BP sees operational improvements

Following the energy giant’s second lower tertiary oil discovery, we take a look at Morningstar stock analyst Catharina Milostan’s assessment of BP’s UK-listed stock. (Click here for our take on BP’s oil find).

Fair value estimate: 579p ¦ Fair value uncertainty: Medium ¦ Economic moat: Narrow

Thesis
BP's CEO Tony Hayward is making some headway with his mandate to find operational improvements after a few misdirected years that led to a string of plant accidents and depressed financial results. Faced with challenges of low oil and gas prices plus lower recession-driven demand for refined products, BP is focusing on cash restraint and plans to keep 2009 capital spending flat with 2008.

BP is the third-largest integrated oil company behind ExxonMobil and Royal Dutch Shell. BP's storied past evolved from early exploration success to post-acquisition stumbles that prompted recent efficiency and safety goals. Its exploration success migrated from the Middle East and Europe to Alaska and the North Sea in late 1950s and 1960s. BP then embarked on a buying spree, acquiring U.S. oil majors, Amoco in 1999 and Arco in 2000, and the Castrol brand in 2000. However, a directive to integrate acquired businesses and focus on margins led to some misguided spending cutbacks. A series of accidents including a deadly explosion in March 2005 at its Texas City refinery and an oil spill from a corroded portion of one of its Alaskan North Slope pipelines forced BP's managers to renew their focus on improving safety and operations.

Hayward took the reins in May 2007 to set BP's new course with three goals: upstream growth, downstream turnaround, and corporate simplification. Like its supermajor oil peers, the scale and scope of its global growth projects gives BP some economic moat, as many smaller competitors don't have the same resources. To pursue upstream growth, BP's challenge is to find enough new oil and gas fields across several continents to eke out annual production gains. Political tensions continue to reduce access to new fields, forcing BP to consider complex fields with potentially higher costs. BP's recent dispute settlement with Russian partners of its 50%-owned TNK-BP venture may help. But future flare-ups could occur at this important venture where BP gets nearly one fourth of its production. This could explain BP's renewed interest in the United States with recent acquisitions of Woodford Shale and Fayetteville Shale properties and offshore Gulf of Mexico drilling success.

Revamping BP's downstream, or refining and marketing, businesses remains a challenge, given the volatility of crude-oil feedstock costs and prospects of recession-induced decline in gasoline demand. In contrast to ExxonMobil and Shell, BP's downstream business accounts for a smaller share of earnings versus its upstream unit. BP is making steady progress in restoring its damaged Texas City refinery, reaching full capacity at year-end 2008. Steady operating improvements may help, but fluctuating refining and marketing margins are more of a factor for earnings potential.

However, like its peers, BP faces challenges of low oil and gas prices and lower refined product demand amid a weakened global economy in 2009 and possibly into 2010. BP's response is for more cash restraint, while still continuing safety and growth projects. The firm suspended its share-repurchase programme but is keeping 2009 capital spending flat with 2008. BP's cash-flow priorities in 2009 also include paying a progressive dividend.

Valuation
We're raising our fair value estimate for BP to 579p per share from 533p as the firm stays on course with major operational goals and projects (based on exchange rates as of June 29, 2009). Higher oil prices also helped to boost near-term earnings. In our discounted cash-flow model, our benchmark oil and gas prices are based on NYMEX futures contracts for 2009-11. For natural gas, we use $4.30 per thousand cubic feet in 2009, $6.45 in 2010, and $7.00 in 2011. For oil, we use $61 per barrel in 2009, $75 in 2010, and $79 in 2011. We adjust our benchmark pricing to reflect the quality, location, and hedging of the firm's production. In our base scenario, we assume long-run perpetual oil prices of $80 per barrel and natural gas prices of $7.50 per mcf. We're encouraged by BP's ability to maintain production levels in early 2009 while scaling back capital spending. Lower oil services helped during the 2009 first quarter and may lead to lower capital spending in 2009. BP is moving ahead with more offshore Angola discoveries and startup of offshore Gulf of Mexico fields in early 2009. We look for production declines from mature fields to offset the benefit of new fields startups during the next two years, but in the longer term, we look for production growth to resume as drilling picks up amid an economic recovery. Our model assumes some potential political risk in Russia with BP's joint venture TNK-BP. In our low case where perpetual prices drop to $50 per barrel for oil and $5 per mcf for gas, we look for a scaleback in oil and gas production and lower E&P operating margins to drive down our fair value estimate to 362p. Our high case assumes long-run oil prices of $150 and gas prices of $15 and greater E&P operating margins to drive up our fair value estimate to 965p. BP's ample inventory of E&P growth projects and refinery improvement plans should help drive long-term growth. Its conservative balance sheet with healthy cash flows and financial flexibility should allow BP to weather a potential global recession.

