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BP Plc – 15th May 2014

Company Overview:

Founded in 1908, BP Plc (British Petroleum) is one of the world’s largest oil and gas companies. It operates under two business units: Exploration and Production followed by Refining and Marketing.

Worldwide, BP pumps 3.2 million barrels of oil equivalent per day, employs 83,900 people and has 17.9 billion barrels of oil equivalent in proven reserves. It also owns and operates 14 refineries as well as 17,800 retail sites (petrol stations) across the globe.

Index FTSE 100 Ticker BP.L Latest Close 502.00
52 Week High 510.62 52 Week Low 426.55 P/E 6.38
Dividend Yield % 4.68 Dividend Cover 3.35 Dividend (Pence) 23.40
CEO: Bob Dudley CFO: Brian Gilvary

Initiating Coverage; BP Plc

Rising levels of international conflict and civil unrest, along with compressed margins within refinery businesses and an increasing cost of extraction, have each helped to make the last 18 months a testing time for oil producers. BP Plc has been no exception in that both business units have faced headwinds of their own.

The end of April saw management announce a 23% decline in profits for Q1 2014, which it attributed largely to weaker refinery margins and impairment charges in relation to exploration write-offs. This was while the ongoing litigation process resulting from 2010’s Deepwater Horizon incident continues to pose a further threat to the group’s profitability.

Despite this, the outlook for oil prices remains stable while BP Plc continues to make headway in its pursuit of strategic objectives. Today’s report provides an overview of our expectations for the group going forward, along with a price target for the shares throughout the months ahead.

BP Plc Weekly Chart

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Loose policy and a return to growth drive support for oil prices into the New Year

Although 2013 saw oil producers facing a number of challenges, weaker Crude prices were not one of them. This was as many of the world’s developed economies returned to growth following a relentless period of contraction and crisis, while the increasing profile of regional and international conflicts continued to stoke concerns over potential supply disruptions.

Another key influence throughout the year was unprecedented levels of monetary stimulus from some of the world’s major central banks. Coupled with the effects of another year where interest rates remained at record lows, central bank policies were the leading cause of a persistent rise in global equity indices and a resounding return of optimism among investors, consumers and business leaders.

While improving sentiment toward global economic prospects was more noticeable in the likes of the UK, the US and Japan, the standout performer in terms of progress was the Euro zone, which went from the verge of collapse at the close of 2012 to positive growth for the full year of 2013.

These developments each helped to underpin a more optimistic outlook among investors as the 2014 year has gotten underway, carrying with it elevated levels in oil benchmarks that have seen BP trading inventory comfortably above its own price floor of $100 per barrel.

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Supply concerns and constraints an important driver of prices during 2013 

In addition to growth expectations, geopolitical conflicts and civil unrest continue to contribute toward a positive outlook for oil prices over the year. Some of these include conflict and supply disruptions across Libya and some other parts of Africa, while a rising number of terrorist attacks in Iraq could also threaten to undermine the nation’s newly increased levels of output.

Despite the above, tensions in the South China Sea and the ongoing crisis in Ukraine are perceived as the biggest threats to global oil supply at present. When considering the unpredictable evolution of the Ukraine crisis, the lack of a resolution on the horizon and the fact that one third of global freight passes through the South China Sea, some would say that the supply side concerns of investors are warranted.

Although any kind of conflict has negative implications from a humanitarian perspective, the above threats are positive for oil prices and positive for BP.  In short, with current growth projections taken into account, along with supply side forces, the outlook for oil prices over the remainder of 2014 is positive.

This is while the most significant driver of oil prices over the longer term remains population growth. Between 2012 and 2050, the global population is expected to grow by 33 %, according to the Population Reference Bureau (PRB) based in Washington DC.

Should this projection evolve into a reality then the outcome for oil demand would be likely to continue rising steadily over time. Accordingly, the US EIA (Energy Information Administration) expects Brent Crude prices to continue rising steadily over the next 25 years, peaking above $200 per barrel in 2038.

