BP is London-listed [LSE:BP], with each of the American Depository Receipts representing 6 shares of the underlying UK shares. About 27% of BP's "normal" shares are underlying the ADRs, with JPMorgan as the listing bank.
Let us briefly rehash some of the risks associated with ADR investing that we detailed in the earlier article on National Grid:
- You have become an implied FX-trader
- Cultural differences with what you are used to
- Reporting style (and requirements) can differ from what you expect in the US
To hedge against these risks, I choose British companies, where corporate and popular cultures are closer to that of the USA. I also choose companies that have significant business in the USA. Further, there is nothing like reading an annual report in native language! Actually, BP goes a step further and lists financials in USD.
BP PLC is a century-old company that traces its roots to the colonial days of Great Britain. It is the "rebranded" British Petroleum -- the name most people still call it by. Regardless of how large the company is relative to its US counterparts, its global reach and name recognition is phenomenal. Though, its link to the colonial days does not necessarily mean that its name conjures affectionate thoughts. In effect, half of the nations of the United Nations have -- or had -- some BP business at one time or another during the past century!
For the USA, the word British Petroleum is what people infer when you say BP, forgetting that Standard Oil of Ohio (one of the all mighty Standards), ARCO, and Castrol are now BP!
BP, at the time of writing, is a $147 billion company, with a trailing PE of 6.4 -- yes, you read it right -- and a dividend yield of around 4.8% due to a quarterly dividends payout of $0.57. You look at these numbers and one thought comes to mind: Gulf of Mexico Oil Spill!
The path from the original days in the Persian Gulf to the current days of being one of the six oil majors was not all pleasant. In particular, a major existential risk resulted from the Deep Water Horizon oil spill in the Gulf of Mexico. In some sense, it seems -- and seems is the right word -- that the damage, to the company and not the environment, has been contained.
Regardless of how large the final cost to BP will be, as long as it keeps on trickling and does not come in the form of a flood, then the enormous cash flow of the company and the tax credits will continue to make the damage to BP's finances very well-managed.
In the context we are discussing here in this series of articles, the major damage has already been done! If you examine the dividends history, you will be struck with two observations that fall under "taboo" for dividends investment:
- Missed dividends payments -- Q3- & Q4-2010
- Reduced dividends payouts -- starting Q1-2011
As a principle in my dividends investment, any of the two incidents listed above would immediately mean that the company is no longer in my trading set. That is, it would be sold immediately without regard of P&L. Invariably, any of these two incidents occurring foreshadows darker times to come.
You see, "missed dividends" is no different to a dividends investor than an employer dropping by his employee and passing him the "pink slip!" You really have to go and work somewhere else "to earn your income," don't you?
Similarly, imagine your employer issuing a statement to employees telling them that salaries have been halved! CVs would start flying out of the corporate offices almost immediately.
In effect, to a dividends investor, dividends payout is a sort of income that you have factored into your life style, just as you would a salary. This is something corporate boards need to understand, and so do investors new to dividends investing.
You cannot "cut corporations slack" if they deprive you from your due income. You just should not!
Why are we still discussing BP?
In BP's case, the dividends miss and halt were actually the price paid by the company to appease the US Government, US Regulators, and Lawmakers. If you do recall, there was a serious uproar in Congress once it was known that BP planned to continue to pay dividends.
You may have environmental, ecological, cultural, political, or any other number of reasons to question this company. Yet, your wrath for missing dividends should be directed elsewhere. Just like tobacco, Oil majors' investors need to reconcile investing in these companies based on their own cultural and moral standards. If you are not comfortable with any of these issues, then you should not invest in such companies. From financial point of view, these companies represent some of the best cash flow generators on Earth. And none pays out as much as BP -- or at least used to.
Since BP is the first oil major that we discuss in this series, it is worthwhile discussing some of the oddities of this business and some of the misconceptions.
First of all, oil majors like to refer to themselves as "Energy" companies and not oil companies. You see, even when they talk about oil, they talk about "Barrel of Oil Equivalent" or BOE. In essence, it is how much energy you get, not where you get it from.