Risk
BP's valuation carries more uncertainty than ExxonMobil's or Shell's because the firm is less integrated, with more of its earnings coming from the E&P business than from potentially offsetting refining operations. Like its peers, a sustained drop in oil and gas prices can hurt upstream earnings. Lower crude-oil feedstock costs could help refining margins, but refined product pricing lags could quickly swing refining profits to losses. BP's global business faces potential disruptions caused by political risks, particularly with its heavy exposure to Russia. Disruptions caused by environmental and operational constraints could further limit earnings potential.

Strategy
CEO Tony Hayward redirected BP's strategy by setting new goals of upstream growth, downstream turnaround, and corporate simplification in 2008. Upstream growth centers on developing key project areas including the Asia Pacific region, Azerbaijan, Algeria, Angola, Trinidad, and the deep-water Gulf of Mexico. BP is focused on resolving issues with its TNK-BP venture in Russia to support long-term growth. Downstream turnaround and corporate simplification hinge on operating changes and adoption of best practices.

Management & stewardship
After John Browne's resignation, Tony Hayward was promoted to group chief executive in May 2007 to instill a new direction for the firm. Tony Hayward joined BP in 1982 and came up through the E&P business to eventually head that unit as chief executive officer. The strategic shift came after a few troubling years for BP, with the deadly Texas City refinery explosion, Alaskan North Slope oil pipeline leaks, refinery shutdowns, and project delays. BP is investing more in safety and operating improvements. Along with Hayward's appointment, BP shifted to new heads of the E&P and refining units. Andy Inglis became chief executive of the E&P unit after joining BP in 1980 and working successfully at BP's North Sea and U.S. deep-water Gulf of Mexico operations. Iain Conn became CEO of the refining and marketing unit in June 2007 after joining BP in 1986. After a long 12-year tenure, BP's nonexecutive chairman of the board Peter Sutherland will pass the baton to Carl-Henric Svanberg, who will become BP's nonexecutive chairman on Jan. 1, 2010. Svanberg will step down from his CEO and chairman post at Sony Ericsson to devote the majority of his time to BP business. During 2008, BP bought back $2.9 billion worth of shares and paid $10.7 billion in dividends.

Profile
London-based BP is the third-largest integrated oil major behind ExxonMobil and Royal Dutch Shell. BP's business began in 1909 and evolved to its current form and name after the 1998 merger of British Petroleum and Amoco. BP operates across six continents, producing 3.8 million barrels of oil equivalent per day in 2008, operating refineries with 2.8 million barrels per day of capacity, operating petrochemical plants, and selling petroleum through 24,100 service stations.

Growth
We look to a weakened global economy to damp near-term earnings because of lower oil and gas prices plus lower demand for crude and refined products. We look for earnings growth to rise as the global economy recovers, driving up oil and gas prices and refined product demand. New field startups plus improved refinery performance may help boost earnings longer term.

Profitability
Profitability will depend on BP's ability to fully utilise its assets while managing operating and capital costs. BP's profit margins could be squeezed by low oil and gas prices and low demand for refined products during the next few years. Longer term, we look for rising oil and gas prices to help boost margins, but concurrent cost inflation could limit margin upside potential.

Financial health
As a result of decades of profitability, BP has a nominal amount of debt for a company its size. This is the case even as it has been paying out a healthy dividend and repurchasing shares.