BP Is A Tempting Value Bet, But What Are The Risks And How Do You Hedge Them?

| About: BP p.l.c. (BP)
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BP (NYSE:BP) is a major international oil and gas industry company based in the UK. It is the world's fifth-largest company measured by 2012 sales, as well as the fifth-largest oil and gas company in the world by market cap. It is vertically integrated and well diversified, having operations in all major activities including production, refining and marketing. The company has also diversified energy sources, including wind and biofuels in renewable energy. BP has more than 20,000 service stations in over 80 countries.

BP is currently very attractively priced and trading at discounted values predominantly due to the uncertainty looming from the highly unpredictable size of potential future liability claims resulting from the 2010 Deepwater Horizon oil spill disaster. Despite the fact that it is impossible to precisely estimate the size of the outstanding liabilities, the company has already settled and paid many claims. Additionally, BP regularly puts money aside for future liabilities as its estimates emerge.

History Tidbits

  • In 1909, the Anglo-Persian company was established as a subsidiary of Burmah Oil company, to discover and extract oil in Iran.
  • In 1954, it changed its name from the Anglo-Iranian company to British Petroleum, today known just as BP.
  • In 1965, BP was the first company to discover oil in the North Sea.
  • The infamous 2010 Deepwater Horizon disaster was the largest ever involuntary oil release into sea waters.

What I like about BP

1. Industry comparison

If you click the enlarge link, you will see in the following table Integrated oil and gas companies ranked by market cap, compared head to head by various valuation and financial metrics, some of which we use in this analysis. BP certainly looks extremely attractive compared to some of its fully priced peers, such as Chevron (NYSE:CVX) or Exxon Mobil (NYSE:XOM), which trade at average P/Es and other valuation metrics.

2. Excellent trailing P/E of 6.19

BP has the second-lowest current trailing P/E in the Major Integrated oil and gas industry. With a P/E of 6.19, only Statoil (NYSE:STO) beats it in this metric with a P/E of 6.11.

3. Very low price-to-book value of 1.07

The price-to-book of 1.07 is also very promising, and close to a value investor's dream, considerably limiting the downside risk.

4. Very attractive dividend of 5%

The current 5% dividend yield is one of the highest in the industry. What's more, it is achieved at a relatively low payout ratio of 27.47. Of course, if the earnings per share dropped in the future for any reason, this ratio would automatically deteriorate even at an unchanged dividend amount paid out. On the other hand, the expected future 5% earnings growth gives upside room for future gradual dividend increases while maintaining this low payout ratio.

The following chart shows that BP isn't one of the smoothest dividend payers. However, this abrupt 2010 dividend decrease was caused by the disastrous event of the Deepwater Horizon oil spill. Statistically, this is a one-off event, and shows why oil and gas companies trade at lower P/E valuations than stocks from some more defensive sectors. This kind of black swan event risk is present in virtually every oil and gas company and should be priced in.

source: dividata.com

On a positive and contrarian bullish note for BP, it is currently emerging from one such black swan event, which gives it very favorable valuations going forward in terms of the four major positive metrics mentioned above.

For example, the dividend has been steadily increasing since the 2010 spill by 8.85% each year, in line with the trajectory of constant dividend increases before the Deepwater Horizon event.

5. Relatively high expected future growth of 5%

Analysts expect the company to grow earnings by 5% p.a. in the next five years. This is one of the highest values in the industry among the six supermajors. Of course, this is just an estimate that can change downward or upward in the future, so we have to take it with a grain of salt.

Main Challenges Currently Faced by BP

1. Many of the Deepwater Horizon damages are still unsettled

Nobody, including the company, can be sure how much the total damage claims bill will be. There are still various legal disputes pending. The expected costs of settlement vary widely, and some of them are virtually unpredictable at this stage.

What is positive for me is the fact that BP continuously creates reserves for future claims as it learns the expected size of these settlements. Moreover, part of the damages have been already settled. With every next settlement, more and more investors are likely to jump on the bandwagon as the pile of unknown future claims just gets smaller and smaller.

One can even argue that BP offers the highest margin of safety of the entire oil and gas industry, thanks to trading at such low valuations, because every major industry player faces similar potential risk of future oil spill.

On the other hand, this probability doesn't rule out that BP will have yet another disaster happen very soon. Now, that would really put BP's stock price and its finances under pressure.

2. Selling assets to pay for damages

As a result of the Deepwater Horizon settlements, BP needed to make divestments in order to pay for settled claims and create reserves for any future costs of this disaster.

