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Morningstar | BP's 3Q Earnings Soar on Higher Oil Prices, Outlook Remains Positive; Shares Undervalued

The combination of BP's reduced cost base and the rise in oil and gas prices during the third quarter led to a doubling in earnings to $3.8 billion from $1.9 billion a year ago.

Despite the increase in earnings, operating cash flow excluding Gulf of Mexico payments was flat at $6.6 billion because of a buildup in working capital. Year to date, operating cash flow totals $19.0 billion compared with $17.9 billion during the same period last year. Importantly, capital spending is running below last year’s levels as management has cited continued cost deflation despite the increase in oil prices. Guidance for full-year spending of $15 billion with spending of $15 billion-$17 billion in the next couple of years is unchanged. We continue to expect growing free cash flow in future years as capital spending holds around current levels and cash flow generation increases with production growth and margin expansion. Our fair value estimate and moat rating are unchanged, leaving the shares undervalued, in our view.

The strong cash flow generation over the last year has prompted management to complete the previously announced BHP acquisition with cash as opposed to issuing equity for half of the $10.5 billion purchase price. The decision might result in gearing ratios increasing slightly above the targeted 20%-30% range in the near term, but the $5 billion-$6 billion in divestments associated with the transaction will go toward debt repayment, reducing leverage over time.

The increase in earnings was concentrated in the upstream segment, as earnings rose to $4.0 billion from $1.6 billion a year ago thanks to the higher prices. Production volumes remained flat at 2.5 million barrels of oil equivalent per day, but excluding the effects of production sharing and divestments increased nearly 7% due to new project startups. BP holds a strong set of projects currently under development, which we expect should deliver average growth of about 5% during the next five years. Higher prices also translated into higher Rosneft earnings of $872 million compared with $137 million a year ago.

Downstream earnings remained strong but slipped slightly to $2.1 billion from $2.3 billion last year as weakness in refining product margins and turnaround activity offset the benefit of wide North American heavy crude differentials. Earnings are likely to weaken further in the fourth quarter as margins weaken seasonally and the Whiting refinery undergoes a major turnaround. Long term, BP’s downstream segment remains well positioned with high-quality refining asset based and marketing earnings growth opportunities.