The stock of BP (BP) has plunged 55% this year. Just like the entire energy sector, the stock temporarily bounced off its March lows but it has steadily declined in the last four months. As a result, it is now hovering around its 25-year lows and is offering a 7.4% dividend yield. The depressed stock price of BP has led many investors to wonder whether the stock has become a great bargain. In order to determine this, investors should first understand why the stock has collapsed at its current level.
The pandemic has caused an unprecedented downturn in the energy sector. Due to social distancing and work from home, the demand for gasoline and diesel has significantly decreased this year. Even worse, the demand for aviation fuel has collapsed due to the reluctance of people to travel by plane amid the coronavirus crisis. Consequently, the global demand for oil products is expected by the Energy Information Administration [EIA] to slump by 8.3 million barrels per day on average this year, from 101.4 to 93.1 million barrels per day. This will mark the steepest decline in the global oil consumption in at least three decades.
The impact of the pandemic on BP was evident in the results of the oil major in the second quarter. The price of Brent averaged $30 in the quarter, much lower than the average of $50 in the first quarter and $64 in the full-year 2019. In addition, the average price of U.S. Henry Hub natural gas was $1.70 in the second quarter, the lowest level in 25 years. Moreover, due to the slump in the demand for refined products, the refining margin of BP fell 61%, from $15.20 in the prior year’s quarter to $5.90, and its refinery utilization plunged from 89% to 70%. All these major headwinds led BP to switch from an adjusted profit of $2.8 billion in the prior year’s quarter to a loss of -$6.7 billion.
As the second quarter was marked by unprecedented lockdowns worldwide, BP will certainly improve its results in the second half of the year. Nevertheless, while BP stated that the demand for gasoline and diesel improved to 85-90% of its normal level in August, the demand for its aviation fuel remained 70% lower than a year ago. Overall, BP is expected to post a loss of -$1.16 per share this year.
Transition to renewable energy sources
The pandemic is the primary factor behind the material losses of BP this year but the collapse of the stock near its 25-year lows cannot be attributed solely to the pandemic per se. To be sure, the broad market has retrieved all its pandemic-driven losses and is now hovering around its all-time highs, thus showing that the investing community views the coronavirus crisis as a temporary headwind for the global economy.
Indeed, there are numerous vaccine studies underway, with the most promising results coming from Moderna (MRNA), Johnson & Johnson (JNJ), AstraZeneca (AZN) and Pfizer (PFE). These companies have identified vaccines that block the coronavirus but still have to prove that their vaccines are sufficiently effective and safe on a large scale (30,000-60,000 people). A vaccine is widely expected to be developed until early next year and distributed worldwide in about a year. As soon as this materializes, the coronavirus crisis will be contained and the global energy market will recover. The Energy Information Administration certainly agrees on this view, as it expects the global demand for oil products to rebound by 6.3 million barrels per day next year and thus retrieve most of its losses caused by the pandemic this year.
A side effect of the pandemic is the accelerated growth of investments in renewable energy sources. Total (TOT) recently announced a significant increase in its annual investment in clean energy while Royal Dutch Shell (RDS.B) and BP, recently, announced that they intend to proceed with a major shift from fossil fuels to renewable energy until 2030.
More precisely, BP intends to increase its investment in clean energy 10-fold in an effort to increase its renewable energy generating capacity 20-fold over the next decade. It also targets a 10-fold increase in the number of charging points of electric vehicles. Moreover, the oil major aims to partner with 10-15 major cities worldwide to help them meet their goals for zero emissions.
Source: Investor Presentation
All these goals seem benign on the surface but BP also stated that it intends to reduce its investment in oil and gas projects so much that it expects to reduce its oil and gas production by 42% over the next decade, from 2.6 million barrels per day now to 1.5 million barrels per day in 2030.
This is the part of the business plan of BP that has caused panic in the market. When a company shifts from its core business, in which it has decades of experience and thus great expertise, to a new business, it causes panic to the investing community due to the great uncertainty that results from this shift. Not only does the oil major have no expertise in renewable energy projects, but it will be nearly impossible to achieve the same margins it enjoyed in the oil industry for decades. It is also worth noting that BP is infamous for having repeatedly dismissed renewable energy projects in the past, claiming that oil was much more profitable. Moreover, the business plan is still vague, with very few details, and thus it does not help reduce the uncertainty that surrounds this historical shift of the company.
The accident in the Gulf of Mexico
BP had the most catastrophic accident in the history of the oil industry in the Gulf of Mexico, in 2010. As the accident occurred a decade ago, most investors have completely forgotten about it, thinking that it does not affect the stock of BP anymore. Unfortunately, this is far from true.
Since the accident, BP has paid approximately $70 billion for its liabilities. This amount exceeds the current market cap of the stock ($57.6 billion). Even worse, the oil major is still paying appreciable amounts for that accident every year. In 2019, nine years after the accident, BP paid $2.4 billion (24% of its earnings) for the accident. The company paid another $1.4 billion in the first half of this year. Therefore, the accident continues to burden the cash flows of BP significantly.
It is also remarkable that the total liabilities BP has paid so far for its accident are nearly equal to the total earnings of the company ($73.8 billion) since 2011. In other words, the liabilities for the accident have nearly offset all the earnings of the oil major over the last decade.
Moreover, due to its excessive liabilities for the accident and its persistence to keep paying extremely generous dividends since 2011, BP has accumulated an excessive amount of debt. In the last 12 months, BP has posted operating losses of $4.3 billion and hence it has been unable to cover its net interest expense of $2.0 billion. Furthermore, its net debt (as per Buffett, net debt = total liabilities – cash – receivables) currently stands at $128.5 billion. This amount is more than twice as much as the market cap of the stock and about 32 times the earnings of the company last year and hence it is excessive. The huge debt load that BP has accumulated due to its accident in 2010 and its markedly generous dividends have certainly taken their toll on the stock price of the company.
The stock of BP has collapsed near its 25-year lows for various reasons. The pandemic is certainly the primary factor but not only for its impact on the demand for oil products. The pandemic has also accelerated the transition from fossil fuels to renewable energy sources and thus it has pushed BP to announce a seismic shift in its business strategy, a shift from its core business to completely new endeavors. This shift has caused great uncertainty over the future prospects of BP and thus it has taken its toll on the stock of the oil major.
Moreover, the liabilities of BP for its catastrophic accident in 2010 have essentially erased all the earnings of the company throughout the last decade. In addition, they still consume a significant portion of the cash flows of the oil major every year. Given also the extremely generous dividends of BP over the last decade, it is easy to understand how the oil major has accumulated an excessive debt load. During boom times, the market may almost ignore the debt of a company but during downturns, such as the ongoing one, a high debt load weighs heavily on the stock price.
To conclude, BP is currently facing a perfect storm, partly for its own sins and partly for reasons beyond its control. As usual in such cases, the stock has been beaten to the extreme. The pandemic is likely to subside next year thanks to a vaccine and thus the global demand for oil products is likely to recover. As a result, those who purchase BP near its 25-year lows are likely to be highly rewarded. On the other hand, investors should be aware of the aforementioned risk factors that will weigh on the stock in the unlikely event of a prolonged pandemic.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.