BP: Still Attractive

by The U.K. Income Investor

Oil major BP (BP) appeared front and centre in the investing news earlier this week. The company announced a headline grabbing asset write-down, which it will book in its 2Q20, that could top $17.5B. That came on the back of it lowering its average price forecast to $55 per barrel out to 2050. That is around $20 per barrel lower than its previous baseline figure. It sees demand reduction from COVID-19 and a shift to renewable energy as being the main drivers of that shift.

At first glance, none of that looks particularly good for those mulling an investment here. I suppose the first place to start is with the dividend. At the risk of stating the obvious, a reduction looks a bit more likely now. I doubt that comes as much of surprise to anyone, but it’s worth pointing out nonetheless. Indeed, the last time I covered the stock I made the value case irrespective of a cut. Despite the price of oil rallying since then, the shares remain rather subdued.

Anyway, back to the dividend, which is in a more precarious spot due to the company’s debt load. In terms of the numbers, this is what BP is looking at. A $17.5B asset write-down would lower its shareholder equity to around the $70B area or so. With net financial debt clocking in at around $55B, that implies a current gearing level of around 45%. That is way above the company’s target range of between 20% and 30%.

Gearing

Let us imagine a scenario in which the dividend is cut by circa 50%. That would see BP retain an extra $1B or so each quarter compared to its current level of cash outflow. In order to get gearing back down to the 30% area, it needs to reduce net debt by circa $15B in total. An extra $4B in annual retained earnings certainly helps, hence why there is a strong chance management will announce a dividend cut soon.

On the flip side, the company is taking big steps to lower its cash outflow. It reckons it can generate cash cost savings of $2.5B by the end of FY21, and it has reduced annual capital spending to $12B. On that basis, the company has lowered its cash breakeven point to circa $35 per barrel for next year. That is lower than the current Brent crude price of circa $40.70 per barrel. Granted, it cannot sustain such a low level of capital spending for too long, but as a response to low prices this seems normal.

If we throw cash from asset disposals into the mix, there is a pathway for BP to reduce gearing while still paying its current dividend. The company has announced just over $10B worth of divestments since the start of FY19; that is out of a planned total of $15B by mid-2021. From what I can see, the company has received around $3B of that so far in terms of hard cash. Quick maths suggests there is $12B to go, though the timing of the actual cash inflow is obviously uncertain. On that basis, I think there’s still a chance that management will soldier on without a dividend cut, but let’s see. It certainly wouldn’t come as a surprise if it happened.

Value Case

The way I say it, the best way to think about a long-term investment here is to use mid-cycle conditions. For instance, BP posted $25.7B in cash from operating activities last year, while underlying replacement cost profit clocked in at $10B. I have the latter figure worth around 50¢ per share, equivalent to an earnings yield of around 12.5% based on the current stock price. That was in a mild low-$60s per barrel Brent crude price environment.

Not that long ago, BP saw itself throwing off circa $14B in free cash flow this year under its $55 per barrel reference conditions (real terms, 2017). That was based on annual capital spending in the $15B region. The above cashflow figure, plus reductions in Gulf of Mexico spill payments, explain most of that figure. Even if you factor in slightly higher levels of actual depreciation, it strikes me that BP is still a $12B profit business at circa $60 Brent. COVID-19 has clearly wrecked that price environment for now, but this is pretty much in line with how the company sees the next thirty years in terms of oil prices.

In per-share terms, I have the above profit figure as being equal to around 50 pence or so based on current exchange rates. At a conservative 10x multiple, you are back above the 500 pence per share mark, all other things being equal. The current share price is just over 320 pence. Moreover, we still expect some level of cash dividends on top. Cut or no cut, I still view that as an attractive medium-term proposition.

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