2014 Regional Growth Projections – IMF World Economic Outlook

BP IMAGE

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Brent Crude with WTI Overlay (Daily Chart)

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Chart of US Energy Information Agency forecast for steady appreciation in Brent Crude through to 2038

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BP’s drive to become a more concentrated business begins to pay off; Cash flows improve

2013 and the opening quarter to 2014 saw BP continue its drive to become a more “focused” oil and gas company that “delivers value over volume”. The group announced, in its Q1 results, that it had completed its $38 billion divestment program and had finally closed the sale of its stake in TNK – BP for $27.5 billion.

BP also announced that it was nearing the end of the $8 billion share buyback program. Management also outlined their intentions to divest a further $10 billion of assets as part of ongoing efforts to reshape its portfolio, $3 billion of which has already been completed.

The current plan sees most of this cash returned to shareholders through dividends and further share buybacks. This is positive for the group and positive for investors as the end effect will be one that frees up management to focus on projects with greater prospects, reduces the regular capital expenditure of the business, unlocks spare cash from redundant or under performing projects and ultimately provides management with the increase in cash flow that they believe will enable them to improve shareholder returns.

The below graphic illustrates the improvement in free cash flows and reduction in capex which took place throughout 2013 as a result of the TNK-BP disposal.


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Best results in exploratory drilling for a decade in 2013: Precedes a positive quarter for new projects

BP’s 2013 annual report saw the group announce the end to its best year in a decade for exploratory drilling. The exploration teams tapped a total of 17 test wells over the period which yielded seven “potentially commercial” discoveries.

Q1 results for 2014 saw the group unveil yet more positive news in relation to its future pipeline with four new major projects coming online. The group has also completed eight new exploration wells within the opening stage of the year that  have led to two more discoveries. With a notable inventory of untested sites, management intend to complete drilling on a further seven exploration wells by the close of 2014. Each of these developments has positive implications for both production as well as future earnings.

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Poor settlement negotiation means final bill for Deepwater Horizon spill is yet to pass through the till

While the Deepwater Horizon (DWH) incident of 2010 has already led to BP paying out in excess of $13 billion in settlements, the final tab for damages is yet to be calculated. This is as January 2014 saw US circuit judges reject an application for a permanent injunction to prevent new “Business Economic Loss” claims being made against BP.

The group applied for the injunction after becoming concerned over potential loopholes in the claims process as well as the terms and condition under which courts have ordered that it must accept claims for damages relating to the DWH disaster in 2010.

Under the current ruling, businesses that wish to claim against BP for losses suffered as a result of the 2010 incident do not have to prove any connection to BP or provide any proof of causality. In short, they do not have to show that losses sustained by the business after the incident in 2010 were in fact caused by BP.

Lawyers for the company have argued that this leaves the process, and BP, vulnerable to fraudulent claims and that this has in part, been responsible for the significantly higher than expected level of claims against the company. Nevertheless, judges have rejected the application to permanently suspend further payments and instead, BP lawyers have pursued another form of ruling which, if granted, will allow the group to rewrite the terms and conditions under which it must accept claims.

Should the latest legal move prove successful then it may, potentially, reduce the end cost of the disaster by a significant margin. At the present time, the temporary injunction upon the processing and payment of new claims remains in place.

This is while the final phase of US legal proceedings under the Clean Waters Act is set to get underway during January of 2015. Reuters reported estimates that BP could face charges of up to $17 billion under the Act but that this was unlikely to happen.

Regardless, the group has set aside $43 billion since 2010 to cover the costs of legal action and the clean-up operation in the Gulf. This is expected to cover the lion’s share of costs. However, the wild card is a separate ruling upon Business Economic Losses which could give rise to further claims which may materially impact upon financial performance.

As a result, it is not possible to reliably estimate the end cost to BP of the DWH disaster which means that the potential liabilities relating to this will continue to pose a risk to investors for some time to come.

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Risks

In addition to the threat of further costs from the 2010 disaster, there are other risks that BP faces, the most notable of which can be seen in the group’s commercial interests in Russia. As a substantial shareholder in the, largely state owned, oil company Rosneft, BP is exposed to the whims and will of Russian government which places the company at risk of bearing the brunt of geopolitical frustrations, particularly given the recent crisis in Ukraine.

