BP: Valuation Alone Is Not Enough To Go Long Today

| About: BP p.l.c. (BP)
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It is always interesting when the first major company in an industry reports earnings. While all companies face unique challenges, few industries rise and fall as a sector more than energy. Political instability, liability issues, and oil and gas production numbers are all important issues for energy companies. Still, energy prices will always be the most important factor for this highly cyclical sector, and this is why the earnings reports of any major oil and gas producer will always be seen as a harbinger for the industry.

The energy sector has been one of the worst performing cyclical sectors since early March - when oil prices topped out at around $110 barrel. While many leading energy stocks and oil service companies have rallied hard over the last couple weeks, most leading energy companies such as BP p.l.c. (NYSE:BP), Exxon-Mobil (NYSE:XOM), and Schlumberger (NYSE:SLB), have still consistently underperformed the S&P 500 and its tracking exchange fund SPY by a fairly wide margin over the last year.


This is why I thought BP's earnings report this week was so interesting. As an attorney, I've closely watched BP's legal issues for some time.

BP has seen a number of significant positive legal developments over the past year. In addition to reaching a historic class-action settlement with most Gulf plaintiffs, the president's recent decision to sign legislation limiting fines BP will face under Federal Pollution Laws to $5-$20 a barrel have been very positive as well. The company has also nearly fully funded the spill fund setup by the Obama administration several years ago, and payments to this fund are set to end in late 2012.


BP trades at around 7x average estimates of next year's likely earnings,and the stock seems undervalued if oil prices hold up and the company's litigation costs stay within the $900-million-dollar range management recently guided during the company's recent earnings report. BP's fairly strong dividend payout is also less than 20% of projected 2012 revenues, and the companies payout ratio is considerably lower than peers Chevron and Exxon-Mobil.

Still, valuation alone is not a good enough by itself to buy BP today for several reasons. First, the company's biggest challenges today are in Russia. BP has tried for several quarters to resolve the company's disputes with its partners in its TNK joint venture, still the company was recently ordered to pay $3 billion by a Siberian court, and BP's recent attempt to partner with Russia was a failure.

Most analysts who follow Russia closely think the Siberian court ruling will ultimately be irrelevant, but still the company's significant production drop of nearly 7% and management's consistent problems in Russia are linked. BP's partnership in the TNK joint venture was extremely successful over the last decade, and the company still gets nearly two-thirds of its production outside of North America. With the company's Russian production numbers waning, while management continues to face political difficulties in the nation, BP faces significant uncertainty abroad as well.

This is why I question simply looking at the largely positive recent legal developments this company has seen. BP still had to sell significant assets to fund the spill fund setup by the Obama administration, and the company's poor recent production numbers are likely significantly linked to asset sales and management's continued difficulties in Russia. BP recently reported that the company's oil production numbers dropped 7% year-over-year, while Exxon-Mobil reported a 1% increase in year-over-year oil production, and Chevron reported only a modest drop in year-over-year oil production numbers.

To conclude, BP is likely to resolve its civil liabilities with the Federal Government fairly favorably. Still, it will need new strategies both in Russia and North America over the next several years, and the company may need to significantly increase capital expenditures to raise its oil production numbers over the coming years. While BP looks cheap, energy sector valuations can change quickly as oil prices rise and fall, and BP still faces significant uncertainty in the U.S. and abroad.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.