Analysis: BP

Tuesday morning, before the opening bell, BP (BP) reported a strong top- and bottom-line beat with its fourth-quarter earnings results.

Revenues of $76.885 billion exceeded the $62.61 billion consensus, while underlying replacement cost profit -- a non-GAAP proxy for net income defined as the replacement cost of inventories sold in the period and arrived at by excluding inventory holding gains and losses from profit or loss -- came in at $3.477 billion (+65% YoY), above consensus of $2.63 billion resulting in earnings of $1.04 per share.

Speaking on the release, CEO Bob Dudley stated, "We now have a powerful track record of safe and reliable performance, efficient execution and capital discipline. And we're doing this while growing the business - bringing more high-quality projects online, expanding marketing in the Downstream and doing transformative deals such as BHP. Our strategy is clearly working and will serve the company and our shareholders well through the energy transition."

Cash Flow

Underlying operating cash flows, which excludes post-tax Gulf of Mexico oil spill payments, were $7.1 billion. This includes a $1.5 billion working capital build in the quarter (after adjusting for inventory holding losses). When including what BP annually pays out for the oil spill, on a post-tax basis, fourth-quarter operating cash flow came in at $6.8 billion.

Importantly, looking ahead and speaking to management's ability to continue returning cash to shareholders, Chief Executive of Upstream Bernard Looney noted on the conference call, "We have the capability within our current resource base to grow pretax free cash by 40% to 50% from 2021 to 2025 under the current capital frame and with increasing returns," while Chief Executive of Downstream Tufan Erginbilgic guided for segment free cash flow to increase from $7 billion in 2018 to $9 billion to $ 10 billion by 2021.

Capital Allocation

On the capital allocation front, BP announced a quarterly dividend of $0.615 per ADS (American depositary shares, the type of shares we own in the trust), expected to be paid on March 29, 2019. Additionally, the company repurchased 2 million ordinary shares in the quarter for a total cost of $16 million.

Debt did see an increase to $44.1 billion, from $37.8 billion in the year-ago period, and as a result BP saw its net debt ratio, also referred to as "gearing" (debt related to equity capital) rise to 30.3%, up from 27.4% in the year-ago period. As a reminder, net debt and the gearing ratio are non-GAAP measures that management uses to give investors a clearer understanding of the true economic impact of debt; per the release, "Net debt enables investors to see the economic effect of gross debt, related hedges and cash and cash equivalents in total. The net debt ratio enables investors to see how significant net debt is relative to equity from shareholders." We would also note that while gearing was marginally above management's target range of 20% to 30%, on the release, management noted their expectation for gearing to move toward the middle of their targeted range in 2020.

Macro Environment & Environmental Initiatives

Before digging into the individual operating segments, we believe it is important to call out management commentary relating to the macro environment as oil companies, by their nature, are largely joined at the hip to the swings in commodity prices (though improvements to operating efficiencies can obviously work to improve overall results). On the call, Dudley noted that "During the second half of the year [2018], inventories began rising driven by a combination of increasing OPEC production levels, record U.S. supply growth and the decision by the U.S. government to grant waivers to buyers of Iranian oil. Together, these saw the Brent oil price fall from a 4-year high in October of $86 per barrel to around $50 by the end of the year."

Regarding the current environment and expectations for the first half of 2019, Dudley stated, "Looking to 2019, the Brent oil prices improved to around $63 as OPEC plus has started to implement their decision to reduce production for the first half of 2019. On supply, U.S. tight oil is expected to continue to grow strongly especially in the second half of the year as new pipeline infrastructure is introduced. On demand, we expect growth to remain above average supported by continuing gains in China and India."

That said, Dudley did add that, "The outlook for oil is expected to remain volatile with many uncertainties, including how markets respond to evolving sentiment, around ongoing trade discussions, and Venezuela is an obvious concern." Looking even further out and speaking to China's impact on oil demand going forward, a factor we have regularly called out in our Weekly Roundups, Dudley called out management's expectations that "the world is likely to need around 30% more energy by 2040 to continue to grow. The majority of this additional demand comes from a growing prosperity in Asia with around 2.5 billion people set to be lifted from low to middle incomes over the next 20 years."

