BP is entering a new phase in its history, with it having drawn a line under the costly oil spill of 2010. Its valuation and yield have appeal in my view within a sector that remains generally undervalued. Therefore, I feel that now is the right time to buy BP and that 2017 could be another strong year for the company.
Even the most optimistic of oil bulls is unlikely to have accurately predicted the performance of oil in 2016. At its lowest ebb, oil traded at $28 per barrel in January, but yet ended the year at over $56 per barrel. That’s a 100% gain in less than a year, which seemed unlikely given the persistent glut of supply.
However, with OPEC agreeing to a production cut, the outlook for oil is now much more positive. This has been followed by a cut in production from non-OPEC members.
With Donald Trump less concerned about the environment and on regulations concerning fossil fuels than his predecessor, demand for oil in the US could remain high for longer than previously thought.
Emerging-market demand could also push the price of oil higher in my view, while reduced exploration and capex spending across the industry could help demand and supply to move back into line.
All of this bodes well for BP (LON:BP). Alongside its improving financial position following the 2010 oil spill, a high yield and an appealing valuation, this makes it a sound long-term buy in my opinion.
Supply side
OPEC’s deal to cut production was a surprise for many investors, myself included. The cartel had raised production to record levels in autumn before announcing that it had reached a deal to reduce production by just over 1.2 million barrels per day (mb/d).
This was followed by an agreement among non-OPEC members to likewise cut production, resulting in a more favourable outlook for the oil price.
In recent weeks, the effect of this on the oil price has been positive, with prices rising by over 10% in the last month. Reduced production should have an even bigger impact over the medium term since it will allow demand to slowly catch up to supply.
The International Energy Agency (IEA) has stated that the current oil surplus could be wiped out by the end of Q1 2017, now that production will be lower than expected.
The International Energy Agency (IEA) has stated that the current oil surplus could be wiped out by the end of Q1 2017, now that production will be lower than expected.
Over a longer period, oil production could remain at or below current levels. The low price has caused oil producers to slash costs and become more efficient, prioritising survival over exploration. Therefore, supply could be restricted in future by a lack of new assets coming onstream.
Although a rising oil price will mean improving profitability and more cash for exploration, I believe that the fear of lower prices could lead to a high degree of management caution on capital allocation over the medium term. This could push oil prices even higher.
Demand side
Demand for oil is forecast to rise in 2016. According to the IEA, global oil demand is expected to increase by 1.4 mb/d in the current year. This is 120 kb/d above its previous forecast and it now anticipates that demand will exceed supply within the next few months.
Looking further ahead, demand for oil should benefit from favourable conditions within the world’s two largest economies. In the US, President Trump represents a step change in recent views on climate change.
He stated in 2012 that global warming was ‘created by and for the Chinese in order to make US manufacturing non-competitive’. Therefore, it seems likely that regulations on fossil fuels will be relaxed at the very least, which could reduce the incentive to seek out cleaner forms of energy.
Similarly, in China the prospects for energy demand in the long run are bright. It is expected to account for 25% of global energy consumption by 2035, with growth in its energy consumption of 48% forecast over the next 18 years.
Chinese demand for all fossil fuels is due to rise and contribute 53% of its increase in energy demand between now and 2035. Demand for oil is expected to increase by 63%, while demand for gas is forecast to rise by 193% by 2035.
Energy consumed in transport is set to increase by 93%, with oil remaining the dominant player in this space. With only 69 out of every 1,000 Chinese owning a car versus 786 per every 1000 Americans, the potential for rising car ownership remains high. In fact, it looks set to be a positive catalyst for the oil price in my view.
BP’s outlook
A rising oil price bodes well for BP. In recent years its financial resources have been stretched by the compensation payouts for the 2010 oil spill.
The total bill for the disaster is $61.6 billion, although the company has now drawn a line under it. No further payments will therefore be made, which should provide BP with improving cash flow through which to develop and maintain its asset base. It could also lead to improving investor sentiment in my opinion, since it is one less risk for investors to weigh up before buying the company’s shares.
…BP’s prospective P/E of 16 is appealing given its improving financial position and the quality of its asset base.
BP has prioritised dividend payments to its investors in recent years, thereby further stretching its finances. Since 2012, dividends per share have risen by almost 18% and while this is a risky option, it looks as though they will remain affordable. Dividends are expected to be less than EPS next year and with the aforementioned upbeat outlook for oil, it seems probable that the company’s yield of 6.1% will remain sustainable.
In my view, BP’s prospective P/E of 16 is appealing given its improving financial position and the quality of its asset base. Undoubtedly, there is scope for it to fall if the oil price reverses in the short run, but given the long term growth drivers within the energy markets discussed above, I doubt that BP’s current valuation will prove to be excessive.
The right time to buy
Although the oil price has risen sharply in recent weeks, I believe that it could move higher over the medium term. Restricted supply from OPEC and non-OPEC producers should continue to have a positive impact on the price of oil, while rising demand means that the current surplus could be wiped out within a matter of months.
Longer term, more favourable policies towards fossil fuels in the US and growth in energy demand in China and the emerging world mean that the prospects for the oil and gas industry remain bright.