Why I’m Resisting The Temptation To Buy Shares In BP plc

I’ve owned shares in oil giant BP (LSE: BP) before. But, despite the recent plunge in the firm’s share price, I’m not going to buy shares again now.

Multiple issues

There’s so much to think about with BP right now, but one issue dominates all the others to influence my decision not to invest in BP, as you’ll see.

Just reading BP’s recent second-quarter update gives a flavour of what BP has on its plate. The firm struggles with lower oil and gas prices, losses in Libya, lower income from the company’s Russian investment in Rosneft, the prospect of fiercer US sanctions on Rosneft leading perhaps to lower earnings still, ongoing cash payments to settle Gulf-of-Mexico claims, asset sales to re-shape the firm for a lower oil price environment…

A lower oil price tends to improve earnings from BP’s downstream refining business, but in the first half of the year the decline in upstream earnings more than offset the financial gains from downstream operations.

Is this a cyclical low, or something more enduring?

BP is working hard to reduce its overall cost structure, in order to survive a prolonged period of lower oil prices. An ongoing asset sale programme, re-structuring and other measures will probably help BP survive a lower oil-price environment.

BP itself makes no mention of such trading conditions being temporary, but many people seem to expect the oil price to bounce back to its previous highs, including investors who are keeping BP’s price-to-earnings ratio at an elevated level. Yet, even if the oil price does bounce back, BP’s asset selling could lead to reduced earning potential down the road.

At today’s 351p share price, the forward price-to-earnings (P/E) ratio runs at almost 12 for 2016. For a cyclical firm such as BP, that’s fine if we are seeing cyclical trough in earnings. The P/E ratio will allow for a return to higher earnings during the next cyclical up-leg. However, what if the price of oil stays where it is or falls lower for the medium to long term? If that happens, BP’s P/E ratio looks too high and would be more comfortable down at about eight — about right for a commodity cyclical in a mature phase of the wider macro-economic cycle, as now.

Looking at historical oil prices on a chart, it’s easy to imagine oil prices down where they are now, or lower, for years and years to come. Spikes in the oil price in recent times look like bubbles in the long-range charts. Indeed, right now we see an oversupply of the black stuff that could overhang and influence the result of the supply/demand equation for decades.

What about the dividend?

BP’s 7.5% forward dividend yield looks tempting at first glance. But City analysts’ estimates of forward earnings for 2016 cover that payout only once, or thereabouts. I’d describe that dividend as fragile. If the price of oil slides further — taking earnings with it — the dividend payout could be a casualty. If not cut completely, it could be in line for a drastic pruning.

So, overvaluation is my biggest issue with BP. To me, BP looks priced for cyclical recovery, but a recovery may not happen. If a recovery in the oil price doesn’t happen, I think the share price could fall to establish a more realistic P/E rating and the directors may trim the dividend to preserve cash and to restore dividend cover from earnings.

What next?

Investing in BP now looks like a fifty/fifty gamble to me. The outcome could go either way. I’d rather invest in firms with less cyclicality and less dependence on selling a raw commodity.

Firms that add value to raw commodities by manufacturing a product, or by producing a service, are less reliant on the fickle swings of commodity prices in order to prosper. That's why I'm keen on a Motley Fool wealth report about five firms with healthy balance sheets, dominant market positions, and reliable cash flows. The shares discussed in this special report, called Five Shares To Retire On, demonstrate attractive characteristics, and our analysts think they could form an excellent foundation upon which you can then add further investments. To find out more, free of charge and for a short while longer, click here.

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.