To spell out, oil majors, their siblings, children or controlled companies, are into many businesses, to:
- Explore for oil
- Set up extraction environment (rigs, wells, oilfields, etc.)
- Extract (Produce) oil
- Transport it (pipelines, shipping, etc.)
- Store it (storage, tankers, underground)
- Refine it or otherwise process it
- Market it -- retail (gas stations, etc.) and bulk (airports, military, shipping, etc.)
- Trade it (spot, futures, etc.)
- Process it (petrochemicals, fertilizers, plastics, etc.)
And you can repeat all above for gas, oilsands, biofuels, alternative energy, hydrogen fuel cells, and almost any other source of energy you can think of.
Further, rights to exploration and extraction are tradeable. As such, many of the oil companies end up acting more like real estate traders, where they acquire rights, possibly in places they have no intention of developing, and then trade or sell these rights to others.
BP itself refers to all development and exploration work as Upstream. Storage, transportation, and processing are referred to as Midstream. Everything else we mentioned above is considered Downstream.
As such, the first mythology to debunk is that these are "oil" companies. Yes, we still refer to them as "oil" majors. And yes, a good percentage of their income comes from oil. But even then, exploration and support services represent a good deal of the upstream business of extraction or production. You have all the midstream transportation and storage, and all the downstream marketing and petrochemical industries totally unaccounted for in this limited view of "oil."
BP participates in most above mentioned activities. Hence, there is a level of diversification and "deep pockets" built into the operation. This is the reason the company could weather the Gulf of Mexico Deep Water Horizon financial aftermath hurricane.
To start our conventional analysis of the company, we note that due to Foreign registrant status, the SEC reports are not of much help -- not because the information is not there, but it is hard to search for. As such, you may as well go to the company website for information. Annual reports are the least that you need to examine, and the last one (2012) is the one we will refer to in the following discussion. It is a worth-reading report, and is educational if you are in the Oil & Gas investing business.
Yet, before we go on with that, let me point an example of the "reporting style" concern that may strike you as an ADR investor -- listed as item 3 in the opening paragraphs.
You see, the annual report is littered with the mention of "Replacement Cost (RC) Accounting," along with multiple mentions that it is not GAAP-compliant but is "close to IFRS" requirements for segment reporting! Page 98 of the annual report attempts, but not very well, to explain RC. KPMG lists that 23% of companies use alternative accounting definitions, including Replacement Cost accounting. It also turns out that on the UK's FTSE, BP is not the only one to employ such practice -- as per this document.
You see, this RC method of accounting seems to be acceptable in the UK, and if it were that BP started using it after 2010's disaster, I would be worried, but considering it started in 2005, there does not seem to be "implied malice" in this choice. As much as this does represent a "leap of faith," I am willing to categorize this choice as a cultural and regulatory difference between the UK and the USA.
If I am to convey my understanding of RC accounting, it is similar to you revaluing your portfolio with net liquidation value. In essence, it does not matter how much you paid for the equities -- the inventory equivalent -- in your portfolio; it is how much you can get them for on the market that matters. This is what determines your true profit and loss, not any other consideration. I know this is overly simplistic, but the equivalent for BP is that the cost of replacement of a rig or inventory is what determines the incremental cost of using that rig to produce oil or to replace that inventory, not how much the rig or the inventory cost initially.
What that means for you as an investor is that if prices of oil and technology keep on rising, then the company will be continually "underreporting" its profit, since new costs will be applied to the remaining life of the producing assets. On the other hand, if things are going south, then the company will be overstating its profits, since the newer costs will be lower than the already deployed costs! This is very important for a company like BP, since this is a very capital-intensive business, with a huge time lag to production. Decades may pass between acquiring rights, equipment, and staffing on one hand, and actual production, if any, at the end.
Let us continue with our standard analysis. Clearly, BP has been in the business for almost a century, and the management of this company, as usual, is our first focal point. This is what kept the company running.
