We've
lowered our estimate of the marginal cost of domestic natural gas from
$6.50 per thousand cubic feet to $5.40 per mcf, driven primarily by an
updated analytical approach. Because our upstream valuation methodology
incorporates an out-year marginal cost-based view on oil and gas prices,
it follows that a reduction in marginal cost results in a revaluation
of our gas-weighted upstream energy coverage universe. For those firms
most leveraged to gas production, our fair value estimates have
decreased 10%-15%. However, oil and liquids exposure provides insulation
from any meaningful change to fair value estimates for the majority of
our upstream coverage list. Our valuations also reflect our current
midcycle view on oil, incorporating $95 per barrel West Texas
Intermediate and $99 per barrel Brent. In addition, we assume that North
American natural gas liquids composite prices trade between 40% and 50%
of crude oil throughout our forecast period.
We remain bullish
on domestic natural gas and continue to see considerable upside to
current gas prices. Our analysis indicates that Henry Hub gas prices
tend to track marginal cost quite well over longer time intervals,
strongly suggesting a rebound from today's $3.70 per mcf within a few
years. This is reflected in our stock calls, as for the most part our 4-
and 5-star stocks remain just that, even after updating our models with
a lower out-year gas price assumption. We continue to view Ultra
Petroleum UPL and Devon Energy DVN as the most attractive gas-weighted names, Apache APA and Canadian Natural Resources CNQ as the most attractive mixed-oil/gas stocks, and Suncor SU and Occidental Petroleum OXY as the most attractive oil-weighted firms.
When
viewing the oil majors' prospects, one key competitive challenge stares
down each and every company: replacing reserves is becoming
increasingly difficult and costly. To be sure, there's a lot of oil left
in the world, but finding low-cost barrels of oil has never been
harder, in no small part because many governments now don't allow
Western oil companies access to their resources.
Excluding Russia, BP produced the equivalent of 920 million barrels
of oil and gas in 2011; this represents the number of new reserves it
needs to book each year if its resource base isn't to shrink. But there
simply are not 920 million barrels of conventional oil reserves (that
is, the lowest-cost barrels) accessible to BP in a given year. This has
created a resource scramble that is increasingly focused on
non-conventional resources: deep-water, oil sands, LNG, and
unconventionals (shale gas/tight oil). What this means is at a given
level of energy prices, we expect BP's returns on capital will be lower
in future years as non-conventional resources are much costlier to
develop and produce.
Of course, BP has much to worry about beyond higher cost reserves,
with its major concerns being the unfolding aftermath of Macondo and its
future in Russia now that it has tied itself up with Rosneft ROSN.
Although largely independent of each other, taken together these are
likely to change the shape of BP in ways that would have been hard to
imagine at the beginning of 2010.
The impact from Macondo on BP's operations has been tremendous. Net
pretax cash outflows have been $30 billion to date, and our expectation
is $10 billion-$20 billion more is still to flow out before all is said
and done (our valuation assumes $15.5 billion from 2013 onward).
Further, BP has been forced to sell off the equivalent of 10% of its
production and reserves during a period of high oil prices. Beyond the
fines and penalties that remain to be paid, a further $3 billion-$4
billion of asset sales are planned before the end of 2013. BP was
producing 3 million non-Russian barrels of equivalent per day of oil and
gas before Macondo. When the dust settles, volumes will likely be
20%-25% below this level.
The other major near-term issue is what the new tie-up with Rosneft
means to BP's future. BP actually owned 1.25% of Rosneft's outstanding
shares prior to the recent deal, so the company actually now owns
19.75%. But this isn't the same old Rosneft; after purchasing TNK-BP,
Rosneft is now by far the largest publicly traded oil producer in the
world. Further, it has a huge resource base from which it can keep
production growing for years to come. Of course BP only owns 19.75% of
this company rather than the 50% it held of TNK-BP (a huge company in
its own right). Our initial review shows that BP's proved reserves are
likely to increase by 400 mmboe because of this deal, while production
and profits are likely to be slightly lower than they were from TNK-BP.
Though in many respects this looks like a decent deal (BP gets $12.3
billion in cash in addition to 18.5% of Rosneft's shares), Russia is, of
course, not the friendliest of places for Western oil companies. In our
view, two considerations could make this deal less attractive than it
appears at first blush: future cash flows and sovereign risk. With
respect to cash flows, what matters to BP is the cash dividends
received. First, Rosneft intends to pay out much less in dividends than
TNK-BP did, meaning cash flows from Russia are likely to be billions
less in the coming years than they have been of late. Further, Rosneft
is spending $40 billion in cash to acquire TNK-BP (on top of giving $14
billion in stock to BP) and with only $5 billion of cash on hand, it
will have to take on a lot debt to finance this deal. Put together, it's
clear the outstanding cash flow numbers from TNK-BP (BP put in $4
billion and assets in 2003 and received $18 billion in dividends) are
unlikely to be repeated, and in a crisis BP could be asked to contribute
capital in the future.
The second risk is impossible to quantify but there's no question to
its existence: How long will Russia be OK with BP owning 20% of its
national oil champion? And if Rosneft ever is re-nationalized
(undoubtedly a possibility over the long term), will BP be compensated
in a fair manner? The pessimistic answer to this question is that
Western oil companies have been getting burned in Russia since the
Soviets took power, and if the Kremlin moves expel BP from Russia
there's likely little the company can do about it. The optimistic
rebuttal to this is that Russia's state energy companies have paid fair
prices for recent deals (for example, TNK-BP and Sibneft), so BP could
be compensated in a reasonable manner if and when it heads for the
exits.
