Is BP a Buy?
Before we jump into the analysis of BP directly, it is worth taking a look at the current events in the oil & gas industry and how they effect BP.
The ‘War Profiteers’
Across the energy industry this year we have seen exceptional profits. This is largely attributed to the war in Ukraine that sparked US president Joe Biden to label US energy companies as ‘war profiteers. The UK prime minister, Rishi Sunak, has not been quite as scathing on the European and UK supermajors with his words, but the proposals of the increased windfall tax by himself and Jeremy Hunt for UK oil companies like BP will hit where it really hurts, company’s profits.
I will delve further into the windfall taxes later in the report but first, let’s have a look at the astounding profits BP has already turned over this year.
For the 9 months to September 2022, BP recorded profits of £22.8bn. The morality of these profits has been questioned due to the current cost of living crisis and war in Ukraine. The price of oil and gas prices skyrocketed in the first half of 2022, as a result of the war and the decision of Russia to suspend the delivery of gas to Europe in August of this year.
However, we are starting to see a reversion of these gas prices as they fall to the levels witnessed before the invasion. Gas prices are about 70% less than the summer peak and a big factor in this is the unusually warm month of October seen across Europe. Due to this warmer weather, most European countries have managed to fill their reserves for the winter ahead, with 95.6% of EU gas storage being filled.
Some analysts have argued that Europe’s strong storage position, combined with a drop in demand for oil and gas (global oil demand is forecast to fall by 240,000 barrels a day in the fourth quarter compared with last year, according to the IEA), has led to analysts at Goldman Sachs predicting a 30% drop in gas prices in the coming months. Analysts’ predictions of 85 EUR/MWh would hinder BP’s profits for the next couple of quarters, especially if investors are expecting similar profits seen to those seen in the most recent quarters. The main task for European countries at the minute is trying to facilitate their gas supplies for the medium term. A lot of European countries’ gas reserves, whilst full, are full of largely Russian gas. As Europe aims to pivot completely away from Russian gas supplies, it will feel the impacts of these reduced supplies towards the second half of 2023. Fatih Birol, executive director of the IEA, stated that there will be a very small amount of liquified natural gas (LNG) hitting the market in 2023. This along with the reopening of China, which was the world’s largest importer of LNG in 2021, will make whatever LNG is available, highly sought after, which is good news for BP which targets LNG as one of their major products.
With the boom in oil and gas prices since the pandemic reopening, BP has been rewarding investors with large dividend payments and share buybacks. The most recent announcement of a further $2.5 bn in share buybacks will excite shareholders, as it indicates that the company still believes its share price is undervalued despite the near 30% increase in stock price from this time last year.
Demand, Demand, Demand
Ultimately, for BP to sustain the levels of revenue seen in recent quarters, demand must increase, especially if oil and gas prices are projected to fall in the early stages of 2023. Off the back of the hot UK inflation report seen this week, which saw UK CPI rise to 11.1%, a 41-year high, we can expect further interest rate hikes from the BOE. With average UK mortgage rates for 2-year-fixed around 6% and the cost of living continuing to rise, I fear we haven’t even begun to see the impacts of what could be a very challenging recession. A contracting economy will severely impact the demand for energy and BP’s revenue streams. BP is tightly linked to the airline industry, refuelling over 6000 aircrafts a day across 55 countries, with aviation fuelling stations situated across the world as shown below. Air travel is heavily reliant on discretionary spending and in a recessionary environment these industries, in particular, will struggle and will begin to appear in BP’s revenue streams.
We can see that BP is positively correlated with a growing economy through a market beta of 0.63, so it is important to consider the macroeconomic climate Europe is heading into.
The cost-of-living crisis is affecting BP and other supermajors directly as global supply problems have been exacerbated in recent months, through industrial action at European refineries. Workers at BP’s 380,000 b/d Rotterdam facility have also threatened to strike, and resultant pay increases coming into 2023 will eat into BP’s operating costs. As the cost of living continues to rise and BP workers see the profits being made by the firm throughout this year, the threat and demands of industrial action are only going to heighten.