On a positive note, these divestments make BP more focused and more effective. One can even argue that BP would have to perform many of the divestments even if it didn't have to deal with any oil spill disaster because virtually all its peers keep divesting assets to maintain high profitability and return on investment.

What I appreciate about BP is that it decided to divest assets and reorganize rather than just increase debt. In fact, BP's debt-to-equity ratio currently stands at 0.36. Although it offers some room to swallow future settlements, I predict that future divestments will be needed nonetheless.

3. European risks

Although the UK is not part of continental Europe or the Eurozone, BP is still somewhat penalized for being close to the euro crisis. I partly see this as a positive point because it just helps smart long-term investors buy BP shares cheaper now while this perceived risk lasts.

4. Russian roulette

With a 19.75% stake of Rosneft in its portfolio, as part of the sale of TNK-PB to its Russian partner partially in exchange for Rostneft stock, BP is pursuing some risky bets that don't really suit my investment style. These investments can pay off big time, or result in a fiasco due to political risk. However, I see that by backing out of the TNK-BP deal, BP is heading the right direction for me and I expect that the Rosneft stake could even be on the sell list if further Deepwater Horizon claims threaten to drain the company of its cash.


BP is a very attractively priced oil and gas company with sizeable upside potential, which will be realized once the Deepwater Horizon uncertainty is mitigated. The total costs of the disaster are very hard to predict now, even for the company itself. However, due to this very fact, BP takes proactive steps to maintain effective operations and remain financially strong, ready to withstand any adverse development in future settlement claims. I am positive the company will not only withstand them, but will also emerge as a more effective business and its price will reflect this fact.

Recommendation and Risk Management

1. My portfolio move

I am purchasing BP stock now to take advantage of the dividends and keep full upside price potential. I am also purchasing January 2015 LEAPS protective puts at a strike price as close to my stock purchase price as possible (at-the-money) to protect myself from potential future downside.

My total return will be lowered by the cost of the puts. However, with implied volatility of BP so low, long-term protection is really cheap and costs approximately the same on an annual basis as the current dividend yield (5% of the current stock price for January 2014 at-the-money puts and 10% for January 2015 at-the-money puts).

I intend to roll the 2015 LEAPS one year further in just over 12 months from now to keep the expiration as far away as possible in order to capitalize on the lowest average monthly time decay on the longest-dated options.

If BP continues to pay at least the same dividend as currently, these dividend payments will just about cover the costs of this put protection, in effect giving me unlimited upside potential and zero downside risk from the purchasing price. But I am, in effect, giving up on the dividends.

In this investment, investors can trade all dividend income for complete downside protection. It is up to every investor, and his risk profile and income stream need to decide whether this kind of trade-off is beneficial for him, or if he prefers to just buy and hold the stock.

For investors who see BP as a bit too risky, I recommend having a look at Chevron, Exxon Mobil or ConocoPhillips (COP). And for investors with more risk appetite, Royal Dutch Shell (NYSE:RDS.A) has interesting valuations.

2. Pair trade

Investors who are more risk averse and are afraid to take a full position in BP due to either company-specific risks, such as potential for unexpectedly high Deepwater Horizon damage payments, or industry-specific risks, for example a bearish outlook for the oil and gas industry, falling price of oil, etc., are advised to add a hedging investment in the form of a short position in the energy industry (NYSEARCA:XLE) or take a short position in oil futures.

3. Russian risk

Investors who feel as uneasy about BPs endeavors with Rosneft as I do can partly and imprecisely hedge the long BP position by shorting Rosneft or the Russian stock index (RSX) to try to further distill the Deepwater Horizon uncertainty in its purest form.

4. Options play

An interesting alternative play for investors who want to limit BP's downside potential is purchasing long-term January 2015 options (LEAPS) instead of stock. Of course, there is no free lunch. Options play will greatly limit your losses, and magnify your potential gains as a percentage of invested capital. However, you are giving up all the dividends and paying for the options premium, which is similar to put options premium at the moment, albeit a bit lower.

One final option is to sell calls. However, I don't recommend this strategy in general if a stock is undervalued, as selling calls would hinder the stock's upside potential. Moreover, in the case of BP with low volatility, the call premium would be very low and probably all consumed by bid/ask spreads and trading fees - not to mention short-term capital gains for those investors who are impacted.

However, it could be a profitable strategy as well, for example in the first year from now, if uncertainty prevails and the stock keeps trading in a 10% sideways range as in the last 12 months. Nevertheless, investors should keep in mind that they can't time the market, and if the stock shoots up sooner than a call seller expects, the upside potential is lost.

Disclosure: I am long BP, CVX, XOM, RDS.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.