The two dueling forces in the energy sector are a need for more energy with the goal of driving down carbon emissions, and BP's management team is committed to both. On the call, Dudley followed up his commentary on the need for increased production by saying, "We all have a role to play in reducing emissions, governments, consumers as well as businesses like BP. Yet on current trends, emissions are likely to continue to edge upwards in the near term. As a global energy business, we are very committed to playing our part in a lower-carbon future. We have introduced a clear framework that will shape our approach and hold us accountable through clear targets." Management hopes to achieve these two goals, increasing output while decreasing emissions, via their Reduce, Improve Create (RIC) framework. Through this framework BP will seek to reduce the emissions in their operations; improve products to help customers reduce their own emissions from the products they buy and use; and create low-carbon businesses building on the company's existing alternative energy business.

Upstream

In its Upstream operations, BP posted underlying replacement cost profit before interest and tax (RCPBIT) of $3.886 billion (+74.8% YoY), up from $2.223 billion in the year-ago quarter. Per the release, "The result for the fourth quarter mainly reflected higher liquids and gas realizations, strong gas marketing and trading results and higher production including BHP assets acquired by BPX Energy (previously known as the US Lower 48 business)."

On that note, production (excluding Rosneft) was 2,627 mboe per day, representing an increase of 1.8% versus the year-ago period. From an underlying perspective, which is defined as production after adjusted for acquisitions, divestments, and entitlement impacts in BP's sharing agreements, BP increased production by 3.4% due to "major product ramps."

On the release the company called out the following highlights from the quarter (pulled directly from the release):

  • On 31 October, BP completed the acquisition of BHP's US unconventional oil and gas assets.
  • On 23 November, BP announced the start-up of the Clair Ridge project. This was the sixth major project to start up in 2018 (BP operator 45.1%, Shell 28%, Chevron 19.4% and ConocoPhillips 7.5%).
  • On 14 December, BP announced the sanction for two new gas developments offshore Trinidad, Cassia Compression and Matapal.
  • On 17 December, Sonangol and BP signed an agreement to progress to final investment decision the development of the Platina field in deepwater Block 18, offshore Angola. Sonangol also agreed to extend the production licence for the BP-operated Greater Plutonio project on Block 18 to 2032, subject to government approval, and for Sonangol to assume an equity interest in the block (BP operator 50% and Sonangol Sinopec International Limited 50%).
  • On 21 December, BP announced final investment decision, subject to regulatory approvals, for Phase 1 of the Greater Tortue Ahmeyim LNG development in Mauritania and Senegal (BP operator 62% in Mauritania and 60% in Senegal).
  • On 8 January, BP announced sanction of Atlantis Phase 3 development (BP operator 56% and BHP 44%) in US Gulf of Mexico. In addition, two oil discoveries were also announced: Manuel (BP operator 50% and Shell 50%) and Nearly Headless Nick (LLOG operator 26.84%, BP 20.25% and other partners) in the Gulf of Mexico.
  • On 14 January, BP and Eni signed a heads of agreement with the Ministry of Oil and Gas of the Sultanate of Oman to work jointly towards the award of a new exploration and production-sharing agreement (EPSA) for Block 77 in central Oman (Eni operator 50% and BP 50%).

Looking ahead to the fourth quarter, management expects underlying production to be higher in 2019 versus 2018 as a result of major projects coming on line, though it noted that reported production will depend on several factors including "the exact timing of project start-ups, acquisition and divestment activities, OPEC quotas and entitlement impacts in our production-sharing agreements." In the first quarter of 2019, management expects reported production to flat sequentially. Speaking on the conference call, Dudley also called out, "we remain on track to deliver 900,000 barrels per day of new major project production by 2021, supported by the start-up of a further 6 major projects during 2018." Recall, it is this clear line of sight into future production growth that has given us the conviction to scale into the position as we can gauge future activity with less uncertainty regarding the need for additional surprise expenditures going forward.

