BP: With Uncertainty Looming, Not Yet A Buy

Apr.10.12 | About: BP p.l.c. (BP)

Shareholders of BP (BP) have suffered significant value erosion since the infamous oil spill at BP's Macondo oil well in the Gulf of Mexico almost two years ago. Since the well blew out on April 20, 2010, BP's shares have declined by more than 28% from about $60 to a recent price of about $43 per share.

In the wake of this environmental and public relations fiasco, the company has been actively engaged in efforts to limit the financial damage, which includes $20 billion in cash payments to the Gulf Claims Trust, and civil penalties which have not yet been settled, but will be in the billions. Total civil penalties are estimated to be around $12 billion, based on an estimated 4.1 million net barrels of oil spilled at $3,000 per barrel in penalties.

Whatever the ultimate amount of the penalty is, BP will share the cost and will likely be responsible for about 75%, or $9 billion, if the cost estimate is accurate. BP has been forced to sell off assets and cut its dividend to fund its spill-related obligations and it intends to complete another $20 billion in divestments, which will be a drag on cash flow going forward.

However, shares are as appealing as they have been since the oil spill, because a conclusion to the Gulf spill litigation is approaching. Expectations are so low that even minimal improvement in BP's exploration and production operations could boost shares. Planned upgrades of 50% of U.S. refining assets should support revenue growth and margin expansion, and six to nine major projects are expected to start up in 2012 and 2013. Also, the dividend was increased by 14% for the first quarter of 2012.

The prospects for BP are improved from the recent years past, but a great deal of uncertainty remains for the company. First is the unsettled cost of civil penalties related to the Clean Water Act and the Oil Pollution Act. Although estimates for the cost are reasonably firm, unwelcome surprises are possible until all legal matters are concluded, and any variance from expectations could cause shares to suffer.

The flip side of this risk is that if settlement costs turn out to be lower than estimated, the Gulf Trust, which holds BP's contributions, would be overfunded. A corollary to this point is that the company's ability to recover any excess contributions is unknown. Next, future asset sales, specifically its large North American refineries, could prove to be at unfavorable prices for BP.

Turning to operations, there is much uncertainty about BP's ability to grow production and reserves going forward because production is falling in BP's Alaska fields. Also, future production levels in the Gulf of Mexico, where it still is the largest operator, are unclear due to the Macondo spill.

BP's Russian joint venture with TNK-BP makes up more than a quarter of the company's total production and the recent collapse of a strategic agreement with Russian company Rosneft demonstrates the company's international risk. In this business segment, BP relies on its Russian partners to effectively manage its significant investment because BP does not control the strategic investment decisions of the joint venture.

And the overarching issue of the price of oil looms over all these considerations. BP expects it can drive 50% operating cash flow growth by 2014 versus 2011 with oil prices at $100 per barrel, which would be extremely bullish for shares, but divergence below this level would be a major headwind.

In the fourth quarter of 2011, production volume was down to 3.5 million barrels of equivalent per day from 3.7 million for the previous year as a result of the forced asset sales. As a result of lower production, profit in the "upstream" segment was down 5% to $7.6 billion from $8 billion in the prior year, badly lagging the other majors that posted strong growth.

For example, Shell (RDS.A) (RDS.B) saw upstream profits grow by 48%. Refining or "downstream" results fell off as well in the fourth quarter, as many regions had very weak refining margins. A profit of $564 million was posted in BP's downstream unit, which was $400 million less than previous year and almost $1 billion less than the third quarter of 2011.

At a recent price of about $43 per share, BP trades at a forward price to earnings ratio of about 6.3x based on 2012 earnings per share estimated to decline by about 10.6% to $6.78. In 2013, analysts estimate earnings per share of $6.97, which yields a price to earnings ratio of 6.2x and a price to earnings to growth ratio of about 2.2x. These earnings estimates are predicated on revenue growing by 3.3% in 2013.

At these levels, BP is more richly valued than Exxon Mobil (XOM), but less than Chevron (CVX). Exxon is estimated to have a forward price to earnings to growth multiple of 1.3x for 2013 based on the current share price of about $85 and earnings growth of 7.5%. Analysts are assuming revenue growth of only 0.9% in 2013. Chevron's 2013 price to earnings to growth multiple is 3.5x at the recent share price of about $105 based on earnings growth of 2.2% and revenue growth of 3.5% in 2013.

Analysts are projecting that like BP, earnings per share growth will be negative in 2012 for both Exxon and Chevron. I think that the estimates for BP in 2012 are reasonable, given the uncertainty in operations and Gulf spill litigation, and that there is upside to the earnings projection in 2013 if these uncertainties diminish sooner than currently anticipated.

BP is a very interesting company that at some point will emerge fully from the shadow of the Gulf oil spill disaster and its valuation will reflect its intrinsic value based on operations and assets. However, I do not think the time is now for investors to buy shares because the uncertainty level is still too high and there are too many ways that the company could be seriously harmed.

My investment philosophy resists buying a forward price to earnings to growth multiple above 2x, unless I spot a compelling reason why earnings growth is underestimated or another catalyst supersedes that high multiple. Neither of these conditions apply to BP, and even though shares are more appealing than at any time since the disaster two years ago, they are not yet a "buy" at the current price of about $43.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.