BP Earnings Review: Lower Oil Prices Offset Higher Upstream Production, Thicker Downstream Margins

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BP Plc. (NYSE:BP) recently announced its 2015 first-quarter results. The company’s underlying replacement cost profit, which is profit adjusted for one-time items and inventory changes, fell by slightly more than a fifth to $2.58 billion or $0.85 per ADS (American Depository Share). Most of the decline in the company’s earnings was primarily driven by lower oil and gas price realizations, as the average Brent crude oil spot price was down more than 50% year-on-year during the first quarter due to oversupply. In addition, despite a significantly colder than normal winter season in the U.S., the average Henry Hub natural gas price was down more than 44% from the year-ago quarter. This led to a significant erosion in BP’s upstream margin, because of which its oil and gas exploration and production earnings fell by more than 86% year-on-year, to just over $600 million. The decline in upstream earnings more than offset the improvement in downstream margins, higher upstream production, and a one-off tax benefit arising from the recently-announced changes to the supplementary tax rate in the U.K. The British government recently reduced the supplementary charge on oil and gas companies, levied on top of a 30% corporation tax rate, from 30% to 20%. The change was implemented with the purpose of boosting investments in the development of hydrocarbon reserves in the North Sea and was backdated to January 1, 2015. Overall, if we look beyond the volatility in commodity prices, which depend on the global demand and supply situation, and the changes in effective tax rate, which are decided by the regulatory bodies, the key takeaway from BP’s first-quarter earnings release was the visible improvement in its upstream production and downstream margins. Below, we take a closer look at the key factors driving that. [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 first-quarter results, we have revised our price estimate for BP to $45 per share, which values it at around 24x our 2015 full-year earnings per share (EPS) estimate of $1.87 for the company.

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Higher Upstream Production

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 $41 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 four years. Its average daily hydrocarbon production rate fell by almost 25% since 2010 to 2,143 thousand barrels of oil equivalent per day (MBOED) last year.

In order to revive its operational strength, BP started production from as many as eight new projects in 2012 and 2013. Last year, the company brought another seven new upstream projects online. These projects contributed significantly to the 2.2% y-o-y growth in its underlying oil and gas production in 2014. Currently, the company is working on several new projects that are expected to bring online over 900 MBOED of cumulative production – net to BP – by 2020. More than 50% of these new projects have crossed the critical, final investment decision (FID) stage of development, and are currently under construction. This year, BP plans to start production from four of these new projects under construction. Production from these new projects is expected to more than offset the decline in BP’s base production (due to natural field declines) and result in a gradual increase in its upstream production in the long run. During the first quarter, BP’s net upstream production, excluding Russia, grew by 8.3% year-on-year. [2]

However, some of that increase in its net oil and gas production could be attributed to higher entitlements from projects under production-sharing agreements (PSA). A PSA is an arrangement through which an oil company bears the risks and costs of exploration, development, and production. In return, if exploration is successful, the oil company receives entitlement to variable physical volumes of hydrocarbons, representing recovery of the costs incurred and a stipulated share of the production remaining after such cost recovery. Therefore, under such agreements, the production volume entitled to an oil company increases during the period of lower oil prices. BP derives almost one-third of its total net hydrocarbon production from production sharing agreements, and therefore, variable entitlements have quite a visible impact on its reported upstream production when oil prices are volatile. The company’s net oil and gas production, adjusted for changes in entitlements and portfolio impacts, grew by 3.7% year-on-year, primarily driven by the ramp-up of recently-started projects. [3]

Thicker Downstream Margins

BP’s downstream earnings increased by more than 77% during the first quarter. Most of this increase was driven by thicker refining margins because of the improvement in the refining environment, in general, and increased refinery optimization by the company. BP’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, increased by almost 14.3% y-o-y to $15.20 per barrel during the first quarter. In addition to thicker refining margins, the company’s downstream earnings were also boosted by a strong performance from its supply and trading business. The income from trading operations depends largely on the level of volatility in commodity prices. Given the recent spike in the volatility of benchmark crude oil prices, BP’s trading operations benefited greatly during the most recent quarter. [2]

Going forward, we expect BP’s downstream margin to continue to improve in the long run since the company is targeting significant efficiency improvements in its refinery business. It plans to enhance its feedstock advantage in the U.S. by increasing the proportion of cheaper crude oil — primarily from Canadian oil sands and the Bakken shale — processed by its refineries from around 70% currently, to almost 90% in the medium term. In addition, it also plans to reduce its unit breakeven cost in the petrochemical business by divesting  some of the highest-marginal cost assets and licensing its proprietary technology to third parties. Through these measures and a streamlining of its downstream operations across verticals, BP plans to deliver annual cost savings of around $1.6 billion by 2018, versus a 2014 baseline. [4]

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Notes:
  1. BP First Quarter 2015 Results, bp.com []
  2. BP 1Q 2015 Financial Statements, bp.com [] []
  3. BP 1Q 2015 Earnings Call Presentation, bp.com []
  4. BP 2014 Full-Year Investor Update, bp.com []