BP’s Q3 Earnings Reflect Signs Of Turnaround In Key Business Drivers

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BP Plc.’s (NYSE:BP) third quarter earnings fell by almost a fifth, compared to last year on lower crude oil prices and weaker Russian Rouble, partially offset by thicker exploration and production (E&P) and refining margins. The company’s underlying replacement cost profit, which is profit adjusted for one-time items and inventory changes, declined 18% y-o-y. Global crude oil benchmark prices have fallen sharply over the past few weeks on rising supplies and slower demand growth, especially from China, where the rate of growth in demand for petroleum products has fallen to almost half of what it was a year ago. In addition, BP’s share of Rosneft’s (Russian state-owned oil company) estimated third quarter earnings fell by more than 85% to just $110 million, primarily because of the sharp depreciation of the Rouble. However, on the brighter side, there was a visible improvement in the company’s upstream operations during the quarter with production ramp ups from new projects boosting both volumes and profitability. On the downstream side as well, the company’s refining margins improved significantly because of the Whiting refinery upgrade completed last year. Overall, we maintain our positive outlook for BP despite uncertainties associated with oil spill costs, as we believe that the company’s core operational drivers are on the cusp of a turnaround. [1]

Headquartered in London, BP is one of the world’s leading oil & gas multinationals with operations in more than 80 countries. As a vertically integrated oil and gas major, it has both upstream as well as downstream operations. The upstream division primarily includes exploration and production activities for oil and gas, while the downstream division focuses on producing refined petroleum products such as gasoline.

Based on the recent earnings announcement, we have revised our price estimate for BP to $52/share, which is more than 25% above its current market price.

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Hydrocarbon Production Bottoming Out

BP has changed a lot since the 2010 Deepwater Horizon incident, primarily due to divestments made by the company in order to fund charges associated with the oil spill fiasco. By the end of last year, the company had completed divestments of around $38 billion. A majority of these asset sales primarily included upstream installations, pipelines and wells, while the company has managed to retain most of its (~90%) proven reserves. This has led to a sharp decline in BP’s production rate over the last three years. Its average daily hydrocarbon production rate fell by almost 21% since 2010 to 2,256 Thousand barrels of oil equivalent per day (MBOED) last year.

In order to revive its operational strength, BP started production from as many as five new projects in 2012 alone. Having started three more last year, the company plans to bring another seven new projects online by the end of this year. During the third quarter, BP’s upstream production declined by 2.7% y-o-y, excluding Russia. However, it was primarily due to the expiry of the Abu Dhabi onshore concession agreement in January this year. The company’s upstream volumes adjusted for the impact of the Second World War-era contract expiry and other divestments actually grew by 4.1% y-o-y during the quarter. We therefore expect BP’s average daily hydrocarbon production rate to bottom out by the end of this year and gradually increase thereafter.

The three projects started in 2013 include the Chevron-operated Angola LNG project and the Atlantis North Expansion project in the Gulf of Mexico, which began producing during the second quarter, and the North Rankin 2 project that came online during the third quarter. Located approximately 85 miles off of the northwest coast of Western Australia, the North Rankin 2 project aims to extend natural gas supply from the aging North Rankin and Perseus fields by extracting low-pressure gas.

This year, BP has already started production from five major projects including the Chirag Oil project in Azerbaijan, the Mars B and phase 3 of the Na Kika project in the Gulf of Mexico, the North Atlantis Expansion 2, and the CLOV project in Angola, which is operated by Total (NYSE:TOT). [2] BP holds a 28.5% in the Mars B project, which is expected to ramp-up total hydrocarbon production from the Mars field to 100 MBOED by 2016. Last year, the Mars field produced an average of over 60 MBOED. [3] The Na Kika Phase 3 project included drilling and completion of two new wells along with the development of subsea infrastructure supporting them and some new equipment to enhance production from an existing well. It is expected to boost Na Kika’s daily production rate from 130 MBOED to 170 MBOED in the coming months. [4]

Additionally, BP is also working on bringing up two new projects later this year. These projects include the Kinnoull project in the North Sea and the Sunrise Phase I project in Canada. During the third quarter earnings call, BP noted that the start-up of the Kinnoull project is in progress and should complete soon. The company also announced that the Sunrise Phase I project is on track, with construction of the central processing facility over 95% complete. These new project start-ups are not only boosting BP’s upstream volumes but are also expanding its operating margins. The company expects cash operating margin from these projects to be twice as much of its average upstream margin in 2011. According to our estimates, BP’s upstream EBITDA margins improved by more than 260 basis points y-o-y during the first nine months of this year. [2]

Downstream Margins Improving

BP’s downstream margins took a bad hit last year due to industry overcapacity. A lot more refining capacity has been recently added globally than what has been retired. This is because governments in different parts of the world continue to expand their existing refining capacity just in order to sustain employment and reduce their reliance on imported fuels. Most of the recent refining capacity addition has taken place in Asia and the Middle East. [5] In Asia, China has led the growth in refining capacity. At 12 million barrels per day, the country’s refining capacity already surpasses its domestic demand. It turned into a net exporter of refined products last year and continues to make progress on capacity expansions, due to be completed this year and the next. In the Middle East, Saudi Aramco Total Refinery & Petrochemicals Co. (SATORP), a joint venture between Saudi Aramco and Total, started shipments from the 400,000 barrels per day Jubail refinery in September last year. This is just one of the three such massive facilities planned by the Kingdom. [6]

This has put a severe downward pressure on the profitability of refining business at a time when high crude oil prices and environmental costs are already weighing on margins. According to our estimates, BP’s adjusted downstream margins fell by ~80 basis points last year. However, we expect its downstream margins to improve this year on the complete ramp-up of heavy crude refining capacity at its Whiting refinery in the U.S. and improving refining environment. With the Whiting refinery being fully operational after a major upgrade completed last year that enhanced its capability to refine heavier grades of crude oil, BP’s refining margins improved significantly during the third quarter, compared to last year. The company’s average refining marker margin (RMM), which is a measure of the difference between the price a refinery pays for its inputs (crude oil) and the market price of its products, jumped almost 15% y-o-y during the quarter. [2] We expect to see a similar performance during the fourth quarter as well. (See More: BP Set To Start Processing More Of Cheaper Canadian Crude At Its Whiting Refinery)

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Notes:
  1. BP Reports Third Quarter 2014 Results, bp.com []
  2. BP Third Quarter 2014 Earnings Call Presentation, bp.com [] [] []
  3. Production begins from Shell’s Mars B field in Gulf of Mexico, offshoreenergytoday.com []
  4. BP begins oil production at major Gulf of Mexico Deepwater hub, nola.com []
  5. Global Overcapacity To Squeeze Oil Refining Margins, reuters.com []
  6. Satorp ships first products from Jubail refinery complex, ogj.com []