Has BP hit the ‘sweet spot’ with investors?

BP has unveiled its biggest acquisition since the Deepwater Horizon oil spill, which has held back the company’s ability to grow over recent years. With the deal providing immediate growth in important regions onshore the US, and being coupled with higher returns, is BP finally hitting that sweet spot?

BP
Source: Bloomberg

‘This is a significant moment for BP – it is the largest acquisition we have made in almost 20 years,’ – BP chief executive Bob Dudley.

BP has struck a landmark deal to catch up with its rivals tapping oil and gas in the US after recovering from the Deepwater Horizon oil spill. The oil giant has been held back since the crisis in 2010 but with the total cost nearing $70 billion, BP knows it is over the worst of it and is now making up for lost time.

BP is purchasing virtually all of BHP Billiton’s onshore oil and gas business in the US for $10.5 billion, outbidding rivals including Royal Dutch Shell and Chevron to capture a group of producing assets spread across three basins. The move will be a major boost in BP’s efforts to close the gap after falling behind in the race for acreage in the US, as higher oil prices and better technology spark an aggressive competition amongst oil majors that had previously invested only limited amounts in US shale.

For BHP, the sale will hopefully draw a line under the tensions with some of its shareholders, led by activist investor Elliot Management, who convinced the company to place its oil and gas assets up for sale late last year after arguing it didn’t fit into its primarily mining-focused portfolio.

Read more about activist investors and how they work

BHP vowed to be patient and ensure it got the right price, but having bet big on US shale by spending $20 billion on the assets when oil prices were riding high at $100 a barrel, and the fact the assets carried a value of almost $14 billion, questions may remain over the deal itself. BHP plans to return the proceeds of the deal to shareholders, with a decision on how expected shortly. However, some have argued that BHP’s decision not to reinvest the funds shows there is a lack of compelling mining opportunities for the company (and possibly the wider industry) to pursue.

Read more about our guide to activist investors and how to use them in your trading strategy

BP spends $10.5 billion to catch up in race for US shale?

BP hopes to close the deal by the end of October, when it will pay $5.25 billion in cash up front, with the remainder deferred over the following six months.

Importantly, BP intends to fund the deferred consideration by raising equity, which it then intends to offset by buying back shares using the money it makes from selling off more of its own upstream assets.

The company is already running a programme that is seeing $2 billion-$3 billion of assets being sold off each year, and this will continue going forward. But following the BHP deal the company intends to significantly reform its upstream portfolio by selling an additional $5 billion to $6 billion worth of operations.

The cash generated from these additional asset sales will be used to conduct share buybacks, repurchasing stock to counter the shares it will issue to raise the funds to pay the deferred half of the total consideration. BP has continued with its existing share buybacks, having bought $200 million worth of stock in the first six months of 2018.

However, the firm has said that it may look to fund the deferred consideration another way, if a window of opportunity presents itself during the six months after the deal is completed, boasting of its flexibility. One possible alternative that BP could consider is utilising the 1.5 billion shares that it has stashed away in its treasury that it could sell to the market. Still, some wonder why BP doesn’t turn to short-term debt to bridge the gap between buying BHP’s assets and selling off others, but the company has admitted that it is looking to make the additional $5 billion-$6 billion of divestments over time. This suggests that it is either being patient to squeeze out the maximum value or is not overly confident about how long it will take to offload them.

BP hikes dividend for first time in nearly four years and prepares for share buybacks

Following BP’s positive interim results, days after announcing the BHP deal, BP’s chief financial officer Brian Gilvary said BP was ‘hitting that sweet spot’ with investors. After almost four years of dealing with stagnate dividend pay-outs while some of its competitors grew shareholder returns, BP investors have finally been rewarded.

To demonstrate its confidence behind its new assets and the prospects they offer, BP raised its second quarter (Q2) dividend by 2.5% to 10.25 cents, representing the first lift in 15 quarters. With buybacks already in the pipeline, shareholders finally have a reason to get excited about growing returns from BP, especially as the company said it would even consider ‘further buybacks’ should the business find itself sitting on surplus cash.

BP and Lower 48: building US onshore production and improving product mix

‘In a move that will upgrade and materially reposition its US onshore oil and gas business, BP has agreed to acquire a portfolio of world-class unconventional oil and gas assets from BHP. The acquisition will bring BP extensive oil and gas production and resources in the liquids-rich regions of the Permian and Eagle Ford basins in Texas and in the Haynesville gas basin in Texas and Louisiana,’ – BP.

BP plans to integrate its new assets with its existing operations onshore the US. BP separated its onshore US business four years ago and named it ‘Lower 48’ in the hope it could improve at a quicker rate after discovering independent drillers that have long dominated the US shale space were extracting resources far more efficiently.

