BP Earnings: Oil Prices Offset Thicker Refining Margins; Focus on Lowering Upstream Cost Structure

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BP Plc. (NYSE:BP) recently announced its 2015 second-quarter results. The company’s underlying replacement cost profit, which is profit adjusted for one-time items and inventory changes, fell by 64% year-on-year to $1.3 billion, or $0.43 per ADS (American Depository Share). [1] 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 44% year-on-year during the second 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 40% 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 89% year-on-year, to just around $500 million. The decline in upstream earnings more than offset the improvement in downstream margins, which drove a more than 154% increase in the company’s adjusted downstream earnings. However, BP is taking measures to reduce its overall cost structure in order to be able to steer through this commodity trough in a good shape. We believe that these measures will be beneficial in lifting the company’s cash profit margins as oil prices recover gradually in the long run. Below, we provide a brief overview of what’s driving changes in BP’s downstream margins and upstream cost structure.

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 second-quarter results, we have revised our price estimate for BP to $45 per share, which values it at around 17.9x our 2015 full-year adjusted earnings per share (EPS) estimate of $2.51 for the company.

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Downstream Margins

BP’s second-quarter underlying replacement cost profit before interest and taxes from downstream operations increased by almost 155% year-on-year. 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 26% y-o-y to $19.40 per barrel during the second quarter. This is the highest level for the company’s average RMM since the third quarter of 2012. 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 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. [3]

Upstream Cost Structure

In addition to efficiency improvements in the downstream, BP is also taking steps to lower its upstream cost structure in order to steer through the commodity down cycle. The company’s management mentioned during the earnings call that they are working closely with their suppliers to renegotiate contracts with them in view of the steep fall in oil prices. The chart below highlights the range of rate reductions the company has been able to achieve on renegotiated contracts to date in some of the key upstream cost categories. [4]

BP Upstream Cost Cutting

 

Source: BP

The benefits of these renegotiations are expected to show up in both capital spending as well as cash operating costs. Examples of both include a more than 30% reduction in drilling costs for a well on the Mungo asset in the UK North Sea and an 18% reduction in logistics costs through more efficient use of boats and helicopters in the company’s operated Gulf of Mexico assets. While we believe that a large part of the drilling and service cost deflation will eventually reverse in the long run, along with a recovery in oil prices, cost savings from efficiency improvements are more sticky and will reduce the company’s overall upstream cost structure in the long run. [4]

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Notes:
  1. Second Quarter 2015 Results, bp.com []
  2. Quarterly F&OI, bp.com []
  3. BP 2014 Full-Year Investor Update, bp.com []
  4. BP 2Q 2015 Earnings Call Presentation, bp.com [] []