Since the end of September, shares in BP (LSE: BP) have rallied by just over 17% as a rising price of oil has lifted energy stocks. The big question is, will this rally continue?
I believe BP is one of the most undervalued companies in the energy sector, and there’s plenty of evidence to support this conclusion. However, the market is failing to take this evidence into account, and many investors believe that BP should be avoided until the price of oil returns to $100 a barrel.
Committed to improving returns
BP is doing everything it can to reassure the market that it can weather the slump in oil prices. Management is now preparing for a $60/bbl world and is slashing capital spending according. For example, at the end of October the company announced that it is planning to reduce annual running by $6bn, around a fifth of the group’s controllable cost base.
The good news is that BP isn’t alone, and industry-wide efforts to reduce costs are starting to push Big Oil’s operating costs lower. Take BP’s Mad Dog 2 well in the Gulf of Mexico for example.
When it was initially conceived, Mad Dog 2, which is being developed in conjunction with French oil major Total, had a price tag of $22bn. At this price, the economics of the well would only make sense with oil trading at $100/bbl. However, thanks to steep falls in the cost of deepwater rigs, the cost of Mad Dog has now fallen to $10bn. According to the Financial Times, City analysts believe that Mad Dog’s new lower price tag could have pushed the well’s break-even cost down to $50/bbl.
All in all, one analyst believes that this year, the breakeven price of Big Oil — the level at which Big Oil makes a cash profit — has fallen 20% year-on-year to $80 per barrel. A further decline in costs to $60 per barrel is expected by 2017.
With prices falling across the oil services industry, BP is now extremely well placed to capitalise on the price environment and invest for the long term. By lowering costs across the group, BP is not only ensuring that it remains profitable in a $50/bbl world but if the price of oil recovers, the group will see a rapid recovery in profitability.
Long-term outlook
Over the long term, it’s likely that BP’s shares will return to 500p. After all the company has now settled almost all of its liabilities stemming from the Gulf of Mexico disaster and has spent years pruning its portfolio, shedding non-core low-return assets.
Also, BP now has the opportunity to buy exploration and production companies, whose business models are being called into question by their debt-servicing costs. The company will be able to pick and choose any new assets it wants to bolt-on to its existing portfolio. It’s likely that the company won’t have to pay a premium price for these assets either.
BP’s shares support a dividend yield of 6.7% and trade at a forward P/E of 16.4.