The Windfall Tax
As inflationary and recessionary pressures continue to mount, the UK government is going to look to use all available tools they have to curb them. The profits of supermajors like BP have come under a lot of scrutiny, particularly from the general UK public, as they have felt the weight of rising energy bills. In his Autumn budget, the current UK Chancellor Jeremey Hunt increased tax on excess profits from 25% to 35%. He has also extended the scheme out to 2028. It is important to note, oil prices are considered within the new tax so a significant drop in oil price would mean the new policy is reviewed. The windfall tax particularly targets oil production in the North Sea and BP CFO, Murray Auchincloss, has stated that “$2 out of every $3 we make [in the North Sea] is going to the government”.
The fact that BP was caught in the taxman's net hasn't done much to quell calls for the windfall tax to be revised, with opposition MPs in the UK focusing on the contrast between people that can't afford heating and supermajor energy companies that are making record profits. Despite paying different amounts of taxes, BP and Shell both produce roughly 120,000 barrels of oil equivalent per day from their operations in the UK.
A greener future
With the windfall tax being extended out to 2028 (oil prices dependent), it is now even more important for BP to continue to diversify its business and focus on more sustainable energy practices and projects. The company has recently had an overhaul of its renewable energy business,
employing experts in the field of renewable energy including, Matthias Bausenwein and Dave Vinton – both veterans at Wind Energy Provider Orsted. BP hopes this will give them an edge in a growingly competitive market for renewables across Europe and the UK.
BP has committed to increasing investments in low-carbon projects and to building or acquiring 50GW of renewable power by 2030. A major area BP is targeting is off-shore wind energy, stating on its website that more electricity is generated by offshore wind in the UK than anywhere else in the world. Wind energy contributed 26.1% of the UK’s total electricity generation in Q4 2021, so the growth potential within the space is why BP wants to be a leading developer of offshore wind.
One wind farm currently operating is BP’s ScotWind project, which is sufficient to power more than 3 million homes. The only issue with these projects is that European turbine makers are struggling with inflation and supply disruption. These issues will only be intensified as inflation rises and Europe moves into a highly probable recessionary environment.
BP has been part of a major acquisition of US domiciled, Archaea Energy which is a low-carbon biogas producer. They process energy from organic waste in landfill sites and the farming industry. BP is paying a large premium for Archaea, suggesting that BP feel this is a quality company in a key area for low carbon energy growth and helps them to get a strategic position within the US. This was reiterated by Bernard Looney, BP CEO, who stated, “It’s the best deal I’ve seen inside the company since we did Aker BP in 2016.” The purchase would boost BP’s biogas supply volumes by 50% with over 1000 landfill sites across the US with the capabilities of applying these technologies.
Biden’s Bill
It would be naive to overlook the importance of the oil/gas supply on the global stage as well as just in Europe. Coming into the mid-term US elections, many were predicting the ‘red-wave’ of republicans to claim the majority in the Senate, but this did not prove to be the case as Biden headed to the G20 summit this week with surprising confidence. In particular, he will feel that the US public responded well to his energy bill, which was very pro-renewable and anti-oil/carbon-based energy. The bill hoped that the US would generate 80% of its electricity with renewables by 2030 and carbon-free electricity by 2035; a 50% reduction in CO2 emissions economy-wide by 2030 and a net-zero economy by 2050. Despite rising fuel prices this year in the US, Biden will feel the US public has given him the credibility he needs as he tries to persuade other nations to slash their levels of non-renewable energy production. This points towards lower oil/gas prices in the long-term and puts more emphasis on BP’s plan as they aim to spend a quarter of future capital expenditure in the UK on oil/gas projects.
Biden has come under scrutiny for his trigger-happy policy to release barrels from the Strategic Petroleum Reserve (SPM) at will. The release of 180 million barrels from the reserve this year has helped to maintain oil prices at a sustainable level in the US. In a recent press conference, Biden was very critical of energy companies once again saying that they should be using record-breaking profits to increase production and refining instead of paying out dividends. Amongst Biden’s critics is former U.S. Energy Secretary Dan Brouillette, who believes Biden is using the SPM as a political tool rather than an emergency supply as it is supposed to be used. If Biden continues to control oil price levels by releasing more from the SPM, which wouldn’t have been as likely if the ‘red-wave’ had come to fruition, BP’s profits will also be weakened through lower global oil prices.
Now we will take a in-depth analysis of BP.
