British Petroleum (BP): In need of more refining

Having surpassed analyst expectations for the three successive quarters, oil giant BP could not make it four and last week provided fourth quarter results which fell short of market expectations.  Despite the initial negative market reaction, our view on the oil giant remains unchanged and with CEO Tony Hayward promising further efficiency drives, earnings will continue to strengthen as the global economic recovery gains traction.

 As has very much been the case in this earnings season (arguably more so than in others), sentiment has taken its lead from outlook statements rather than the historical financial matter presented. Tony Hayward’s statement that he expects the recovery from last year’s recession to be ‘slow and gradual’ coupled with lower expected production in 2010 proved the catalyst for a share price drop of around 3% in the immediate aftermath of the announcement last week Tuesday.

The share price though recovered later in the day and results actually provided plenty of reasons for optimism.

Upstream performance was buoyed by new field start-ups in the Gulf of Mexico and production rose by 4% to over 4 million barrels of oil equivalent a day over the course of the year, with output jumping by 3% in the final quarter. And what’s more, encouragingly, the group replaced its reserves by 129 percent of 2009 production, marking a 17th year in which it found more resources than it extracted.

Earnings have reflected this robust performance. Fourth quarter replacement cost profit came in at US$3.45bn, 33% higher than 12 months previous. Higher energy prices boosted operating profits from exploration and production during quarter to US$7.1bn (up from US$4.3bn in corresponding quarter of 2008).

2009 though was a year which was characterized by low energy prices (remember oil reached US$147 in July 2008), weaker refining margins and a global recession. It is therefore unsurprising that BP’s downstream arm has continued to labour. The group’s refining business has suffered from both a fall off in demand for oil products as well as overcapacity and refining margins were close to their lowest in 15 years.

With a relatively high oil price and low demand for petrol, refining margins have been squeezed to the point that BP made a profit of US$1.49 on each barrel of oil it refined, compared with US$5.20 a year ago. Indeed, the underlying operating profit in the refining and marketing business for the final quarter came in at just was just US$15 million, down from about US$600 million in the corresponding period of 2008.

Refining has hammered all of the globe’s major players.  However a gradually improving picture in the United States and the Western world (even Europe) will set the stage for refining margins to improve over time.

Management have pressed ahead with efficiency drives and encouragingly cash costs were US$4 billion lower for 2009 than in 2008.  The group is underpinned by a bullet proof balance sheet (net debt to equity stands at a safe 20%) and a continued focus on costs will allow management to maintain the group dividend which it held steady at 14 cents per share this time around.

Whilst others have struggled to replace reserves, BP has excelled with the drill bit. With the recent award of a contract to access the Rumaila oilfield in Iraq as well as recent discoveries at the Tiber Prospect in the Gulf of Mexico and Teeba offshore Angola, earnings in our view are extremely well supported.