In July, we profiled BP plc (BP), but quite a bit has happened, so it would be well worth updating our investment thesis. BP is up nicely today after posting solid third quarter earnings, and at $42.99, the stock has a market capitalization of around $136 billion. BP possesses normalized earnings power in excess of $20 billion per annum, assuming $90 plus oil prices, even after dispositions. It is our belief that the Macondo disaster forced the company to refocus its approach to safety, profitability, and capital allocation. Ultimately, we believe that as the smoke clears and the new BP emerges, investors will be rewarded for their patience. We believe that BP is worth around $60 a share, and investors will receive around a 4.5% dividend that is growing while they are waiting for the capital appreciation.
On October 22, BP agreed in principle to sell its 50% stake in TNK-BP to Russian government owned Rosneft. BP is to be paid $17.1 billion in cash, and shares representing 12.84% of Rosneft, which will be the largest oil company in the world. BP then intends to use $4.8 billion of the cash proceeds to purchase an additional 5.66% of Rosneft from the Russian government, giving BP a 19.75% stake in Rosneft -- including its existing 1.25% stake -- and BP will still have $12.3 billion of the cash left over.
BP's valuable TNK-BP stake was the source of tremendous uncertainty for the company, as the lack of amicability between the partners created a situation where the entity wasn't paying dividends despite easily having the resources to do so. With Russia's history of expropriation of natural resource companies, having a stake in Rosneft does not eliminate the risks in dealing with the Russian government, but BP should be better positioned to be the international company of choice to leverage foreign technologies to most efficiently increase output, particularly in the potentially lucrative Arctic plays that Russia has access to. This is going to be a long-term relationship, and BP likely won't see too much benefit initially, since Rosneft has previously made other agreements with large international oil companies to develop the Arctic.
BP has operated in Russia for over 20 years, and while the TNK-BP stake might have contributed to a discount in BP's valuation, the initial investment in 2003 of around $8 billion paid out $19 billion in dividends to BP. Russia is the largest oil and gas producer in the world, and it also has the largest reserves. BP will have two board seats and a nearly 20% stake in the leader in its industry. Russian oil companies don't have quite the acumen that a BP or Exxon Mobil (XOM) has in terms of developing the more difficult resource plays, and this acquisition makes BP the logical choice to partner with moving forward.
BP's third quarter underlying replacement cost profit was $5.2 billion, down 5% from last year's third quarter, but 40% higher than the second quarter of 2012. BP's strong results were bolstered by elevated refining margins, which allowed strong profitability from the downstream operations. Underlying replacement cost profit reached a record $3 billion, up from $1.7 billion a year ago. Moving forward, refining margins will likely normalize to a lower level, thereby reducing downstream profits.
The upstream segment posted replacement cost profit before interest and taxes of $4.4 billion, which was consistent with the second quarter, but down from $6.3 billion YOY. Operating cash flow in the quarter was $6.3 billion. BP has continued to focus on higher margin drilling programs, but this organic growth has been offset to a large extent by continuing divestments to raise cash to offset the Macondo disaster. The company continues to believe that full year underlying production in 2012 will be flat with 2011, excluding the impact of TNK-BP. BP's share of TNK-BP underlying net income was $1.3 billion in the third quarter, 38% higher than a year ago, and nearly three times higher YOY. The company also rewarded shareholders with a 12.5% increase to the dividend payout.
In the fourth quarter, BP will make a final payment of $860 MM to complete the $20 billion funding of the Gulf of Mexico Trust Fund. Thus far, the total cumulative net charge has been $38.1 billion for this disaster. At the end of the third quarter, the cash balances in the trust and the qualified settlement funds were $10.9 billion, with $19.1 billion contributed and $8.2 billion paid out. BP's assumptions are in line with the company not being grossly negligent, which is certainly the biggest downside risk that it faces moving forward. Currently, the company is in negotiations to settle this case, but it seems like the sides are pretty far apart. The trial is set to start early in 2013, and I truly believe that even if the final result is greater than BP's reserves, the stock will ultimately react positively due to the decreased uncertainty of this dire situation.
BP has remained immensely busy on the asset disposition front. Since the second quarter, the company has announced $11 billion of asset sales including several refineries, and a number of non-strategic assets. If you include the proposed transaction with Rosneft for the sale of BP's stake in TNK-BP, the total of announced divestments is over $62 billion. If you exclude Rosneft, total divestments are $32 billion of the targeted total of $35 billion. BP has realized good prices for most of these dispositions. Impressively, the program has removed around 50% of upstream installations, 32% of wells, and 50% of pipelines, while only divesting 10% and 9% of BP's reserve base and production, respectively. Since 2010, BP has accessed around 400,000 square kilometers of new acreage, ultimately setting the stage for future production growth.
BP has 15 major project startups by 2014, and the portfolio is 75% complete today. The company expects these projects to deliver twice the average operating cash margin of the 2011 portfolio, assuming $100 per barrel oil. After a two-year hiatus from drilling in the Gulf of Mexico, BP now has seven rigs operating in this high-margin region.
At the end of the third quarter, net debt stood at $31.5 billion, and gearing was reduced to 20.9% versus 21.9% at the end of the second quarter. Assuming that BP doesn't incur additional gross negligence from the Macondo spill, the company believes it should be able to lower the gearing ratio to just above 10%, setting the stage for more dividend increases and buybacks. BP mentioned on the earnings call that it could potentially use the cash from the TNK-BP sale to buy back stock to offset any dilution to earnings. This would be very favorable at current prices, but I wouldn't expect much to happen until the legal uncertainty is in the rear view mirror.
Unless oil prices decline significantly, we expect BP to perform quite well. It's an excellent stock to sell put options and covered calls on for those investors that like using those tools to increase the income potential of the stock. There will certainly be some negative headlines, so patience, discipline, and a dollar cost averaging program are recommended to produce the best results.
Disclosure: I am long BP.