Taking the Measure of Battered Petroleum
Last week I attended Investing Daily’s Annual Investing Summit in Las Vegas. I gave a presentation and my colleague Igor Greenwald and I hosted several question-and-answer sessions about the energy sector with attendees. There were three questions that came up a lot during the sessions:
- What is the expected impact of Saudi Arabia replacing their minister of petroleum?
- What is your outlook for oil and gas prices for the rest of the year?
- Do you still think BP is a takeover target?
I want to address the question about BP (NYSE: BP), as it was the one that was asked most frequently, and in a number of variations. So I told some of the attendees that I would provide an update.
BP is one of the world’s six publicly traded, integrated oil companies known as the “supermajors.” The London-based company’s origins go back over 100 years, and it was initially formed to develop oil discoveries in Iran. Over the ensuing century the company that would eventually change its name to British Petroleum in 1954 transformed into an integrated, global powerhouse.
In the modern era, BP tried to portray itself as a different kind of oil company. In 2000, “British Petroleum” launched a high-profile public relations effort to rebrand the company as the environmentally-friendly “Beyond Petroleum.” They made some investments in alternative energy, but that never amounted to more than a small fraction of BP’s investments or revenue.
Despite BP’s attempt at rebranding, its image was seriously tarnished over the past decade. In 2005 an explosion at the company’s refinery Texas City, Texas killed 15 people and injured 170. That disaster cost BP well over a billion dollars, damaged the company’s image and ultimately resulted in the sale of the refinery to Marathon Petroleum (NYSE: MPC).
An independent safety review of the accident was conducted by former U.S. Secretary of State James Baker. His report cited “a corporate safety culture that may have tolerated serious and longstanding deviations from good safety practice.”
Those issues were not fixed by 2010, when the Deepwater Horizon offshore platform explosion killed 11 workers and spilled nearly 5 million barrels of oil into the Gulf of Mexico. BP’s market capitalization was cut in half over the course of about two months. I had never recommended BP to investors before, and I continued to recommended that investors avoid the stock as the company shed assets worth tens of billions of dollars to meet financial obligations related to the spill.
But there eventually came a point at which I felt the stock was oversold. BP ultimately became so cheap that I finally did something I had never done before. I started recommending it to investors because BP’s market capitalization seemed to be far below fair value even considering the potential financial liabilities of the Gulf spill.
I also made a prediction at the beginning of 2015 that BP would be bought or merged that year. I called that “my most aggressive, wild card prediction for 2015.” As we know, that didn’t happen, but I still think it can. There are certainly antitrust issues that would be raised, and the UK government would very likely oppose such a move. BP remains a very big bite to swallow, with only two or three of the largest supermajors capable of pulling off such a transaction.
But here is the argument in favor of a takeover. Below are some of the important financial metrics for the six supermajors:
- EV – Enterprise Value in billions of U.S. dollars as of May 16
- SM – Standardized Measure, the present value of the future cash flows from proved reserves as of year-end 2015, in U.S. dollar billions
- EBITDA – Earnings before interest, tax, depreciation and amortization for the trailing 12 months (TTM), in billions
- FCF – Levered free cash flow for the TTM, in billions
- Res – Total reserves at year-end 2015 in barrels of oil equivalent (BOE)
There are several noteworthy data points in this table. One is that while BP looks expensive according to the EV/EBITDA and Debt/EBITDA ratios, these are partly a reflection of some of the financial obligations from the Gulf spill. Last year BP settled with the U.S. federal and state governments over its liabilities stemming from that spill, agreeing to pay $18.7 billion over 18 years to settle the claims.
Looking ahead, though, the estimates for BP’s EBITDA are $20 billion in 2016 and $26 billion in 2017 (in line with historical levels). If we utilized this year’s projected EBITDA in the table above, BP’s EV/EBITDA and Debt/EBITDA ratios drop to 6.5 and 2.7, respectively. This would make it cheaper than its peers on an EV/EBITDA measure, and in line on the debt metric.
But what really stands out is BP’s EV/Reserves ratio. What this means is that if you divide BP’s enterprise value by its total reserves, you get $7.69 per BOE. Why might a company like ExxonMobil (NYSE: XOM) be attracted to that? Because ExxonMobil’s own reserves are on the books for $16.80/BOE. ExxonMobil could increase its reserves by nearly 70% at a much lower cost than its current reserves, and it would get BP’s substantial refining assets and huge oil and gas trading group.
There is perhaps an even more compelling argument for a merger/takeover from Chevron (NYSE: CVX) or Shell (NYSE: RDS-A), which could substantially dilute the cost of their own $20+/bbl reserves while creating a company that could rival ExxonMobil in size. Neither competitor has quite the deep pockets of ExxonMobil, but they are both valued roughly twice as much as BP.
The last time I did this exercise, BP’s EV/Reserves ratio was $8.51/BOE. Today, it’s even cheaper than that. I still view the company as a takeover candidate based on the low value the market is placing on its oil reserves, and I continue to believe that BP is trading well below its fair value.