BP's (BP.) shares have traded up since announcing strong first-quarter results and a 3% dividend increase (it was raised 6% just two quarters ago). These lend support to our thesis that BP's legal liabilities appear unlikely to impair the company's ambitions to use its growing operating cash flows to increase its dividend in future years.
There are, however, two potential near-term headwinds that could surface for the BP story: its exposure to Russia via its Rosneft stake and the potential for weakening U.S. crude differentials. This report reviews the potential impact of each, and concludes that neither is likely to have a meaningful impact on the company's long-term outlook or valuation. We continue to view BP favourably at current share prices and it remains our preferred oil major.
How Important Is Russia to BP's Valuation and Cash Flow?
The U.S. sanctions against Russian individuals connected to the Putin regime in response to the Ukraine crisis have raised concern among investors, and the recent addition of Rosneft CEO Igor Sechin to the list of individuals the United States is targeting only heightens these worries. As of yet, Rosneft itself is not the target of any sanctions, but it's worth considering how negative developments from here could affect BP given its 19.75% stake in the company.
At current market prices BP's Rosneft holding is worth about $13 billion, or $4.25 per ADS/GBX 42 per share. The value of BP's stake has fallen by roughly 15% since the start of 2014, a combination of Rosneft's share price declining and a weakening ruble (Rosneft shares are traded in Moscow). For our valuation, we discount the market value of BP's Rosneft stake by 25% to factor in risk/illiquidity, which values this holding at $3.20 per ADS (or GBX 32 per share). This is roughly 6% of our current fair value estimate.
From a cash flow perspective, Rosneft is not overly material to BP, and thus will not make or break BP’s ability to grow cash flows and shareholder distributions in the coming years. Whereas TNK-BP (the company's former JV in Russia) paid BP at least $1.4 billion in annual cash dividends during 2008-12, Rosneft's dividend policy is much less robust. In 2013, BP received $460 million in cash dividends from Rosneft, although this likely will increase to $500 million–$750 million going forward. At the high end of this range, this equates to only 2.3% of the $31.8 billion in cash flow (excluding Macondo) we forecast BP to generate this year.
Gulf Of Mexico: Quantifying Cash Flow Impact of Weakening Gulf Coast Differentials
Another key asset in BP's portfolio that faces a potential near-term headwind is its Gulf of Mexico production. This is a key area of growth, and BP is hoping to increase oil production to almost 300mb/d by the end of the decade (2013: 169mb/d). Growing crude oil inventories in the Gulf Coast has put pressure on oil prices in the region. The main Gulf of Mexico oil price market of BP is Mars, a medium grade crude that historically has been priced off Brent. Since the start of 2010, through the first half of 2013, Mars traded at a discount of more than $6 per barrel to Brent at only one quarter.
But growing Gulf Coast crude inventories in the fourth quarter created significant pressure and for the quarter Mars averaged a discount of $13.25. The first quarter saw the Mars-Brent differential narrow to $7.40, but it has again begun to widen in recent weeks. The likelihood of further growth in Gulf Coast crude inventories this year raises the spectre that Gulf of Mexico realizations could again come under pressure and experience further periods of wide differentials.
Fortunately, any period of severe Gulf of Mexico differentials is likely to be short-lived, as investments to ship crude out of the central United States to the East and West coasts and export markets (after being refined to circumvent the crude export ban) are well underway. At present, we forecast BP's Gulf of Mexico realizations to remain weak for the remainder of the year, before recovering throughout 2015.
From a cash flow perspective, BP's Gulf of Mexico oil production generates after-tax cash flow of around $50-$55 per barrel, or total cash flow of around $4 billion based on our 205mb/d oil production forecast for the region in 2014. When considering the cash flow impact of differentials, each $10 per barrel change to BP's Gulf of Mexico realizations would equate to $750 million, or about 2.5% of the company's total 2014 cash flow.
Pricing is a potential near-term headwind that long-term investors should be aware of, but it's one that is very unlikely to alter the company's long-term outlook.
