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Are BP shares a buy?

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Important: What follows is not a recommendation to buy or sell BP shares. I’m just a private investor, storing and sharing notes for interest and entertainment. Read my disclaimer.

Despite the recent micro-rally to 435p as I write, BP shares are still down over one-third on where they were before its Deepwater Horizon oil rig exploded on April 20th.

On a trailing basis, BP shares yield nearly 9% – an incredibly high yield given that this company pays £1 of every £6 churned out by UK companies every year in dividends.

Clearly, the market fears BP may cut its dividend.

If BP isn’t able to maintain its dividend, it’s going to hit UK investors (including pension holders) hard. The share price fall from 650p to 435p has single-handedly knocked around 185 points off the FTSE 100 index, too.

Yet if BP can maintain its dividend, the shares look to cheap. Now could be a textbook example of an opportunity to invest in a crisis for profit.

The two issues with buying BP shares

There are two main dimensions to whether you should buy BP shares:

Moral: Is it right to profit from an oil rig explosion that cost 11 workers their lives and has caused an ecological catastrophe?

Financial: Is buying BP shares likely to deliver a greater return than buying the market as a whole?

Anyone want to buy the shares for profit has to answer both questions for themselves.

The morality of buying BP shares

Let’s deal with the moral dimension first. Investors, like everyone else in society, walk a tightrope of moral compromises every day. People invest in tobacco firms, companies that make engines that go in jets that bomb civilians, and transport companies that contribute to global warming.

Unless you’re going to opt out of society completely, that is the reality.

I’m not saying ‘anything goes’ – I’m saying we have laws and politics that set and change the rules, not a system of voting by buying shares. If you don’t take an investment opportunity because of the ‘ick’ factor, you’re likely being inconsistent.

You might choose to be inconsistent, true. I have never bought tobacco stocks because I hate smoking and the export of this cancerous business model to the Third World. So I’m not claiming to be immune to the ick factor.

Yet equally, I know I have money tobacco shares in my tracker funds, and also my income investment trusts. My hands are not clean.

Returning to BP, I’m nonplussed by the more extreme U.S. commentators’ outcry over the oil well. I understand the pain having such a hideous disaster off your doorstep must cause, but that doesn’t make the more extreme views rational. In particular, elements of the US media are applying a ‘one rule for the USA and another for everyone else’ mentality to the disaster.

American commentators need to look further before singling out BP. Just last month, for example, ExxonMobile spilled one million barrels of oil into the Nigerian delta. I’d wager roughly 0.1% of Americans know or care. According to The Guardian, more oil is lost in Nigeria every year than has been shed so far in the Gulf of Mexico.

And that’s to not be drawn into the murky world of overseas wars waged to secure oil supplies, or even the idea of banning offshore drilling around the US for righteous moral reasons while greedily sucking it in from Brazil, Australia and elsewhere, where the risks are just as great but US college students don’t expect to find sandy white beaches.

Finally, US oil consumption drives the global market. It’s hypocritical to condemn out of hand companies pushing the boundaries to try to fulfill those needs.

None of this means I’m not appalled by the leak. I wrote recently about how ecological disaster is the biggest risk to my wealth. I’ve spent hours reading about the doomed efforts to protect the marshes and wetlands from oil, and ideas they haven’t tried such as digesting the oil by promoting bacterial growth.

In fact, the one good thing to come out of this is that ecological regulations will hopefully be tightened up worldwide.

For instance, why don’t they drill a relief well as standard, just in case? It’s ridiculous we have to wait three months to stop this leak.

The financial case for buying BP shares

Assuming you’ve not got a moral problem with buying BP shares, is there a financial case for doing so? I think there might be.

I’ve written before about how in a crisis the market can overreact to news, and misjudge the long-term impact on the company.

Certainly the news here looks bad. But has the 35% drop in the share price already compensated for this pain?

As of June 3rd, the company is valued at £35 billion less than it was on April 20th. The P/E rating of BP shares (before they were de-rated by the slick) was roughly 11.

One way of reading this is that the market sees BP’s future earnings as being permanently impaired by:

  • £35 bn / 11 = £3.2 billion a year, forever.

In reality of course, the hit to BP’s earnings will be far lumpier. The cleanup has already cost around $1 billion in actual cash. The final bill will be much higher. There will also be the eventual cost of compensating local businesses, legal damages, and potentially even costs for long-term health complications.

I’ve seen estimates of the final cost vary from $1 billion to more than $30 billion. Notably, however, even the highest figure is already in excess of the lost value as per the market cap – approximately $50 billion.

