BP's Risk-Reward Is Extremely Compelling Right Now

Summary

• BP p.l.c. is the very definition and a classic example of a value stock right now.
• The market must be pricing in a complete collapse of oil and gas prices and refining volumes, which I believe is unlikely.
• With ESG more and more important, BP's energy transition strategy is taking shape nicely. This gives it long term growth to offset oil's eventual long-term decline.

Leon Neal

A lot of stocks look cheap in the UK right now, but BP p.l.c.’s (NYSE:BP) cheapness is unjustifiable. Seeking Alpha gives BP a Valuation Grade of B. Morningstar’s Stock Style for the energy company is Large-Value.

I believe BP’s low valuation and sensible energy transition strategy and improving financial position make the risk-reward ratio very favorable for investors. Although I have some reservations about the CFO Murray Auchincloss, I am a big fan of CEO Bernard Looney.

Energy has been by far the best-performing sector this year, in fact one of the very few industries that’s up on the year. That’s obviously because of high oil and gas prices, so is it too late to get in? For some energy stocks maybe, especially if their long term strategy is not aligned towards the energy transition. BP laid out its energy transition strategy – from integrated oil company to integrated energy company - more than two and a half years ago. This is being executed and means that, over time, BP will be less exposed to oil prices.

But for the outlook for 2023, with a slowing global economy, hawkish monetary policy the world over, and high inflation in my opinion not being temporary, quality energy companies are a good place to be. Afterall, Warren Buffett has large stakes in Chevron (CVX) and Occidental Petroleum (OXY).

BP trades at less than four times forward adjusted earnings, even after strong price action in recent months. Indeed, BP has risen by 46% since the start of the year. In doing so, it has handily outperformed the FTSE 100 by 19 percentage points.

Clearly, a global recession would be bad for oil and gas prices and refining margins, reducing BP’s profitability. But in my view, this has already been priced in, and more, into BP’s stock. BP has a leading position in both retail and wholesale oil product markets, it has been high-grading its upstream portfolio for years now, it has a savvy trading division that usually does well in periods of commodity market volatility, and it has a fast-growing renewables business. It is focused on rolling out electric vehicle charging stations and at increasing basket sizes to capture higher margins at its service stations. So, while the long-term demand for oil might be downwards, BP knows this, and along with Shell plc (SHEL), is the supermajor that realizes this best. So, this very low P/E ratio, even remembering earnings are cyclical, is just too low.

BP’s quarterly results, reported earlier in November, highlighted the firm continues to make great progress in improving its financial position, as one argument BP in the last few years has been its high debt. Net debt has now fallen for 10 consecutive quarters and is now a third lower than at Q2 results in 2021. The net-debt-to-equity ratio is only 30%, which means BP is less exposed to the higher interest rate environment we are going to find ourselves in. Indeed, when Murray Auchincloss unfortunately said in February BP had “more cash than we know what to do with,” this demonstrates that BP is a cash-generative company, the polar opposite of the cash-flow negative tech stocks that are getting smashed now. 2023, in my mind, will see a flight to quality in equites, defined by stocks with high free-cash flow and shareholder return ability. Cash is King once again.

BP’s recent financial performance has been supported by higher energy prices, which climbed to over $120 a barrel earlier this year and currently Brent, the international benchmark trades at $93/barrel at time of writing. With no end in sight to the Russia-Ukraine war, Russia’s exports are unwanted in much of the world, putting a real supply strain on oil markets.

All this has contributed to the strong levels of free cash flow that have enabled the BP to implement a big share buyback program during the year: with a new $2.5 billion program announced earlier in November, BP plans to buy back $8.5 billion worth of stock. In my view, this is an excellent use of capital as long-term hydrocarbon investments are limited, and with BP’s shares trading so cheap, it makes sense.

BP, as one of the leading stocks in the FTSE 100 which is dominated by an investor universe obsessed with income, also recognizes that a large proportion of investors want higher dividends and that is what they are getting as BP expects to raise its dividend by 4% each year over each of the next three years, along with $4 billion in annual share buybacks.

BP has to model its financials to make these promises and it is using a conservative oil price of $60/barrel as its base case. That means these capital returns are highly likely to be realized.

With a dividend yield of over 4% and a trailing EV/EBITDA ratio of 3.8x and forward EV/EBITDA ratio of 2.4x, I can’t quite believe the cheapness of this stock. While the oil and gas sector is challenged in many ways, BP is a leader in the sector in changing direction away from high carbon businesses to low carbon businesses. There should be a differentiation in valuations within the energy sector as to businesses that have high stranded asset or regulatory risk, and those which will be low carbon businesses in the future. Apparently, there is not.

BP’s strong cash flow is giving it dry powder to speed up its net-zero carbon pace and align itself with strong ESG credentials. It’s cash conversion ratio (at December 2021 year-end) of 131% is also helping. One example is the recent acquisition of American renewable natural gas producer, Archaea Energy, for $3.3 billion in cash. It also completed the acquisition of a 40.5% stake in one of the world’s largest renewables and green hydrogen energy hub projects in Q3.

In a way, BP is hedged for the medium term. It has a clear focus to decarbonize, but if the world slows down its transition to net zero due to energy security concerns, given the Russia situation, then BP reliable hydrocarbon business will be valued more. While energy transition was the buzzword in the sector for at least the last five years, the new buzzword is “energy trilemma” the balance between energy security, energy affordability and energy sustainability. Indeed, BP has this year produced a podcast called "Energy Trilemma." The point is, the narrative is shifting, given the elevated geopolitical risks we face today, from sustainability to security and increasingly affordability, given the high price of natural gas and electricity in across much of the world, especially in the UK and Europe where BP has a large portfolio.

Indeed, the respected International Energy Agency forecasts that global oil demand will increase between now and 2030. This should spur BP’s financial performance at a time when energy industry capital expenditure will be biased towards renewables and away from oil and gas exploration. Indeed, BP has axed new exploration outside of areas where it already has licenses, reserves and resources.

Even if the oil price does fall, it needs to fall more than one third before it puts any pressure on BP’s cash distribution plans. Even if oil and gas prices do fall, economic activity will pick up and BP’s refining margins would likely increase. Regardless of the exact path of performance across BP’s integrated set of energy businesses, the stock’s extremely low valuation compensates for these risks.

One risk the market may be overly worried about is the prospect of windfall taxes on the oil majors, so governments can score cheap political points and reduce budget deficits. The thing we must remember is that governments need companies like BP to supply energy and provide that security, so my view is that extreme windfall taxes are unlikely. In the UK the windfall tax has been offset by tax credits on new investment, which BP is taking advantage of, which secures future growth, and reduces the tax burden. Besides, if the Republicans win the presidency in the U.S., that is likely to be favorable for companies like BP, and the gridlocked U.S. government is likely to be favorable for BP’s large U.S. business over the next two years too.

In summary, BP offers excellent long-term total cash returns and is a very worthwhile purchase. BP’s situation is grossly misunderstood by the markets.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in BP over the next 72 hours. 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.