"You pay a high price for a cheery consensus."
Warren Buffett's words ring particularly true in the energy sector where market participants will gladly pay up substantially for integrated oil companies with less ambiguity in future short-term earnings results than that of a company like BP plc (BP). I didn't start to get interested in BP until right after the Deep Horizon disaster when CNBC and Bloomberg were inundated with prognostications that the company could potentially go bankrupt. This prompted coworkers asking me if this was indeed likely and from digging through the numbers, I found those prognostications to be truly absurd. While the scope of the disaster was tremendous, BP is one of maybe 10 companies across the globe that actually could deal with the fallout, without being crippled in the process.
Since the disaster BP has entered into agreements to sell assets with a value of $24 billion. Total divestments since 2010 are expected to reach $38 billion by the end of 2013. Fortunately for BP, buoyant oil prices enabled the company to reap excellent prices on most dispositions thus far, cushioning the financial blow. It is my opinion that the Gulf spill has forced BP to simplify and streamline operations, so as to focus on optimizing capital allocation towards the highest returning assets. This is in contrast to what seems to be the modus operandi of most E&P companies to plow all available funds into acquiring additional resources on the belief that prices can only go higher.
A combination of lower oil and gas prices, extensive maintenance operations particularly in the higher margin Gulf of Mexico, and lower net income from TNK-BP caused the British oil giant to miss earnings expectations in the second quarter. Brent oil traded on average around $9 per barrel lower than a year ago, and Henry Hub traded roughly $2 lower than a year ago. BP flat out said that the North American Gas business is operating at an operating loss due to low prices, which have improved slightly thus far this quarter. Underlying replacement cost profit for the quarter, adjusted for non-operating items and fair value accounting effects, was $3.7 billion, compared with $5.7 billion for the same period in 2011 and $4.8 billion for the first quarter of 2012. BP's share of net income form TNK-BP of $450MM was $700MM less than in the first quarter mainly due to the steep decline in oil prices as the European Crisis spread in the quarter, in addition to the fact that there is a lag in how the Russian oil export duty is assessed, meaning that the duty was based on higher oil prices which should reverse somewhat in the next quarter.
Headline results of a loss of $1.39 billion versus a profit of $5.72 billion a year earlier were also impacted from $4.8 billion of impairments on a pre-tax basis, largely due to $2.1 billion in reductions in the value of U.S. shale gas assets, $2.7 billion in impairments on certain refineries in the company's portfolio, and the decision to suspend the Liberty project in Alaska. Operating cash flow for the second quarter, after $1.7 billion of post-tax Gulf of Mexico expenditures, was $4.4 billion, up from $3.4 billion in the first quarter. BP's production of oil and gas, excluding TNK-BP, averaged 2.275 million barrels of oil equivalent per day (mmboed) in the second quarter compared to 2.457 (mmboed) for the same period last year. The company expects reported production in the third quarter to be lower once again as the seasonal turnaround program continues, before finally beginning to increase again in the fourth quarter. BP believes that for the full year of 2012 underlying production will be consistent with 2011 adjusted for divestments. The company's share of TNK-BP production in the second quarter was 1.016 mmboed, compared to .976 mmboed for the second quarter of 2011.
TNK-BP is one of the most attractive long term global E&P plays, but unfortunately for BP the relationship has been immensely contentious to the point where now BP is looking to sell their stake in the profitable venture. Government majority owned Rosneft is the most likely bidder but the situation is fluid and BP must be sure to obtain a good price if it is to let go of this jewel in BP's crown. Divesting this stake would likely decrease some of the uncertainty that the continuous circus-like headlines have on BP, perhaps forming the basis for an improved valuation.
In the second quarter BP allocated another $850MM charge for the Gulf of Mexico oil spill bringing cumulative charges up to $38 billion, or which $30 billion has been paid out thus far. BP continues to believe that the company was not grossly negligent and these charges are consistent with that belief, but obviously could be at risk for further upside should the courts rule differently. Amazingly even after the unprecedented payouts for the spill, BP's net debt ratio of 21.9% is consistent with where the ratio was right before the disaster, and I believe credit has to be given with conservative capital allocation strategy that BP has taken in dealing with the crisis.
Total net debt at the end of second quarter was $31.7 billion. The company's stated goal is to get the net debt ratio down to the 10-15% range.
BP expects to increase operating cash flow by 50% from 2011 levels in 2014, in a $100 per barrel of oil price environment. By late 2012 payments to the Gulf of Mexico trust fund are expected to cease, and BP is planning on bringing on 15 new higher-margin upstream projects that are scheduled to begin production by the end of 2014. Six projects are scheduled to start in 2012, and 2 projects in the Gulf of Mexico are now on-stream. 6 rigs are now operational on BP fields in the Gulf of Mexico, with a total of eight expected to be in place by year end. BP believes that these projects will produce profit margins that are double current margins.
BP acquired 43 leases in the second quarter in the Gulf of Mexico, which are awaiting regulatory approval. The company also resumed operations of its long-term exploration contracts onshore and offshore Libya. Exploration wells and seismic activities are taking place in Namibia and Angola respectively, and a major seismic survey was completed in BP's acreage in Southern Australia.
At $39.91 BP has a market capitalization of about $126.5 billion and offers a compelling dividend yield of 4.3%. BP has an EV/EBITDA of just over 4 which is cheaper than most of its peers including Exxon Mobil Corp (XOM). By early 2013 we should have a lot more clarity as to the ultimate liabilities of BP for the Gulf spill as the company has been making steady progress already. BP has averaged in excess of $20 billion in net income over the last 7 years if you take out the aberrational 2009 results, meaning that the company is trading at just over 6 times normalized earnings. While the next quarter or so is likely to be difficult while BP performs maintenance on its potentially lucrative Gulf of Mexico rigs, looking 1-2 years out it is very difficult to find an integrated oil company that can be acquired at such a cheap multiple on a "back of the envelope" discounted cash flow basis.
A good way to play BP is through taking advantage of the implied volatility by selling longer term put options. Currently an investor can sell the January 2014 $40 puts for about $6.50. This equates to a 19% target profit on the maximum risk, or 13% annualized. Using this strategy does not enable the option seller to obtain the dividend unless the option is exercised, but it is significantly less risky than owning the stock outright providing a greater margin of safety. While I disagree with most E&P companies' capital allocation policies due to their over-reliance on continuously rising prices, I believe that it is important for investors to prepare for higher inflation over the long term so buying this out of favor profit machine makes sense.