The discussion of the board and upper management starts on page 104 of the annual report. This seems to be a highly competent group, but there is quite an overlap between the Board of Directors and Executive Management, with a large number of the directors being executive directors. This conveys an environment in which the board of directors is truly responsible for all corporate actions.
Salaries and remunerations are meager compared to US standards, given the colossal size of operations for this company, not to mention the large market cap, even at these depressed market prices.
As far as financials, these start in the report on page 179. Do not pretend to understand these without continual referral to the notes starting on page 186.
The all-important cash flow discussion starts on page 182. The company, at the end of 2012, lists $12.2 billion in profit, which is 40% less than the year prior, even though revenues were similar. The culprits seem to be "purchases," "production expenses," and "impairments."
If you look at the purchases -- which refers you to Note 28 -- you will see that it has risen to $293 billion in 2012 from $286 billion in 2011. Now if you look at the note, then there is really no purchasing there. It is -- again -- Replacement Cost accounting, where the note states clearly that this inventory is really ~ $28 billion, but "Cost of inventories expensed in the income statement" is the $293 billion!
Now, let us take this one step further and look at page 184, that is where the equity of the company is calculated. Under assets, the second line is inventories, and here the ~$28 billion reappears (also referring to note 28). Guess what, this is not mark-to-market accounting, nor is it cost-based accounting! In effect, the company, if liquidated, is sitting on $293 billion of inventory (considering Replacement Cost on the cash flow statement) that is being listed as $28 billion!
In essence, if you consider the financial statement line by line, and go over the notes one by one, you will reach a conclusion that you need to either take a leap-of-faith and accept the statement of the directors on page 178 and that of Ernest & Young as the auditor on page 179, or not invest in the company at all.
My own personal assessment is that the company has a huge "locked" value that the accounting schema is hiding. For the life of me, I cannot understand how -- in note 6 page 205 -- can $345 billion of third-party downstream revenue result in $2.4 billion profit, while $29 billion of third-party upstream revenue result in $22 billion in profit.
Will this value be unlocked if oil prices start dropping? Will technological advances reduce or decrease profits?
I really cannot discern. As such, my view is that if you accept being an investor in BP, you have to accept whatever "handout of an income" that the Replacement Cost accounting will provide you with. This currently stands at $0.57/quarter!
Moving into charting and technical analysis, we start by examining the 10-year monthly chart below. Similar to NGG's discussion, you can dismiss portions of the "around financial crisis" action as currency-related -- I repeat the GBP-USD FX chart below for reference. Yet, since oil pricing is in USD, the effect is not as amplified as the drop in the exchange rate from $2.1 to less than $1.4 would have indicated.
The second drop around 2010 is mostly the "Gulf of Mexico" with, again, a bit of FX effect, as this FX chart suggests.
The following chart of the BP ADRs plotted against the London-listed BP shares and the FX exchange rate in USD/GBP should make my comments above clearer.
We now resort to the 3-year weekly charts to analyze more current action.
It seems from above charts that the company's stock price is starting to show some liveliness towards the end of 2013. This may be due to a realization that the financial damage to the company due to the Deep Horizon oil spill is now quantified. It does not seem that the stock price is far ahead of its moving averages, and the frequent mean-reversion in the charts suggests no overheating. Note that some consolidation (and not correction) seems to be at work as far as BP price is concerned. This may require delaying any purchase decision until a direction is discerned -- repeating the "do not catch a falling knife" edict.
In conclusion, there seems to be some deep value locked into this beaten-up giant. It is not clear how this value can be unlocked, as accounting practices have created -- in my opinion -- an unnecessary dependency on market energy prices and those of related technologies.
Further, given how hard it is to internalize the accounting, there is a leap-of-faith needed by a long-term investor that is mainly anchored around the 100-year history of the company, the qualifications of its board and management, and the qualifications of its auditors.
Personally, I am more comfortable "trading" the company, but if I were an investor, concerns about capital preservation and dividends stability seem to be much more remote than any of the companies we examined to date.