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Is BP Stock a Buy?

By Rekha Khandelwal - Feb 29, 2020 at 7:40AM

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BP is trading at a very attractive yield of more than 7%. But does that make it a buy?

It is difficult to ignore an eye-popping 7%-plus yield from a 110-year-old company with operations across 78 countries. BP (BP 1.67%) posted pretty good fourth-quarter results, considering the current energy market environment. What's more, it looks set for growth in the years to come.

BP didn't add to its reserves in 2019

BP's reserve replacement ratio for 2019 was 67%. That means the company didn't fully replace its reserves that it exploited during the year. While oil majors have long been adding to their reserves to drive growth, it is no longer considered the best approach in the current markets. Of course, lower oil prices in 2019 also impacted the value of companies' reserves, which are calculated using trailing 12-month oil prices.  BP is focused on maximizing shareholder value rather than maximizing production volumes. That looks like the right thing to do in the current oversupplied markets.

An engineer working at night at a refinery

Image source: Getty Images.

However, that doesn't mean BP is not focused on growth. The company's reserve replacement ratio was well over 100 in 2016 and 2017 and it was 100 in 2018. That isn't surprising as the average oil prices were higher year over year in both 2017 and 2018.  It's just that the company is being selective and isn't just solely focused on adding reserves. BP's oil-equivalent production rose 2.7% over 2018.

BP's operational performance

Like its peers, BP's 2019 operating results were impacted by weaker oil prices and lower refining margins. Additionally, the company reported significant one-off charges during the year. These included a non-cash charge of $2.6 billion in the third quarter relating to a divestment and a $1.9 billion impairment charge in Q4 relating to the disposal of its U.S. gas assets. BP's replacement cost profit -- which excludes inventory holding losses and better reflects its operational performance -- was $10 billion, down from $12.7 billion in 2018. However, the company reported strong operating cash flow of $28.2 billion, up from $22.9 billion in 2018. 

BP Debt to Capital (Annual) Chart

BP Debt to Capital (Annual) data by YCharts

BP's leverage

One factor that concerns investors a bit is BP's leverage. The company has long been using a higher amount of debt than its peers. However, BP realizes the need to reduce its leverage. The company is targeting a net-debt ratio -- the ratio of net debt to the total of net debt and shareholders' equity -- between 20% to 30% by 2021. The ratio currently stands at 31.1%, an improvement in the fourth quarter. BP plans to dispose another $5 billion worth of assets by mid-2021, which should significantly contribute to reducing its leverage. 

BP generated $28.2 billion in operating cash flow in 2019. Its capital expenditure for the year was $15.2 billion, while it paid around $8 billion in dividends. What's more, a significant portion of BP's divestiture proceeds are expected to come in 2020 and 2021. That placed the company in a quite comfortable position to announce its latest dividend increase.

Attractive outlook

BP's production in 2020 may fall slightly compared to 2019 due to expected declines in some of its low-margin gas basins and divestments. However, the company expects an additional production of 250 thousand oil-equivalent barrels per day in 2021 over 2019 coming from new projects. Moreover, its U.S. onshore business should increase its liquids production. Combined, these factors make company's expectations of $14 billion to $15 billion in cash in 2021 from its upstream operations feasible. Though numbers may fall short if average oil prices remain lower than the assumed prices of $55 per barrel Brent, but the assumption looks pretty reasonable. 

It's not only BP's upstream business that's expected to do well. BP's downstream business should benefit from a widening of crude and product price differentials and lower refinery turnarounds. These factors may contribute to $9 billion to $10 billion in cash by 2021 from downstream operations, though it may fall short if refining margins remain squeezed as were in 2019. However, the IMO 2020 regulations are expected to contribute to wider differentials and improved margins. For example, at its Whiting, Indiana facility, the light-heavy differential at the start of February was around $20 -- much higher compared to last year's differential of around $12.

Finally, BP's outflows relating to the Gulf of Mexico oil spill will come down from $2.4 billion in 2019 to less than $1 billion in 2020. To the company's credit, it has survived numerous spills and accidents during its long history.Overall, BP's focus on creating value for its shareholders and its plans to reduce leverage and grow free cash flows make its yield attractive, especially for income investors.

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