Should You Buy BP Shares? The Oil Giant Looks Cheap, But Approach With Caution

A lot has changed over the past year and a half. Oil demand has spiked and supply is struggling to catch up. The war in Ukraine has only added fuel to the fire, igniting what has to be one of the biggest ever U-turns in global energy policy.

Only a couple of months ago, policymakers were setting out plans to reduce global hydrocarbon production for good, but now they’re rushing to drive up supply. US president Joe Biden has recently reversed his decision to ban drilling for oil and gas on federal land while here in the UK, the government’s flagship energy policy contains new targets for drilling in the North Sea.

It is going to take months if not years for supply to match the world’s seemingly insatiable demand for hydrocarbons. Even major swing producers – namely the Opec cartel – are struggling to ramp up output despite higher production targets.

The supply and demand imbalance has sent prices surging

Global oil and gas markets have responded the only way free markets know how when demand outweighs supply – prices have spiked.

The Brent crude oil benchmark has jumped by 70% in just a few months, returning to levels not seen since 2014. Meanwhile, natural gas prices in the US are up by nearly 200% in the past 12 months (while in the UK and European markets prices have risen by 230% and 340% respectively – gas is not a global market).

In this environment it is not surprising that BP and its Big Oil peers are minting cash. Last year, the firm announced its highest profit in eight years and Factset broker projections are currently estimating a 42% jump in income for 2022. Shell’s (LSE: SHEL) earnings look likely to rise by about a third this year.

However, despite BP’s outstanding fundamentals, the stock’s performance on any timeline longer than 12 months leaves a lot to be desired. The shares have charged higher by 37% on a total return basis over the past year, but over the past decade, they’ve yielded a miserly total return of 3.9% per annum compared to 7.1% for the FTSE All-Share.

Investors should not overlook BP’s progress

BP is not the organisation it was the last time the price of Brent crude was above $100 a barrel. Its return on average capital employed (ROACE) – the company’s preferred measure of operating performance – hit 12.1% in 2021 compared to 9.9% eight years ago.

The company has also moved on from the 2010 Gulf of Mexico disaster, reduced its debt and outlined a plan to reduce its exposure to oil and gas by boosting renewable energy output.

Still, at face value, the stock does not seem to reflect the company’s improving trading performance. Shares in BP are selling at a forward price-to-earnings ratio (P/E) of 7.2 while shares in Shell command a valuation of just 6.5.

However, these figures need to be put into perspective. Both companies are generating bumper profits, and there is no guarantee this will last. From a different perspective, BP is trading at a trailing 12-month p/e of 14.1, roughly inline with its five-year average. Shell’s historical valuation is similar.

They’re making money today, but investors shouldn’t forget the fact that these two businesses jointly announced some of the largest losses in British corporate history in 2020 after the price of oil briefly turned negative. And these hefty losses forced both companies to reduce their shareholder payouts, underlining the fragile nature of oil company dividends.

A constant struggle to maintain output and maintain profits

Oil and gas producers face a constant struggle to maintain production. An oil well requires continual investment to maintain production, and sooner or later, the well will run dry. BP and its peers are always looking for new prospects and this costs huge amounts of money.

Last year, BP’s capital spending totalled $13bn and in 2020, the company had to spend $14bn, far more than the earnings generated from selling oil and gas in the first place. These figures illustrate the biggest issue these operators face: the need to keep investing and keep spending even if oil prices collapse.

BP and its peers are also having to invest large sums of money in developing green energy projects. These projects are not going to produce returns immediately, and could prove to be a drag on profits for years to come, only adding to the uncertainty for these enterprises.

As such, while shares in Shell and BP do look cheap at first glance, investors need to carefully consider where these businesses are heading and the challenges they may face going forward.

Windfall oil profits may only be temporary, while capital spending obligations are forever. These businesses might have a central role to play in the global economy, but that does not mean they should have a central role in investors’ portfolios.

Source: Should you buy BP shares? The oil giant looks cheap, but approach with caution | MoneyWeek

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