Although direct political interference in the above respect has not been an issue for BP over Q1, the devaluation in the rouble that resulted from Russia’s incursion into Ukraine has. The adverse swing in RUB/GBP FX rates did significantly reduce the value of the dividend that the group received from Rosneft during Q1 2014.

While there is little that BP can do to eradicate the risk of political aggression or swings in the rouble rate, it has publicly emphasised its commitment to doing business in Russia for the long term, which should help to soothe any political hostilities that may develop over the months ahead.

Given that oil and most other petrochemicals (wholesale) are normally traded in dollars, fluctuations in non-rouble FX rates also pose a risk to BP. Now that the UK is widely expected to become the first developed nation to raise interest rates from their record lows, the pound has appreciated substantially against the US dollar, reaching a five year high during early May this year.

Taking into account the current interest rate outlook, it is likely that the recent FX action in sterling is merely a taste of what is yet to come. If this holds correct then BP is at risk of seeing the value of earnings, and dividends to shareholders, eroded. Should this happen then the impact upon the group’s share price would almost certainly be negative.

Despite the above, the risk of material changes in performance as a result of FX fluctuations remains only moderate. With a large corporate treasury, and little history of foreign exchange losses, the most likely outcome here is that the group will be able to successfully hedge its exposure. Nevertheless, the potential for FX to become an issue is deserving of recognition.

Further from here the group is exposed to oil price risk. Although both Brent and WTI remain well supported above the group’s target price floor of $100 per barrel, with a bias toward the upside, a materially adverse change in the global economic outlook would have the power to influence prices toward the downside. Although the risk is only moderate over the near to medium term, should this scenario evolve into a reality then the impact upon revenues and profits would be negative.

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Dividend and Valuation

While the costs of the DWH disaster have eaten into profits they haven’t prevented BP from paying one of the more attractive dividends of FTSE 100 companies. In 2013 the group returned 23.40 pence per share to investors which equates to a yield of 4.68%.

From a valuation perspective BP trades on a multiple of just over 6.38 X 2013 earnings*, which represents a significant discount to the 15.38X average for other large oil and gas companies.

This could be described as fair given that uncertainties continue to surround BP relating to the 2010 DWH oil spill.

Another influence to consider here is fact that revenues and profits are likely to be lower, in nominal terms, over the months and years ahead due to management’s drive to slim down the business and focus on “value over volume”. This leaves the group’s future income stream surrounded by uncertainty which has, most likely, had some form of impact upon the market rating of the shares.

In terms of debt, gearing has reduced from 20% in 2012, down to 16.2% in 2014. This is while management maintains its commitment to keeping this below 20% until uncertainties recede from the external environment.

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Summary

The outlook for BP over the near to medium term has improved modestly over recent quarters; however, uncertainties remain a threat given ongoing legal action in the US.

Management have made good progress in slimming down the business, improving cash flows and increasing shareholder returns. However, the recent reduction in profits leaves an air of uncertainty surrounding the group’s likely future income, which has likely helped to suppress the share’s earnings multiple.

BP continues to add to its pipeline of future projects and proven reserves which bodes well for production over the months and years ahead while current global growth expectations, and other factors, see oil prices stable at or above $100, with a moderate bias toward the upside.

Since releasing Q1 results on April the 29th, BP shares have rallied from 490.00 pence to 506.00, close to a three year high. Given management’s ambitions to reduce the sprawling scale of the business, and the consequent effect upon revenues and EPS, it is unlikely that the shares will ever see a return toward their previous all-time high.

However, going forward we do expect the positive momentum generated from share buybacks and dividend increases to keep BP.L well supported close to its current levels, at or around the 490.00 pence mark. This is while our overall price target for BP sees the shares grinding higher to peak at 540.00 pence over the medium term.

The next major event scheduled in the calendar for BP is the release of Q2 Results on 29 July 2014.

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* P/E estimate based upon 2013 diluted EPS and mid-market USD/GBP FX rate for the full year

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IMPORTANT:
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