And remember, that’s a high estimate. The Exxon Valdez disaster looked like costing that company a fortune, but the actual amount it has to pay has turned out to be far, far less – around $4.5 billion after appeal. In 1989 dollars, that’s small potatoes. Two decades have passed since then.

I’d hope BP will be brought to account far quicker for the sake of those affected and the region, but it’s still going to take years to sort out.

There are other reasons to think the hit to BP won’t be fatal, too:

Obama is all hot air in the long run

America is a legally driven country, not a dictator state that will throw its toys out of the pram to make an unfair example of one company. BP’s lawyers will be given the opportunity to defend the company. The US will not want to seem unreasonably vindictive, especially in 5-10 years time when all this is forgotten yet the court cases are only just getting resolved. Obama is making a lot of noise because he’s as appalled as anyone else by the catastrophe I’m sure, but also because it costs him nothing.

BP isn’t the only company on the hook

Right now BP is getting all the blame, but it’s only a 65% owner in the Deepwater Horizon rig. Services companies like Transocean and Halliburton will also be taken to the courts – not least by BP – and may end up shouldering some of the costs.

BP can afford to pay

As far as I can tell from its March 31st balance sheet, BP has $7 billion in cash. Knock off maybe $1 billion for the cost so far, and it still has a lot of free cash to play with. It’s also got less debt than some rivals – BP’s gearing is about 23% compared to 35% for Conoco, for example. Despite recent downgrades, it could easily take on £10 billion or so in addition debt to keep its dividend while shouldering further costs.

BP is a vast company

It has other operations that are going well. BP’s upstream operations produce about 4 million barrels of oil a day, while its downstream activities (from refineries to petrol stations) process 2.7 million barrels. Even assuming it’s kicked out of the Gulf, which I don’t think is likely, it’s got plenty else going on to support a valuation well north of 435p per share.

BP shares are surely a buy, albeit risky

If you’re ever going to look at a crisis play, you’ve got to look hard at BP. From the press and political witch hunt to the scale of the disaster to the size of the share price fall, everything here except the ecological impact looks overblown.

And as the ecological impact is always – tragically – the least regarded element to our human folly, I think the shares will end up much higher than 435p. ExxonMobile’s shares are nearly ten-fold higher than when they trashed the Alaskan coast in 1989.

I even think BP’s response to the crisis has been good. Sure there have been some gaffs, but what do you expect when spending $1 billion in barely two months? US politicians should be glad that the company was already trying to rebuild its reputation and has clearly grasped the scale of this crisis in my view. If it had happened to a cheaper, recalcitrant company, they’d know it.

Compare BP’s response to President Bush’s response to Hurricane Katrina. From where I’m standing it seems BP has moved faster, more meaningfully and more transparently than the US government itself did when faced with that natural disaster and had no third-party private company to deal with it.

I’m not suggesting it’s certain BP will recover from here. As I write the well is still gushing oil, and every element of the criminal case as well as the normal corporate investigations are yet to begin. There are many, many unknowns.

But on a risk/return basis, I think the shares look good value.

All that said, I’m not buying BP shares directly myself. I’ve got other individually risky stock picks going on elsewhere (such as Lloyds) and I don’t want to take on another uncertain investment; my trading activities are only a complement to my more passive or long-term investing, and the number of positions I take is not unlimited.

I did however invest significant sums into two income investment trusts earlier this week that each have around 6% of their money into BP shares.

By in buying in when BP shares cost 435p, I expect the trust’s NAVs to rise due because of their BP holdings in time. It’s far from a racing certainty, but on balance BP shares look too cheap to me.

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{ 27 comments… add one }
  • 1 ermine June 4, 2010, 10:25 am

    You did well there. I did the old sell on bad news thing on BP late May, but greed overcame fear and I bought in again, now nursing a 12% loss. I was happy to rebuy after dodging the first 20% fall as I am of a similar view. All Obama’s huffing and puffing is all very well and probably depresses the share price more, but in the end the selloff seems out of kilter with the essentials. If this share weren’t so large a part of my FTSE 100 ETF and AVC tracker holdings, I’d be tempted to be greedy when others are fearful and get some more 🙂
    .-= ermine on: Does Paying People More Get Better Performance? =-.

  • 2 Macs June 4, 2010, 11:22 am

    That is the question which has been rolling around in my mind for the past few weeks, so thanks for posting your thoughts. For sure, I could take a dose of Warren and see that ‘others are being fearful’….

    I’ve had BP down as a ‘possible’ for a while, if only the prices weren’t so high. So maybe this is the best opportunity to buy some cheap dividends, maybe it’s the best opportunity to get seriously burnt fingers….

