By Brian Tracz
BP (BP) reported its disappointing earnings on Tuesday, which included a 96 percent decrease in adjusted profit and a 175,000 barrels of oil per day production decrease year-over-year. Bob Dudley, the BP chief executive, cited factors "in both the sector and BP specifically" for this steep earnings loss. Write downs of gas assets, certain refineries, and suspension of the Liberty project in Alaska contributed to the $4.8 billion non-operating expenses of the company--a mix of internal and external factors.
In addition to the maintenance schedule of the company and sluggish commodity prices, the Deep Water Horizon continues to be a major drag on BP's business. By the end of the second quarter, the company had disbursed $8.8 billion to individuals, businesses, and the government in relation to the incident. That brings its total bill for the incident to $38 billion.
Looking at everyday valuation metrics, BP looks undervalued. Of Chevron (CVX), Occidental Petroleum (OXY), and Exxon Mobil (XOM), BP has the lowest trailing and forward P/E ratio--its shares are trading at only about 6.5 times forward earnings. The three others range 8.5 to 11.5 times earnings. For integrated oil and gas companies, profit margin is especially important, and BP's net profit margin comes in at only about 6.9 percent, compared to 10.7 percent and 8.7 percent for Chevron and Exxon Mobil, respectively.
Given this data and the rough earnings report, there's still the question of whether BP is a good short-term or long-term buy. We think that hedge funds stand to give us the best guidance in this area. Seth Klarman, the biggest name in value investing next to Benjamin Graham and Warren Buffett, has a significant stake in BP (his portfolio can be viewed here). According to our analysis last year, Klarman built his position in BP, which at its highest point in the third quarter 2011 consisted of 13.7 million shares, at a weighted average price of $39. In the first quarter 2012, he trimmed about 2.7 million shares from this position, meaning he sold these shares for around $45 a share.
We don't necessarily know what Klarman's strategy with his BP position is, but we don't really need to know. Given the lack of major game-changing events for BP since the year's beginning, we could assume that the basics of his investment thesis still hold, and this thesis pegs BP shares as being undervalued at an average of $39. For short-term cash, Klarman seemed to think that $45 was a good selling point. Klarman's dictum is only to buy stocks that are undervalued, period, and that's what he is doing.
This makes good sense as a short-term idea for BP, given the lack of oil and gas pricing momentum and troublesome Deepwater Horizon payouts. For long-term, three-year investment targets, BP is an even better bet. Oil demand globally is expected to increase in 2013 by 1.09 MMb/d, whereas demand increased 0.91 MMb/d in 2011 and is expected to increase only 0.8 MMb/d in 2012 (data provided by S&P). Natural gas is also showing signs of rebound from its sub-$2 lows earlier this year. BP is well-positioned to take advantage of these upswings in commodity prices. If such commodity price increase synergizes with a final sense of closure to BP's Deep Water Horizon responsibilities, then BP shares are positioned for exceptional returns (BP shares also have a nifty 4.7 percent annual dividend yield).