We
are maintaining our fair value estimate of $46 per ADR. We are lowering
our long-term natural gas price assumption from $6.50/Mcf to $5.40/Mcf;
however, only 11% of BP's 2015 production will derive from North
American natural gas, which makes the valuation impact from this change
immaterial.
In light of the TNK-BP sale and Rosneft tie-up we have removed TNK-BP
from our BP valuation, and our forecast financials don't include any
Russian business activities. To value BP's Rosneft stake we add $12.3
billion in cash to our valuation and the market value of the 18.5% stake
it will own. We discount the value of BP's stake by 25% to account for
illiquidity/risk, which currently equates to a value of $9.5 billion.
Though our fair value increases, so does BP's risk, which isn't what
investors were hoping for given its high-risk story. Accordingly, we are
raising our uncertainty rating to high from medium.
For oil and gas prices, our forecasts use prices based on Nymex
futures contracts for 2012-14 and our own midcycle price assumptions for
2015-16. Brent oil pricing: $112 per barrel in 2012, $108 in 2013, $104
in 2014, $99 in 2015, and $102 in 2016. WTI oil pricing: $94 per barrel
in 2012, $91 in 2013, $91 in 2014, $95 in 2015, and $98 in 2016. Henry
Hub natural gas (U.S.): $2.87 per Mcf in 2012, $4.08 in 2013, $4.31 in
2014, $5.40 in 2015, and $5.40 in 2016.
Cash outflows relating to Macondo lower our fair value by
approximately $4 per ADR (roughly $3 billion in cash outflows destroys
about $1 of value per share). Our key assumptions are: $1.2 billion in
cash outflows will occur during the rest of 2012. $4.5 billion of cash
outflows to settle criminal charges and SEC securities charges are
modeled as disclosed by the company. In 2013, we project a $2 billion
cash settlement from Transocean. We also project a few hundred million
dollars in various oil spill-related spending annually in each of the
next five years.
Beyond these considerations, BP remains liable for various lawsuits
and penalties, the most important of which are Clean Water Act and
claims filed by states in the Gulf Coast region. We currently model BP's
share of CWA fines to $7.7 billion. Also, we assume that settling all
other Macondo-related liabilities will total $3.5 billion. All told,
these cash outflows sum up to $15.5 billion from 2013 onward. Projecting
remaining oil spill outlays is very speculative, but it's clear
billions more will flow out the door during the next few years.
BP's
valuation carries heightened uncertainty due to the uncertainties
surrounding the Macondo oil spill and its high-stakes exposure to the
Russian government through its Rosneft partnership. With Macondo, the
final dollar amounts of various fines and lawsuits are impossible to
predict, but the reality is that remaining outflows are likely to fall
in the $10 billion-$20 billion range. With respect to its 20% stake in
Rosneft, being a foreign company that holds such a large stake in
Russia's national oil company creates a significant amount of sovereign
risk. This last risk cannot be overstated, and it's likely the market
won't give BP full credit for the value of its investment.
Beyond these company-specific issues, BP's profits and cash flow are
largely tied to oil and gas production and are highly leveraged to
movements in the price of oil and to a lesser extent, natural gas.
Periods of prolonged low energy prices weaken returns on capital and new
oil and gas projects would be unlikely to generate their projected
economic results. BP employs huge amounts of capital in building out its
production portfolio, and cost overruns and/or completion delays are
continued sources of uncertainty. Going forward, greater reliance on
highly technical projects is likely to increase these risks.
Management & Stewardship
In
the wake of the Macondo oil spill, Robert Dudley took over BP with the
job of stabilizing the firm and rebuilding its very tarnished
reputation. To date, Dudley has run BP well enough, although his hardest
tests lie ahead when he has to determine how to shape the company after
Macondo and TNK-BP. Macondo is the second time BP has had to shore up
its safety record in recent years, the first being the Texas City
refinery explosion of 2005. Other notable incidents of the past decade
include 6,500 barrels of oil leaking from the Trans-Alaska pipeline in
2007 and a record $303 million fine levied by the U.S. Commodities
Futures Trading Commission for BP traders trying to corner the propane
market in 2003-04. Even after Texas City, BP continued to notch up a
great deal more safety violations than its peers in its U.S. refining
operations, which along with Macondo, does make us believe that BP was
fundamentally flawed in how it was running its operations. It's
impossible to say if BP is finally going to change its ways in terms of
safety performance; after all, Texas City clearly did not usher in a
safety-first culture in the way the Valdez oil spill did for Exxon. But
Macondo is an event of such monumental value destruction that if it
can't shake BP to the core and instill change, nothing can. Putting
together its poor safety record and execution issues, we consider BP
management to be a poor steward of shareholder capital.
Overview
Minus
a material and prolonged decline in oil and gas prices, BP's $38
billion divestment program ($35 billion of which has been completed),
cash proceeds from selling TNK-BP ($12.3 billion) and operating cash
flows should be sufficient to cover capital investment, dividends, and
Macondo-related fines and lawsuits. In fact, we think BP's financial
health is very good and the company will be able to increase capital
spending, dividends, and/or share repurchases as soon as 2013. The
company reinstated its dividend at $0.42 per ADR and has since raised it
to $0.48, which remains below the pre-Macondo level of $0.84.
Management clearly wants to restore the dividend to prior levels, but it
likely won't be until 2015 before this is possible.
Profile:
BP
is an integrated oil and gas firm with operations across six
continents. BP's upstream operations (excluding TNK-BP) produced 2.5
million barrels of oil equivalent per day during 2011. Downstream
operations include refining, chemicals, lubricants, and service
stations. Due to the Macondo oil spill, BP is amid a $38 billion
divestiture program, of which $35 billion has been completed to date.
Included in these divestitures are roughly 10% of the company's
pre-spill production and reserves.
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