Downstream

In its Downstream operations, BP reported underlying RCPBIT of $2.169 billion, an increase from $1.474 billion (+47.2% YoY) reported in the same period last year. Breaking this number down further, during the fourth quarter, BP realized an underlying RCPBIT of $1.324 billion in its fuels business (+66.4% YoY), $311 million in its lubricants business (-17.1% YoY) and $234 million (+90.2% YoY) in its petrochemicals business.

For the full-year 2018, the company reported underlying RCPBIT of $7.56 billion, a company record.

On the call, Erginbilgic noted, "we reduced the BP refining marker margin to deliver 15% returns to $8.6 per barrel, almost at our 2021 target. And pretax returns of 21% in 2018, our best on record, means we have achieved our 2021 target of around 20% 3 years ahead of schedule. This delivery further enhances our competitiveness and provides us with an excellent platform for continued growth," adding that "this strong delivery means that we now lead the competition in net income per barrel of refining capacity, a key major of overall competitive performance which adjusts for business scale. We have come from the bottom of the peer group in 2014 to the very top." Clearly, the business is firing on all cylinders.

Regarding IMP 2020, which we remind members places a sulphur cap on fuel, Erginbilgic stated, "our refining portfolio is well-positioned for the upcoming IMO 2020 changes with around 47% of our yield being distillates and less than 3% being high sulfur fuel oil. This delivery potential and selective investments in an attractive and growing petrochemicals market gives me confidence in further earnings growth to 2021 and beyond."

Looking ahead to the first quarter of 2019, management noted that they "we expect significantly lower industry refining margins and narrower North American heavy crude oil discounts."

Rosneft & BHP

At BP's partnership with Russian oil firm Rosneft, BP posted underlying RCPBIT of $431 million (34.3% YoY) up from $321 million in the fourth quarter of last year. Compared with the dynamics in the year-ago period, the positive results we driven by "by higher oil prices and favourable foreign exchange, partially offset by adverse duty lag effects." On the call, Dudley noted, "In Russia, our 19.75% shareholding in Rosneft provides us a strong position in one of the largest and lowest-cost hydrocarbon resource basins in the world with access to major markets both East and West. In 2018, BP's share of production from Rosneft was around 1.1 million barrels per day and we also received $620 million in dividends and these are after-tax."

Regarding the BHP transaction, management reiterated their commitment to fully fund the acquisition with cash on hand. Recall, management guided for this to be the case on the last quarter's release after initially planning to fund the acquisition via cash and equity, with 50% of the cash due on completion and the remaining 50% to come via six monthly installments funded through the issuance of equity. On the conference call, CFO Brian Gilvary mentioned, "Through the end of January, we have paid the initial consideration and 3 deferred installments totaling $7.7 billion with the remainder to be paid through April."

Macondo Payments

Regarding Macondo payments, BP paid out $272 million in cash during the quarter. With the fourth-quarter payments, BP paid out a total of 3.218 billion for the full year 2018, down from the $5.167 billion in payments made in 2017. Looking ahead, management reiterated expectations for next year's Macondo payments to be approximately $2 billion, weighted to the first half of the year, with the following year's payments to come in at roughly $1 billion.

Our Takeaways

All in all, we believe BP is firing on all cylinders and continue to see improving efficiencies leading to better cash flows and profits over time as management makes progress in working down the company's organic cash break-even level from $50 per barrel currently, a key factor we believe will support increasing returns to shareholders.

Lastly, while macro risks remain and are largely out of management's control, we believe continued execution on those factors that are in their control, including production growth and operating improvements will provide the means for BP to remain competitive versus peers and allow for continued support of the company's dividend payments, a key factor that has both served to support the shares and allows us to remain patient as management works to achieve future financial and production-related goals. As a result of the strong quarter, which analysts at Morgan Stanley referred to in their initial take as "outstanding," we reiterate our One rating.

Bottom line, our patience is paying off and thanks to the robust dividend, we have been and will continue to be compensated for it.