BP Turnaround in Progress but Risks Remain

Be it capital efficiency, E&P operational efficiency, cash distribution, or exploration success, BP  (NYSE: BP  ) has made tremendous progress in the last two years on almost all fronts. However, a lot remains to be done to steer this giant ship in the right direction. While the company is still recovering from the impacts of the 2010 Gulf of Mexico oil spill, the ongoing crisis between Russia and Ukraine places the company at risk again. As reported in a recently published article on Bloomberg, no company has as much to lose as BP if the relations between Russia and West deteriorate.

The Russian risk
BP's 20% stake in OAO Rosneft, which the company acquired last year, is the single largest foreign investment in Russia. The country is the second biggest source of earnings for BP, after the U.S. So you can understand Russia is more important to BP than its peers. Oil is Russia's most important industry and, as President Obama and other western leaders have repeatedly shown their willingness to make Russia pay for its incursions into the Ukrainian territory, the oil industry would be the first target of any further U.S. sanctions on Russia. Tight sanctions would hurt BP more than others in the industry.

The company has said that while it is closely monitoring the situation, it remains fully committed to its investment in Rosneft due to its sheer scale (pumping around 4.2 million barrels a day, around 5% of global output) and importance to worldwide energy supply. Moreover, the company was fully aware of the political risks faced by investments in Russia and must have taken appropriate measures, as Rosneft and BP are mutually dependent on eachother. 

Although the current sanctions would not affect BP's business in Russia to a large extent, the company faces reputational risk. Moreover, if the western governments decide to tighten sanctions or the ongoing crisis is prolonged; BP's long-term operational prospects could worsen. As you can see from figure below, BP's production in Russia is significantly large than its majors peers including Royal Dutch Shell  (NYSE: RDS-B  ) , ExxonMobil (NYSE: XOM  ) , and Total SA (NYSE: TOT  ) .

Source: BP

Turnaround in progress
Other than the unexpected geopolitical risk that the company has ended up facing, BP has done a lot to turn its business around in the last couple of years. The company has embarked on a huge portfolio upgrading program since 2010 and has made divestments worth $38 billion until 2013. Additionally, it plans to divest further $10 billion worth of assets in 2014-15, of which divestments worth $1.8 billion have already been announced.

The disposal plan majorly targets the mature upstream assets, future upstream (including the early stage projects), and mid/downstream assets. After a period of poor investment decisions by oil companies, firms are now looking to dispose of non-core assets. However, BP has not really seen a negative impact on its valuation. Clearly the company would have to make more asset divestments if it undergoes an adverse final legal judgment from the Gulf oil spill.

Flat capex with upstream taking the bigger chunk
BP has managed to keep its capex largely flat since 2012, and the trend is likely to continue in the future as well. Capex for 2014 is expected to be $24 billion-$25 billion and $24 billion-$26 billion during 2015-2018. BP is expected to spend around 80% of this capex on its upstream activities. The company has increased 12% Y/Y capital spending in upstream activities from $21.9 billion in 2012 to $24.6 billion in 2013.

Financials and valuation
The company has $22.5 billion worth cash assets, 4.5 billion barrels of oil in proven reserves and a significant 33.3 trillion cubic feet of natural gas. It also holds equity investments and joint ventures in another 5.4 billion barrels of oil and another 7-8 trillion cubic feet of natural gas. Despite all the challenges, the company reported ROE of 18.41%. Moreover, the company is expected to pay nearly half of its profits in dividends.

BP is trading at a discount to its intrinsic value largely due to the legal overhang. However, if we take into account its financial position, proven reserves, and the fact that it may have many years to pay a large settlement BP's shares are worth more than the current value.

Bottom line
BP is trading at a discount to its peers. BP has current price/earnings ratio of 6.5; however, it is a stock that typically trades at 11-13x earnings. The company has a history of paying huge dividends to its shareholders. It should also see growth in its cash flows, albeit modest. It also offers upside potential on valuation.

However, in terms of the pace and cost of securing new growth, the company is at a disadvantage compared to its peers. BP's recovery will take time and money, and the ongoing crisis between Russia and Ukraine remains an overhang. In the meantime, I prefer to remain on the sidelines.

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