Boring BP? Not for Your Wallet

People invest for different reasons. Some invest for income, some for capital growth. Capital growth tends to be volatile and with a market collapse people can be dismayed. No wonder we hear screams of dismay and disgust calling for the end of buy and hold investing.

For a person targeting future income, frankly, the market levels are of no interest because the capital value of a portfolio is not relevant, what is relevant is the income generated by the portfolio.

This brings me to boring BP.

Fundamentals

Core Business Fundamentals

As regards the future:

BP derives its demand from the Energy Industry. The sector is in a particularly powerful up-trend, caused by demand in emerging markets, most notably China and India. This is offset by demand reduction in developed economies.

Natural resources by nature are finite. The cost of discovering and developing new fields is increasing, and the depletion rate of aging resources is accelerating. As new mines are developed to satisfy rising demand, the marginal cost of production increases. In such a situation, prices must rise. As a relatively low marginal cost producer, firm prices are a net positive for BP.

Natural resource owners typically have backward sloping supply curves during periods when rising marginal cost of new fields causes a shift in the supply curve. Producer assets are safe underground and when prices are low relative to future expectations, the incentive to monetize commodities is also low. Thus supply falls despite rising prices and this drives prices up further; in fact the spread between spot and future prices creates an arbitrage opportunity which puts an upward trend on spot rates. As prices rise, profitability of the entire sector rises; the old low marginal cost fields are highly profitable offset in part by the increased cost of developing new fields. High prices are a net positive for BP.

The massive liquidity and stimulus packages by governments the world over should result in inflation down the road. Inflation expectations typically result in firm commodity prices. This expectation will likely be quickly offset by rapid reduction in leverage and liquidity once a recovery takes hold firmly. Strength in profitability of the resource sector will typically lead to stronger demand and margins for BP.

As risk aversion abates, capital outflows is likely to result in a weaker dollar. The dollar may also weaken as a result of challenges to its status as the world's reserve currency; though this will take time. A weak dollar results in firm commodities; a positive for BP.

Large capacity recently created in the oilfield services and driller industries will maintain a cap on operating and capex expense inflation. The resulting stronger margins are a plus of BP.

The demand for oil from emerging markets is a very clear expectation. However, one has to also consider the case for falling demand. There is a demographic shift which will likely have profound implications. The US Census Bureau estimates that in a mere ten years the number of people aged over 65 will exceed those under 5. The elderly as a % of total population is expected to increase from 7% to 14% by 2040.

The outcome is unknown; as the shift occurs the stress on a smaller working age population might rise; on the other hand, perhaps retirement ages might rise. Then again, the demand for retirement homes might explode; the world may be overwhelmed with the “Young at 65” crowd partying hard.

But perhaps a likely outcome is slower GDP growth. The impact of the demographic shift is likely to be positive for health care, utilities and telecom, neutral for staples and IT; mildly negative for energy, industrials and basic materials and negative for financial services and discretionary sectors. Before this occurs, the strong case for rising demand will be played out as emerging markets play catch up with the developed world.

BP specific risks include risks to continued production growth. Over the next ten years, I believe BP can grow production at a rate of 1% per year from existing projects, with possibility for additional non organic growth through M&A activity and new exploration successes. The earnings growth will come partly from rising production, partly from better price realization and partly from better margins.

Most new opportunities are in ultra deepwater; this is a high marginal cost venture. In ultra deep water, production growth opportunity is in several politically unstable or aggressive areas such as Nigeria, Angola, Equatorial Guinea and Russia. Outside of these areas Iraq is a growth opportunity for low marginal cost oil; but that too is a high risk climate.

Other opportunities in oil sands and shale are available in developed economies such as Canada and US; with Australia having good potential in shale too – but these are even higher marginal cost opportunities. Brazil and Canada are also great ultra deepwater locations. BP has well diversified interests in almost all of these markets; with perhaps an overweight in Russia which makes me feel just a bit uneasy.

Leverage

At the end of the quarter ended 31 March 2009, net debt (debt net of cash and cash equivalents) to net debt plus equity was very reasonable at 23%.

Delivering and Returning Shareholder Value

BP has delivered earnings per share growth of 17.85% annualized over the sixteen years ended 31 December 2008. There were two major acquisitions during this period; Amoco during 1998 and Arco during 2000. These acquisitions were dilutive; the earnings for the company grew at 21.90% ignoring share count and the poor shareholders only got per share growth of a measly 17.85%! All said and done this is a stellar performance.

BP has diligently returned value to shareholders through a dividend payout averaging 53.69% with a median level at 47.69%. They have also diligently managed dilution by performing buy backs; unfortunately most of the buy backs occurred during 2004 to 2007 when share prices were elevated.

Between 2001 and 2008, the total payout after including buybacks has averaged 69% with a median of 73%; of this amount the average payout from dividends was 45.6% with a median of 41.6%. The dividend was cut by 10% once during 1999 and then again in 2003. Both cuts did not impact the long term trend of increased dividends.

In terms of total return, which includes capital appreciation plus dividend yield, BP has delivered 15.44% annualized using the average share price ($43.32) for 2009 as the current value of the share. This does not include the impact of dividend re-investment.

An investor who purchased $100,000 worth of BP stock in 1993 would have bought 12,674 shares. Today, the dividend income flowing from that investment would be $42,585 per year. If the investor had re-invested dividends at the start of the year following the year of dividend receipt, by 2009 the investor would have had 24,672 shares. The capital value of these shares is $1.07 million and the dividend stream delivered is $82,897.

The main consideration is whether BP can continue to deliver these returns to a person investing today. And my answer is probably not. I do believe with a high degree of confidence that BP can deliver growth in line with global GDP plus inflation as a minimum.

Valuation

BP is cheap for traders and buy to hold investors at today’s price of just under $50.

I have assumed a long term growth expectation of 7% made up of 3.5% real global GDP growth and 3.5% global inflation. I believe these rates to be achievable and conservative. Valuing the dividends in perpetuity [(Dividends*1.07)/(11%-7%)] at a target long term annualized rate of return of 11%, gives a value of near $90. An investor buying in at $50 would have a total return expectation of near 14.2% annualized. A twelve month price target should be achievable with relative ease.

Disclosure: Long BP

Comments

[Shiv Kapoor:]

Edits to this article - A twelve month price target of $65 should be achievable with relative ease.

Jul 22 08:57 AM

[blu:]

Purchased BP as a core long term hold at $38/sh...I like the company, the dividend, and its prospects for growth.
Nice article.

Jul 22 10:22 AM

[Living4Divi...:]

I own BP for the dividend.
It is in one of the most maligned industries on the planet - oil. It makes profits. It pays dividends (how old fashioned!). It's boring and dull and will have a low growth rate. To get its oil it has to battle with kleptocracies like russia who may steal back the invested capital at any time.

Still, I like it !!

Jul 22 12:12 PM

[User 459164:]

BP (as with other private oil companies) is opportunity constrained - both geopolitically (all remaining resources are owned by `bad guys'), and physically - depletion of existing resources is higher than discovery of new resources. Investigate how much money BP is returning to the investor in dividends against how much it is investing in new exploration, drilling and operational expenditure. Then check the number of staff it has employed over time. Then explore its pattern of investment in diversifying its energy mix. You will find it has halted material investment in alternative revenue streams, shedding staff rapidly (particularly at middle and senior staff level), and returning more money to its owners than it is investing in its business. There is a word for this - liquidation.

Jul 23 09:47 AM

[Boubou:]

This analysis was very convincing. I am glad I am into BP at the march price.

Jul 23 12:57 PM