Introduction
British Petroleum is the 4th largest private international energy company by 2021’s revenues, headquartered in London and founded in 1908.BP competes with other upstream producers and integrated companies such as Exxon Mobil, Chevron, and Royal Dutch Shell. The 3 major revenue streams of BP are “Gas & Low Carbon Energy” (production of natural gas and the group's renewables businesses, including biofuels, solar, and wind), “Oil Production & Operations” (predominantly production of crude oil) and “Customers & Products” (fuel offerings at retail sites, EV charging, Castrol lubricants, aviation fuelling).
BP’s Strategy Going Forward
BP has defined a business strategy that consists of 3 areas of focus. The first is “Resilient hydrocarbons which involves driving returns, high-grading their portfolio (the sale of more costly, carbon-intensive assets), and lowering emissions. They plan to reduce oil and gas production by 40% by 2030 to create a resilient, lower cost, and lower carbon oil, gas, and refining portfolio that is smaller but of the highest quality, giving them the cashflow needed to help fund their transition to an integrated energy company.
Another focus area of BP’s strategy is “Convenience and mobility” which aims to double adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) by 2030 while sustaining ROACE (return on average capital employed) of 15-20%. This will be driven by BP’s differentiated convenience and fuel offers, acceleration of our EV charging ambition, as well as Castrol, aviation, B2B, and midstream businesses.
The last focus area of BP’s strategy is “Low carbon energy” which involves building out an integrated portfolio of low-carbon technologies, including renewables, bioenergy, electric mobility, and early positions in hydrogen and CCUS (Carbon Capture, Usage, and Storage) on the path to achieving net zero by 2050.
Financial Performance
During the financial year 2021, BP reported a 29% y-o-y increase in revenue, amounting to over USD200bn, and a 100% y-o-y increase in operating income to over USD26bn. The increase in revenue can be attributed to the lack of COVID-19 restrictions in 2021, which caused a demand shock in energy consumption and the need for transportation, thus a sharp increase from the all-time low energy prices of 2020. Total revenue is still 47% below its 2018, pre-pandemic, while BP’s share price is 9.70% lower than the same date in 2018 (476.05 today vs 527.2 on 19/11/18). This may be due to some of the macro factors discussed above for example the windfall tax levied by Rishi Sunak.
Source: TIKR
3Q22 results
3Q22 was a controversial earnings season for BP as it made $8.2bn (£7.1bn) between July and September, more than double its profit for the same period last year. This sparked controversy as U.S. President Joe Biden on Monday called on oil majors to stop “war profiteering” and threatened to pursue higher taxes if industry giants did not work to cut gas prices.
These earnings also outperformed company-compiled consensus by +30%. This strong improvement in earnings and the re-ignition of the cash flow engine for the company looks to continue in the coming quarters as we have entered an era of structurally higher commodity prices. Experts at Goldman Sachs anticipate strength in oil prices driven by supply tightness exacerbated in the near term by OPEC supply cuts and dislocation of Russian crude following the introduction of sanctions in December.
The 3Q22 results were accompanied by the company’s announcement that it intends to execute a US$2.5 billion share buyback before announcing its 4Q results, bringing total announced share buybacks from 2022 surplus cash flow to US$8.5 billion, indicating a potential increase in share price.
Valuation
We have used a DCF to project expected future cashflows and therefore value the stock price going forwards. The DCF we have built demonstrates the best-case scenario we anticipate based on our “best case” assumptions (on the top left of DCF).
Key Risks to our view and price target
1. Lower oil and gas prices realisations than we expect, especially the European gas price, which could result in lower earnings and cash flow generation.
2. Materially lower cash returns to shareholders than we currently expect on the back of the recent economic and commodity price downturn, lower dividends in coming years, and/or a change in the guidance for buybacks.
3. Macroeconomic factors in the oil and gas industry mentioned above
Conclusion
Our recommendation based off the analysis would be to hold. Although our DCF produced a buy recommendation this should be taken with a pinch of salt due to BP being a cyclical business where the company's profits are dependent on wider market movements e.g. oil price.Due to recent profits being so high it would be tough to give a sell recommendation with full conviction .
Until next time,
Euan McNicholl & Kealan Friel
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.