BP (BP) was in the news recently after it emerged that Mikhail Fridman, the Chief Executive of its Russian Joint-Venture, TNK-BP (TNKBF.PK), resigned after a turbulent tenure. Mr. Fridman and his Russian partners control 50% of TNK-BP.
TNK-BP is critical because it accounts for about one quarter of BP's oil output and a significant portion of BP's profitability. In fact, owing to boardroom squabbles, TNK-BP had not yet declared dividends, thereby depriving BP of $3.75 billion in cash.
That's significant because it leaves BP deeply out-of-pocket after having declared $4.1 billion in dividends for 2011. It also means that BP has less cash with which to pay for its $7.8 billion settlement for its Deepwater Horizon oil rig debacle in the Gulf of Mexico. In fact, BP may still be in hot water over its Deepwater settlement, with groups of plaintiffs possibly not accepting the settlement and going at it in a separate suit.
Meanwhile, we may not have heard the last of Mr. Fridman. He and his partners sued BP in early 2011 after the latter signed an Agreement with Russian oil giant Rosneft (RNFTF.PK) in a deal that would have given BP an edge in the race to tap Artic Ocean oil deposits.
Apparently, Mr. Fridman's group was excluded from BP's agreement with Rosneft and it now maintains that the exclusion violates its agreement with BP. They have sought up to $10 billion in damages. These two claims against BP are significant to the extent that BP does not appear to have the cash resources to meet them. Specifically, at the end of 2011, BP had about $14 billion in cash.
Assuming that the Deepwater settlement rises by 50% to $11.7 billion owing to claims by plaintiffs who reject the original $7.8 billion settlement, and courts rule in favor of Mr. Fridman and his partners, BP is looking at a total bill of $21.7 billion. That's 54% more cash than it stated in its end-2011 Balance Sheet. Fortunately for BP, it has been able to defray the vast majority of its Deepwater-related costs through asset sales, otherwise its cash drain would be larger.
Even though BP should be able to monetize its inventories to meet these hypothetical payments, any negative ruling on TNK could put renewed pressure on BP's credit rating, which already took a series of hits in the wake of its Deepwater troubles.
That's something that BP would sooner avoid: its financial strength ratios are only average relative to the industry, and its level of long-term debt-to-equity is actually 32% higher than the industry's. A lower credit rating would only make the cost of its debt more expensive.
What's more, its peers such as Chevron-Texaco (CVX) and Exxon Mobil (XOM) are considerably less indebted, with debt-to-equity ratios at 0.07 and 0.21, respectively. These give both companies an advantage over BP in the form of room to spend on joint ventures in key oil exploration areas, and also financial insulation in the event of oil spills of their own.
Part of this is due to BP's generous dividend yield of 5%. This bears watching for value investors: if BP has to pay TNK's legal claims, it may have to scale back on its dividend. That won't sit well with BP shareholders as these experienced a reduction in their remuneration after the Deepwater incident.
Chevron and Exxon have much lower dividend yields of 3.6% and 2.8%, respectively, which provide a range of where BP's dividend yield might fall if it's required to pay down claims or reduce its long-term debts.
This is not to suggest that BP's long-term debt levels are alarming. Quite the opposite actually: at 0.33, its debt-to-equity is less than half the S&P500's 0.82. What's more, financial theory suggests that a debt-to-equity ratio of 1.00 is considered optimal and below that level suggests under-leverage. Rather, the emphasis on BP's debt is meant to show the impact that legal issues such as Deepwater have had on its finances.
Clearly its legal troubles are weighing its value down but should that deter investors?
Conclusion
To get an answer, it's instructive to look at BP's stock price activity as it relates to Oil Prices. Despite BP's legal settlements and other such issues, its price actually tracks that of oil fairly closely. In that sense, like much of the Oil Industry, its true value fluctuates as the oil price moves. Given this, an alternative way to determine whether BP is undervalued (and therefore, worth buying) is how much its market capitalization relates to the market value of its oil reserves.
Let's call this relationship oil companies' Oil Value-to-Capitalization (O/C) ratio. Using 2010 reserve figures, here are the value of the reserves relative to Market Capitalization of BP, Chevron and Exxon-Mobil. It's assumed that their reserves have remained static at these levels.
- BP had reserves of 18.071 billion oil-equivalent barrels in 2010. At a market price of $91 per barrel, that's worth $1.64 trillion compared to a market capitalization of around $121.58 billion, for an O/C ratio of 0.07;
- Chevron had reserves of 10.545 billion oil-equivalent barrels in 2010. At a market price of $91 per barrel, that's worth $960 billion compared to a market capitalization of around $195.07 billion, for an O/C ratio of 0.20; and
- Exxon-Mobil had reserves of 84.5 billion oil-equivalent barrels in 2010. At a market price of $91 per barrel, that's worth $2.26 trillion compared to a market capitalization of around $383.82 billion, for an O/C ratio of 0.17
What's nice about the O/C ratio is that it shows what the market is effectively paying for each company's oil reserves.
Based on this metric, BP is among the cheapest of the oil companies. The market is basically paying it just $6.37 for every barrel of oil it owns. Granted, there are costs such as exploration, extraction and so forth to bringing this oil downstream, but the fact remains that BP is relatively a cheap bet on oil.
Moreover, BP has been providing better growth to its shareholders: its 5-year sales growth rate of almost 4.9% is superior to Chevron's 3% and Exxon's 3.8%. It's here that the impact of BP's ongoing legal on its share price can be seen: despite better sales growth, its Price-Earnings ratio is only 5 times earnings, compared to 7.3 times for Chevron and close to 10 times for Exxon.
Oil has recently been on a downtrend - the result of slower growth in the markets like the US and Europe that make the most use of it. However, with global growth expected to accelerate going into 2013, the Oil price will almost certainly recover.
As such, I can see BP being an attractive play in 6 months' time. My belief is that its current legal struggles have already been built into BP's current price. As such, I would buy BP shares now, and I am anticipating a 30% yield by mid 2013.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
