It’s common knowledge that BP (LSE: BP.) shares have underperformed those of its peers for some time. Now the vultures are beginning to circle. Shell may have denied takeover rumours, but should a big US name enter into the race, I think that might change.
However, among all the speculation, I’ve remained focused on underlying fundamentals, and I continue to believe that BP’s significant discount to its peers is unjustified.
Ditching renewables
Back in February, the CEO admitted that it had moved “too far too fast” by investing so heavily in renewables. Now that it has pivoted back to what it does best, I expect healthy growth in free cash flow.
The oil major’s targets are bold. It wants to see free cash flow with a compound annual growth rate of 20% out to 2027, from around $8bn in 2024. It’s also aiming to grow return on average capital employed to 16% from 12% over the same time frame.
Questions do remain as to whether the company can meet such ambitious targets. One of my main concerns relates to the price assumptions on which they’re based. BP predicted oil prices would average $71.5 in 2025, rising to $74.4 by 2027. A protracted period of $60 oil would make hitting such targets very unlikely. Overpromising and underdelivering would hit the stock price.
Costs
Another area that management is concentrating on is bringing costs down. Between 2019 and 2024 total cost of sales increased by $10bn. A substantial portion of these costs have come from higher transportation, shipping and marketing expenses. They also reflect higher activity levels from its oil trading business.
All these costs are variable in nature and are to a large extent outside of the company’s control. They ultimately reflect strategic choices as it seeks to grow various parts of its business.
When we strip out these variable costs, last year it delivered structural cost reductions of around $800m. At its Capital Markets Day last February, it set a target of reducing such costs by $4bn-$5bn by 2027.
With its Q1 results back in April, it reported that structural costs had fallen by nearly $500m compared to Q4 2024. A large part of this reduction was achieved through workforce cuts. Some 3,000 contractors have already left, and a further 3,400 contractor roles are now being assessed.
Commodity cycle
Investing in any oil company requires two beliefs. First, that demand for hydrocarbons will remain robust, and second, that prices are heading higher.
On the first front, what the last few years have highlighted is the importance nation states place on hydrocarbons. In a world where countries are increasingly turning inward, the strategic importance of oil and gas is essential to ensure energy security.
The supply/demand dynamics of oil are complex. In its latest oil market report, the International Energy Agency expects US production to peak by 2026. If that’s correct and the shale-producing basins begin to decline, then supply shocks become increasingly likely.
Patience is undoubtedly needed with BP as it offloads poor-returning assets. But with a sector-leading 6.3% dividend yield, I’m being paid handsomely to wait. For all these reasons, I think it’s one investors could consider adding to their own portfolios.