    As for the morality angle, well, I reckon if you buy the product (and 99.99% of us do, however much we may deplore its effects) then is buying the stock any different? I can see your point in not buying tobacco companies, as a non-smoker. Alas, I am afflicted, but still wouldn’t buy into them!

    I’m in nearly 100% agreement on your thoughts here, the one I might quibble with is the ‘Obama’s all hot air’ statement. From my perspective, I think the biggest risk element is the political angle. Can’t remember where I saw it, but someone was calling for ‘nationalisation’ of BP’s US holdings – which is kind of extreme coming from America! Then there are the Senators demanding BP cease dividend payments, though I don’t know how much influence they really have. I’m also (somewhat cynically, I admit) expecting Halliburton and the other subs to be shielded so BP takes the whack.

    I’d love to know whether Warren Buffett is buying or selling right now 😉

    ps – Meanwhile in conspiracy-land, people are asking ‘Was it really a coincidence that Goldman Sachs sold off $250million in BP stock just prior to the blow-out?’ but maybe that’s StockTickle material?

  • 3 Faustus June 4, 2010, 2:45 pm

    You make a strong case, and it’s one that I agree with, having luckily bought in on Tuesday at 419p. Some analysts had been screaming buy since the blowout occurred in late April, but this seemed foolish given the unpredictability of disasters such as these. Now that the worst case scenario is priced in (barring a terrible hurricane season) of an August solution with the relief well, any potential downside seems limited.

    I’m afraid the so-called moral case doesn’t really wash – as Macs suggests, we all consume BPs product every day without batting an eyelid. Moreover, investors are buying BP shares anyway every time they invest in a FTSE 100 or all-share tracker, or most UK income trusts.

  • 4 Financial Samurai June 5, 2010, 6:42 am

    Really some fantastic analysis Monevator! I was thinking whether BP is a buy as well. On the face of it, it seems over done based on your analysis.

    I wonder what the punitive damages will be. Definitely not 30 bil+ worth!

    Sounds like you have already bought some shares!

  • 5 Aury (Thunderdrake) June 6, 2010, 11:14 pm

    I’ve developed a lot of ire for BP myself. The typical ire that the majority would have. Obviously the environmental damage is what’s got me the most. I haven’t thought about stock participation however.

    But I’ve been extremely tempted to buy put options on the company. Their dividends are pretty attractive I suppose, but I do shamefully admit that morality and emotions have a big role on how I think about BP.
    .-= Aury (Thunderdrake) on: 3 more things you can put in your hoard =-.

  • 6 Andrew Hallam June 8, 2010, 6:45 am

    Monevator:

    I’m curious about this line:

    “Yet if BP can maintain its dividend, the shares look to cheap. Now could be a textbook example of an opportunity to invest in a crisis for profit.”

    Doesn’t the intrinsic business value of BP shares remain the same, whether they are paying dividends or not? Emotionally, yeah, I can see people “thinking” that the company is worth more if it pays a dividend (or in this case, maintains a dividend) but I’m thinking that the business’ intrinsic value would be the same regardless, and that it’s only the emotional perception that would change?

    In some circles (and I know that Buffett thinks like this at times, according to his essays) if a business has a high intrinsic rate of return on total capital, then dividends are something that are taxed twice–once at the corporate level and again at the private shareholder level. As an owner of the business, then, you’re taxed twice.

    I feel that if BP cuts its dividend (instead of maintaining it) the company will be a better buy—because its shares will plummet in value. And then a slew of value investors can sweep up loads of shares. The best buys always make you feel sick to your stomach when you’re making them though, don’t they? Whether BP chooses to reinvest its capital or pay it out shouldn’t really have an immediate effect on the business’ value, should it? And when the market values it downward (if it cuts the dividend) then it becomes a much better buy than if it had kept its dividend. What do you think?

    Cheers,
    Andrew
    .-= Andrew Hallam on: Willie Wonka’s Chocolate Factory and Stock Market Profits =-.

  • 7 The Investor June 8, 2010, 10:40 am

    Hi Andrew, thanks for your thoughts. Sure if BP cuts its dividend and the shares ‘plummet in value’ (you mean price, of course 😉 ) then they will be a better buy. Cheaper is always better!

    But they are partly pricing in a dividend cut already, I think. They are such a massive constituent of professional income investors’ portfolios that any credible confirmation of the dividend’s security would lift the shares up pretty sharpish.

