Investment Rationale
BP p.l.c. (NYSE:BP) is strategically transforming itself while performing healthily on the operational and financial front. The current oil price scenario is encouraging to the company’s upstream operations, whereas a strong fuel demand will underpin the growth of the company’s refining business. The company’s steps towards debt reduction and conducive position on the liquidity, profitability, and solvency front make its stock attractive.
About the Company
BP is an integrated energy company that explores and produces oil and natural gas, and refines and markets petroleum products. It also generates solar energy and manufactures and markets chemicals. In the production and operations segment, the company finds, develops, and operates hydrocarbon resources, as well as refineries, pipelines, and terminals. BP’s customers and products segment delivers convenience, mobility, and energy products and services. Its gas and low-carbon energy segment concentrates on creating low-carbon energy solutions.
Healthy Fundamentals
In the last two years, BP’s revenue has shown consistent growth and is on track of surpassing the annual pre-covid number by the end of 2022. EBIT for 2022 was weighed down higher impairment and losses on the sale of the business and fixed assets. Lower exploration expenses were able to partly offset the negative impact. The following table summarizes the group income statement on an annual and quarterly basis:
On the liquidity front, the current ratio has been consistently above one, which indicates sufficient coverage of short-term liabilities with short-term assets. The Quick Ratio, which excludes inventories, is at a decent level at or above 0.75.
On the solvency front, the company’s debt-to-equity ratio has been consistently less than 1 which indicates that the debt portion is less than the equity. The times interest earned ratio, which shows the ability of EBITDA to cover the interest expense, has been attractive for most of the previous quarters, which enhances shareholders’ confidence in the risk tolerance of the company.
In terms of profitability, the company has recorded decent profitability ratios except for the year 2020 which was hit by the COVID-19 outbreak, and Q12022 which was impacted by the Russia-Ukraine War.
Modest Q32022 Results
In Q3 2022, a decline in Russian pipeline imports led to a sharp rise in gas prices, which are expected to remain high depending majorly on Russian pipeline flows and the state of winter in the Northern Hemisphere. BP p.l.c. reported a lower replacement cost profit at $8.2 billion as compared to $8.5 billion reported in the previous quarter. The numbers were weighed down by weaker refining margins and an average oil trading result, along with lower liquids realizations. Inventory holding losses and a one-off charge for adjusting items hurt the company’s profits.
On the segment front, the gas and low-carbon energy segment benefited from exceptional gas marketing and trading performance, higher production, and higher gas realizations. The oil production and operations have shown lower liquids realizations, partially offset by higher gas realizations. In the customers and products, the results reflected lower realized refining margins, and oil trading returning to an average contribution compared to an exceptional result in the second quarter.
Reduction in Net Debt with Improving Cash Flows
In Q3 2022, BP p.l.c. reported decent operating cash flows of $8.3 billion, which include a working capital build of $6.2 billion owing to an increase in the forward price of LNG. The company’s debt was reduced for the tenth successive quarter and reached $22 billion by the end of the third quarter of 2022. In the past three years, the debt number has been consistently falling, whereas the free cash flow generated by the company has been increasing. The main contributor to the advancing of free cash flows (“FCF”) has been the rise in prices of oil and natural gas. Overall, BP is committed to generating higher free cash flows and using them to reduce debt.
Undervaluation of Shares
We compared the stock of BP p.l.c. with its peer companies based on valuation metrics such as forward EV to EBITDA ratio, forward P/E ratio, and price to FCF ratio. Based on the above ratios, the stock of BP p.l.c. is relatively undervalued as compared to its peer companies. The following charts compare the valuation of the stock of BP p.l.c. with its peer companies.
Transforming to an Integrated Energy Company
In the third quarter of 2022, BP p.l.c. has taken some additional steps in accelerating its transformation as an integrated energy company:
Hydrocarbon Business – Growth in its biogas strategy by agreeing to acquire Archaea Energy, which is a leading U.S. biogas company, creation of Azule Energy, and selling of upstream business in Algeria.
Convenience & Mobility – Collaboration with Hertz (HTZ) in North America for installation of a national network of electric vehicle (“EV”) charging solutions, expansion of partnership with retailer REWE in Germany.
Low Carbon Energy – BP p.l.c. closed an acquisition of a 40.5% stake in AREH, a planned renewable and green hydrogen energy hub, shortlisting two BP-led projects in the UK which support carbon capture, use, and storage.
Additional Factors Making BP’s Stock Attractive
The momentum in oil prices is indicating a good commodity pricing environment, which will help in the company’s upstream operations. The healthy oil price scenario and improved daily production are likely to boost the bottom line.
BP p.l.c. has a majority of its refining capacities in the United States. These refineries are connected with a robust logistics infrastructure. The company has the potential to capitalize on the rising fuel demand in the U.S. The company is focused on returning capital to shareholders and announced plans to execute a $2.5 billion share buyback before its fourth-quarter results. After this, the total announced share buybacks will be $8.5 billion, around 60% of 2022 surplus cash flow on a YTD basis.
BP’s stock offers one of the highest yields among the integrated energy companies.
Seeking Alpha’s proprietary Quant Ratings rate BP as “Hold.” The stock is rated low on growth but high on profitability factor.
Risks
BP stock has been underperforming for the last two years as investors and governments are inclined more toward green energy firms. Likewise, BP has been taking steps towards the adoption of green energy by cutting production and spending on the low-carbon project, hoping to turn into a green power producer. Transitioning to green energy will be a challenging track for oil majors as they have less experience in renewables and fresh investments carry an execution risk. In this process, the returns from the traditional business of oil may be hampered.
Conclusion
Integrated companies having presence in upstream, midstream, and downstream operations have a diversified business and hence, are relatively less volatile during periods of fluctuating oil prices. A recovery in demand for end products due to global shortages in refining capacity makes the prospects for major refining companies like BP p.l.c. brighter. Improving production, healthy and growing fundamentals, steps towards the transformation to an integrated energy company, and undervaluation of its stock make BP p.l.c. attractive for long-term investors.
Read More: BP Stock: A Top Energy Sector Dividend Stock (NYSE:BP)