Lower 48 has made significant progress in its time, having slashed the cost of both production and development by over one-third with less than half the amount of employees.

Track record of performance chart

Technology has played a big part in the Lower 48’s performance, allowing it to improve efficiency while cutting jobs. Drilling has also become more factory-like, to make new wells more economic. US shale has boomed over recent years and is on the cusp of turning the country from being reliant on imports to one that can export. The current drive has been producing oil, where the US is forecast to add half of the world’s new oil capacity over the next five years. This has been thanks to new technology and more attractive economics encouraging the entry of oil majors that have transformed an industry which has traditionally been fragmented.

But while its rivals have been expanding their footprints in the US and building out their oil portfolios BP has, until now, been unable to effectively compete in an increasingly competitive mergers and acquisition (M&A) environment. Lower 48 predominantly produces gas at present, with just 10,000 barrels of oil being pumped out daily.

The new assets will rebalance the company’s product mix. Of BP’s total production onshore the US at present, 86% is gas with the other 14% being liquids (mostly oil). Meanwhile, 83% of its resources in the ground were gas versus just 17% liquids. After integrating BHP’s assets, BP’s output will comprise of 73% gas and 27% liquids and its resource base will be made up of 71% gas and 29% liquids. The firm’s current resources onshore the US stand at 8.1 billion barrels of oil equivalent (boe) and the BHP assets will add a further 4.6 billion barrels. Overall, it suggests that the new operations will hold about 10% of BP’s total resources.

The deal is transformational for BP and makes the area a new heartland for the business. The firm is ambitious with its plans to grow oil output in order to catch up with its rivals, with plans to grow those 10,000 barrels being produced each day to 200,000 barrels daily ‘by the middle of the next decade’.

BP boosts daily production by 190,000 barrels with plans for more

BP currently produces 3.6 million boe per day, with 744,000 barrels coming from its US operations: with the Gulf of Mexico contributing 320,000 barrels, Alaska 109,000 barrels and its US onshore operations 315,000 barrels. That means its US operations as a whole account for about 21% of BP’s global production, with US onshore accounting for just 8.8%. After the new assets have been integrated (and taking into account anticipated asset sales in Alaska), BP will produce 25% of all its oil and gas from the US, with onshore operations contributing at least half of that.  

The acquisition pushes shale to the forefront of its portfolio and will make BP a formidable player onshore the US alongside other major players like Exxon Mobil, Chesapeake Energy, Whiting Petroleum, Devon Energy, Anadarko Petroleum and Pioneer Natural Resources, to name a few.

BP was already working toward a target of growing annual production by 5% out to 2021 but has said the new BHP assets will be accretive to that, essentially representing a cautious upgrade to guidance.

BP to start with the Eagle Ford but eyes Permian for longer-term growth

‘Returns in the Eagle Ford that we’ve got today are probably higher than they are in the Permian, and that’s where we will direct a lot of the capital on day one,’ – BP.

BP’s new assets are located over three prominent basins in the US, where the speed of development will differ. It provides the opportunity to improve the operations through economies of scale. The immediate job will be to make the new assets profitable, having booked an $800 million pre-tax loss in the 12 months to the end of the June 2018.

The addition of BHP’s assets in the Haynesville basin will double BP’s existing production from 60,000 barrels of oil equivalent per day (boepd) to 120,000 boepd (all gas), triple its acreage and add a further 720 gross drilling locations in East Texas and Louisiana.

The plan at Eagle Ford is similar and where most of BP’s initial attention will be focused. BP plans to apply new drilling techniques to make the operations more profitable and yield synergies by combining them with its existing assets.

As for the assets in the Permian, BP plans to start seriously stepping up its work over the next couple of years to allow new infrastructure to come online, with the area regarded as the most attractive basin for longer-term growth. Although the Permian assets are already producing, this area will be a longer-term focus for BP, which says the acquisition means it has ‘a deep and highly-economic inventory for future drilling’.

There is a severe lack of pipeline and other infrastructure capacity in the Permian, but BP expects new capacity to come online over the ‘next one to two years’. In the meantime, the business plans to shift its initial attention to the Eagle Ford.

Read more about what moves oil markets

BP trumped its Permian expansion by stating its new acreage, centred in one of the 27 counties that span the basin named Reeves County, is ‘in the core of the core’, claiming 72 out of the 500 rigs in the Permian are concentrated in the area. That too demonstrates the prominence of the Permian as a whole, bearing in mind there are thought to be 1000 active rigs onshore the US as a whole at present.

BP believes purchase of US midstream assets underappreciated

‘I think (midstream) is a part of the story that may not have been captured externally as we see it,’ – BP.

On the point of infrastructure, attention on BP’s landmark deal has been focused on the producing assets and the wider potential of the acreage it has acquired, but the firm is also snapping up some midstream assets as part of the purchase, which it thinks has been underappreciated by the market.