    There’s a long debate about as you say about whether a business should pay out earnings or not (though IIRC Buffett doesn’t pay them but likes receiving them) but if you run a big income fund and you’ve got 5% to pay to your investors every year, it’s somewhat academic! 😉

  • 8 The Investor June 8, 2010, 10:43 am

    @Aury – I don’t think it’s shameful – as I say I’m the same with tobacco stocks! – but I do think it’s illogical.

  • 9 The Investor June 8, 2010, 10:50 am

    @Sam – Thanks! I’ve only bought the shares tangentially, via investing in a couple of income trusts.

    Time will tell – good luck to anyone who does wade in, but remember it’s your decision alone! 🙂

  • 10 The Investor June 8, 2010, 10:53 am

    @Macs – Agree with all that, including the political risk. In fact, if there wasn’t political risk, then the shares would probably be over £5 already.

    However you’ve got to remember that noise does not equal outcome in politics. Think of the barracking the banks received, yet they were paying record bonuses barely a year later. Ultimately the rule of corporate law reigns in the US.

    Also, 40% of BP is (from memory) US owned.

  • 11 The Investor June 8, 2010, 10:54 am

    @ermine – Yes, similar here. I sold my direct holding in BP during my cleanout in March (another fluke result!) and kept RSDB – but I realized that I’ve still got about 2-4% of my net worth riding on the stock via collective vehicles!

  • 12 Financial Samurai June 10, 2010, 7:27 am

    Looks like it’s going to zero now the way things are going!!
    .-= Financial Samurai on: Is Becoming A Millionaire The Rule Rather Than The Exception? =-.

  • 13 roym June 10, 2010, 10:36 am

    damn obama and his ridiculous rhetoric. this is what happens when you have leadership by opinion poll

  • 14 The Investor June 10, 2010, 10:44 am

    The price action has been insane in the past 24 hours. I don’t believe it reflects a fundamental change in the situation (which if anything has approved!)

    There’s no doubt anyone buying in faces a rocky ride of course. This sort of situation can take years to resolve; you can’t buy on value grounds and expect anything else.

    Re Obama, he can rant but has no desire to make US the new Russia. There will be big costs, no one disputes that. The question is whether bp can take it and I think it can.

    Seriously tempting at these levels for the long term IMHO but readers buy at their own risk.

  • 15 Lemondy June 10, 2010, 12:33 pm

    I had my mouse finger over a buy at c.350p this morning but bottled it. My better half laughed at me last night when mentioned I might buy some BP, so I’ll blame her if the rout stops here.

  • 16 Wilmoth Wealth June 10, 2010, 6:50 pm

    I am unfortunately not the savy investor you all seem to be. That being said and out of the way, as an American citizen I am terribly upset about the effect this disaster is having, and will have on the ecological invironment in the Gulf for years to come. Although, I would be lying if I said that the last thing that came to mind was buying BP stock. It was honestly one of my first thoughts. I think that I will wait a bit however, until the share price drops a bit more, and I hope and pray that I haven’t made a serious mistake by holding out. As far as the political side of this: Obama is an idiot that couldn’t tie his own shoes “in my opinion”. Bp, up to this point was reporting profits of nearly 95 million a day. They will come back and their stock share value will rise.

    I do agree however that it may take some time to peak again, but it will peak. I just hope my decision which is driven primarily by greed doesn’t bite me in the rear end for waiting for the share price to fall a bit more before I buy in. as far as the morality issue some of you speak of, I dont see a moral issue in the investment of a company that is in some hot water in more ways than one. This type of investment is an example of an old school saying “Make it or Break it”. This situation is one of which has the ability to make Millions, or lose it all. To me that’s what investing is all about. Grabbing the weak “cheap” and then sit back and wait. I plan to dump a Large sum of money into BP stock, I am going to wait until the bottom drops out and then going for broke. Against my financial advisors advice, I plan to pull out 80% of my investments and put it all into BP, once this all blows over I will be laughing my butt off on a beach somewhere, or I will be working till I’m 125 years old. I honestly don’t see that happening.

    W.W.

  • 17 The Investor June 10, 2010, 9:30 pm

    @W.W. – That’s an incredibly risky strategy, and I wouldn’t recommend it to anyone (this site is NOT about advice, and nothing I write here is to be taken as such).

    I’m heartbroken every time I see pictures on the TV of birds covered in oil etc. I’m absolutely green at heart, and even though I think American citizens seem oblivious to the damage their activities cause elsewhere in the world (I don’t see them banning oil extraction elsewhere, or agreeing en mass to abandon cars, for instance) the people and environment affected still have my sincere sympathy.

