segment markets products in over 70 countries and has significant operations in Europe, North America, Australasia and Asia. BP also manufactures and markets products across southern Africa and Central and South America.
Technology makes a critical contribution to downstream activities. Through the research, development and deployment of a wide range of technologies, processes and techniques, BP is creating new market opportunities. For example, in their lubricants segment they launched an oil co-engineered with Ford during the development of Ford’s newly released EcoBoost engine that offers a significant improvement in efficiency.
The fuels business sells refined petroleum products including gasoline, diesel and aviation fuel and liquefied petroleum gas. Within the fuels business, fuels value chains integrate the activities of refining, logistics, marketing, and supply and trading on a regional basis. This provides the opportunity to optimize activities – from crude oil purchases to end-consumer sales – all the way through refineries, terminals, pipelines and retail stations.
The lubricants business is involved in manufacturing and marketing lubricants and related services to markets around the world. BP adds value through strategic collaborations with original equipment manufacturing partners such as the development with Ford mentioned above.
The global petrochemicals business manufactures and markets petrochemicals that are used in many everyday products, such as paints, plastic bottles and textiles.
Market Capitalization: $134 billion
Forward P/E: 7.18
Total Debt/Equity: 0.35
Forward Annual Dividend Rate: 5.20%
There is no question that the Deepwater Horizon disaster was a major shock to BP’s finances. Though well financed, as are most integrated international oil companies, the uncertainty of the financial hit that would result was large, bringing the company’s very existence into question. By the time in November 2010 when we suggested that BP would be “a good candidate if you wanted to add another name to your holdings in . . .” the global energy industry, investors had marked down BP’s shares by about $55 billion in market capitalization.
With aggressive restructuring efforts, and to be sure steady oil prices, BP has been able to fund its known disaster obligations and position itself to manage yet unknown liabilities, that at worst case right now should be capped in the $17-$18 billion range; BP anticipates that they’ll be much less.
With meeting its goal of disposing of $38 billion of assets a year early and negotiating a successful conclusion of the sale of its interest in TNK-BP to Rosneft, management was able to reinstate the dividend in 2011 and raise it twice in 2012. They have also instituted a stock buyback program with the authorization to repurchase up to $8 billion worth of BP’s shares over the next 12-18 months. One of the elements of the firm’s 10-point plan is to be increasing net cash provided by operating activities by about 50% by 2014 over that achieved in 2011; about one half of the improvement will come from winding down payments to the Deepwater Horizon Oil Spill Trust fund and the other half from operations. Management expects to use about one half of the improved cash flow for reinvestment and the balance for other purposes including paying dividends, funding stock buybacks and paying down debt. Net debt equaled $17.7 billion at the end of the first quarter of 2013, down from nearly $31 billion just a year earlier. Its cash holdings have risen to $27.7 billion, up from $8 billion at the beginning of 2010.
Bob Dudley, Group Chief Executive
Bob Dudley joined Amoco Corporation in 1979, working in a variety of engineering and commercial posts. Between 1994 and 1997, he worked on corporate development in Russia. In 1997, he became general manager for strategy for Amoco and in 1999, following the merger between BP and Amoco, was appointed to a similar role in BP. Between 1999 and 2000, he was executive assistant to the group chief executive, subsequently becoming group vice president for BP’s Renewables and Alternative Energy activities. In 2002, he became group vice president responsible for BP’s upstream businesses in Russia, the Caspian region, Angola, Algeria and Egypt. From 2003 to 2008, he was president and chief executive officer of TNK-BP.
On his return to BP in 2009 he was appointed to the BP board and oversaw the group’s activities in the Americas and Asia. Between June and September 2010, he served as the president and chief executive officer of BP’s Gulf Coast Restoration Organization in the US. He became group chief executive on October 1, 2010.
Consolidated financial statements Year Ended December 31, 2012
(In millions, except per share amounts)
(In millions, except shares)