The company said it was securing a thousand miles of oil and gas and water gathering systems as well as five gas facilities, the majority of which is held under a joint venture with Kinder Morgan in the Eagle Ford. However, it has also bought some gas and water pipelines in the infrastructure-starved Permian.

BP said these midstream assets are ‘extremely valuable pieces of infrastructure’ that demonstrates the ‘valuation brick’ of the deal.

BP sets conservative cost synergy target of $350 million

‘This is delivered in the near term with the addition to our portfolio of producing upstream assets alongside a valuable midstream asset position in the Permian and Eagle Ford basins,’ – BP.

Overall, BP is aiming to deliver annual cost synergies of at least $350 million once it has integrated its new assets into it existing operations, although it admits this is a very conservative number to suggest cost savings and revenue improvements could be far greater than currently anticipated.

BP certainly expects those synergies to be higher over the longer term, stating that it sees potential to squeeze further value out of the assets by drilling for new resources.

BP confident it can stay within financial framework despite splashing out

‘The financial repositioning we have delivered in recent years and the confidence we have in our outlook for free cash flow allow us to take this extremely attractive opportunity now without any adjustment to our financial frame. This is fully consistent with our commitment to financial discipline and creating value for shareholders. With our planned additional divestments and buybacks, we expect to deliver this major step forward for a net investment of around $5 billion,’ – Brian Gilvary.

BP has also been conservative when it comes to the price assumptions it had used when calculating the value of the deal, basing it on a WTI price of $55 per barrel, a Midland discount of $7 per barrel in the near term (Midland is a type of WTI that trades at a discount), and a Henry Hub gas price of $2.75 per million British thermal units (BTU). WTI has not traded at that level since late last year and has comfortably remained over the $65 mark for most of 2018, while the average discount to Midland was just over $10 in May, implying that BP believes this discount will narrow as infrastructure and capacity comes online. Henry Hub prices currently stand at about $2.75 per BTU.

Learn more about how to trade oil

At the bottom line, this means the company can take advantage of further upside at higher prices, like now, but fall back onto a cushion should oil prices decline.

The oil giant has not had to shake up its financial framework in order to complete the deal, which will be a boost to earnings immediately and contribute an additional $1 billion of free cash flow by 2021, to take the total to $14 to $15 billion. The purchase is ‘fully accommodated’ within its existing financial plans, BP says, highlighting that the price actually works out to be a net investment of only $5 billion, taking its plans to sell off assets into account.

Learn more about the history of crude oil

Annual organic capital expenditure will remain between $15 billion-$17 billion per year to 2021 as previously guided, and gearing will stay between 20%-30%. Gearing stood at 27.8% at the end of June.

Organic capex has been falling as BP’s cost efficiency improves. In addition to lowering the cost of drilling new wells, the company is also bringing major new projects online at well below cost, typically 15%-20% under budget. Its new Shah Deniz 2, one of the largest projects in the world, is currently on track to be completed at 20%-25% lower than estimated, and it is aiming to halve the well costs in the Gulf of Mexico in the short term.

BP currently ploughs about $1 billion each year into its onshore US operations but following the acquisition it expects this to rise to $2 billion-$3 billion annually over the next few years, which it believes it can accommodate within its existing organic capex budget.

Is BP about to rise above the rest after years of being held back?

BP has managed to keep up with its peers over recent years, despite the costly Deepwater Horizon oil spill which has held back its ability to grow and step up shareholder returns as many would have liked. But BP shareholders should look to the future with optimism following the latest developments.

The purchase should give investors the confidence that BP is now free from the shackles that had limited its M&A muscles, and that it is able to secure the assets it needs to provide both short and long-term growth, and that returns are heading on an upward trajectory after it made the first lift to the dividend in years.

BP has made assurances that it can accommodate such a large acquisition without breaking from its existing financial framework. But the fact it has based that on setting itself some conservative targets suggests there is the possibility of even further upside to the deal than BP has already guided to.

However, some believe BP could look to spin-off the Lower 48 business onshore the US due to the unit’s success since being separated out. This is not uncommon for natural resource companies but BP told analysts that it is very comfortable retaining full ownership of Lower 48. While that is not on the cards for now, it will be a question that investors will revisit once the new assets have been fully integrated.

BP shares have outperformed both the FTSE 350 Oil & Gas Producers Sector Index and its closest rival Shell over the past 12 months and since the start of 2018. In fact, BP has outperformed all Big Five oil producers over the same time periods, apart from French firm Total, with US producers ExxonMobil and Chevron both having actually lost ground since the start of the year.

Read more about whether the good times are back for the Big Oil and the oil industry

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.

Find articles by analysts