    I genuinely think BP is in the middle of the greatest cleanup operation the world has seen, but it won’t be sufficient to make much impact due to the volume of oil coming out, alas. Only time can even hope to cure the situation, and goodness knows what is happening underwater and out of sight. 🙁

  • 18 Len Penzo June 12, 2010, 2:32 am

    Great analysis, Investor! I hope you don’t mind, but I would like to point your readers to a great article over at Control Your Cash that puts the disaster in some much-needed perspective that seems to be lacking by many folks here in the States.

    http://tiny.cc/k91hu

    Best,

    Len
    Len Penzo dot Com
    .-= Len Penzo on: My Store-Brand vs. Name-Brand Blind Taste-Test Experiment #3 =-.

  • 19 The Investor June 12, 2010, 9:24 am

    Thanks Len, and that’s a great rational perspective on the problem.

    Being old (ahem, mid-30s) and benevolent (er, it’s a lovely Saturday morning), I do understand the emotions of the people on the ground affected, and even of the environmental types who see an opportunity to fight Big Oil. Let them have a shout about it.

    What I don’t understand and can’t condone is the rhetoric of the Obama administration. Does he want to shut down America for business? Is the Land of the Free no longer a land of rights, responsibilities, courts and due process?

    I don’t recall a company ever stepping up to the plate like BP has over this so immediately and comprehensively, yet Obama has gone bananas. It makes you wonder what he’d be like in a real crisis (e.g. North Korea). I thought he was supposed to be calm and collected.

  • 20 OldPro June 14, 2010, 3:40 pm

    Good logic but the market things otherwise. With my trackers and income funds all over the shop on BP alone who needs to invest in the shares!

  • 21 The Investor June 15, 2010, 4:29 pm

    10 days on and the situation is getting worse. I have been absolutely amazed at the appalling political posturing from the US over this. I hope it won’t be forgotten.

    So far perhaps 60-100 Olympic swimming pools of oil have been shed into the Gulf of Mexico. 60 too many, but Obama’s comments that it’s the equivalent to 7/11 are beyond the pale.

    With crisis plays you always have to expect to potentially wait years for the situation to resolve itself, but here the bad news has kept coming and the political drama is genuinely frightening.

    I find it hard to believe buying at 350p wouldn’t make you money, except that the US almost seems prepared to throw out due process here. They are acting like Russian politicians.

    The situation has got much riskier here I feel, albeit offset partly by the lower price.

  • 22 The Investor June 16, 2010, 10:44 am

    Interesting chat with a professor of marine law on how much BP may legally have to pay.

  • 23 roym June 17, 2010, 10:07 am

    well, looks like obama is a president with the power to bring companies down.
    does the rule of law no longer apply in the US? how can making post hoc liabilities be allowed?

  • 24 The Investor June 17, 2010, 10:42 am

    @Roym- Agreed, it’s unbelievably un-American. That said, I actually think that last night might have been the bottom for BP, barring the criminal proceedings, at least from a sentiment perspective. The climate is despairing. Presumably BP has threatened to cut the US operation loose, which it can legally do as I understand it as it is ring-fenced. That would not be taken well, but if the option is the whole company being driven into bankruptcy it might be a palatable option – and it would limit what Obama can extract from the company.

    As it is, there’s now money in a slush fund and the dividend suspended for three quarters, which may be a line in the sand. But it is so difficult to tell, especially while the well is still leaking and the relief wells are not yet complete.

    Even environmentally the situation isn’t being seen in perspective. It’s a disaster for those regions affected but the US write large causes more environmental damage every day. The various oil execs turning up at the hearings at the White House in SUVs says it all. Hypocrisy run rampant.

  • 25 OldPro July 12, 2010, 11:19 am

    Looks like the bottom is in on this one now… Yanks to the rescue (Exxon) who would have thunked it?

  • 26 Macs July 12, 2010, 2:32 pm

    Update from Macs Towers: I did buy in eventually, and I’d like to claim great judgment but it just happened to be the day my S&S ISA was finally ready to go when the price was at 302p. Looking back from today’s 390p I’m quite content, which isn’t to say my heart wasn’t in my mouth at the time 🙂

    Also snagging HMV @ 52p was a nice cherry on top. Now to sit back and wait for the ‘long term’.

    And to answer my earlier question: Buffett isn’t buying BP 😉

  • 27 Credit man September 6, 2010, 2:09 pm

    I hope you’re right about the price coming back, I just brought a small amount of stock in BP @ 405p, already slightly up but I am a noob at all this so not sure where it’s going to go!

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