Until recently, I firmly believed that BP (LSE: BP) (NYSE: BP.US) offered the potential for significant gains, when the legal and financial consequences of the Gulf of Mexico oil spill are finally resolved.
However, I’m beginning to question my original judgement, and, as a BP shareholder, I’m not sure the balance of risk and potential reward is in BP’s favour anymore. Let me explain.
Flat output
BP, like its UK peer Royal Dutch Shell, is shifting its strategy away from outright production growth and towards a focus on improved cash flow and shareholder returns.
Given this, it’s no surprise that BP expects full-year production to be down on 2012, although it does expect growth in underlying production, which excludes the impact of divestments.
This means that future profit growth will rely on high oil prices, and high-cost new developments, and will be slow and steady, at best.
Legal risk vs. valuation
BP may yet be found guilty of gross negligence in the Gulf of Mexico spill, which could result in a fine of more than $20bn, for violations of the US Clean Water Act. Even in a best-case scenario, the firm faces a fine of $3bn – $5bn, as well as the escalating costs from a controversial compensation scheme, which it has so far failed to halt.
BP’s original $20bn oil spill trust fund was down to just $300m at the end of the second quarter, meaning that most future payments will come directly out of the firm’s profits.
Given this potential downside, I’d expect BP shares to trade at something of a discount to peers such as Shell, but they don’t, as the figures in the table below show:
| Â | BP | Shell |
|---|---|---|
| Trailing P/E | 9.2 | 9.1 |
| Trailing yield | 5.1% | 5.1% |
| 2013 forecast P/E | 9.0 | 8.8 |
| 2013 forecast yield | 5.3% | 5.4% |
Source: Company results and analysts’ consensus forecasts
BP and Shell currently enjoy near-identical P/E ratings and yields. To me, this suggests that institutional investors and City analysts do not believe that BP will be found guilty of gross negligence for the oil spill, and are willing to bet on it.
If they’re right, then it’s probably true that BP will be able to pay out the remaining costs from its profits and cash reserves, without any significant impact on debt levels or dividend payments. However, if this gamble goes wrong, then I reckon BP’s share price could take a bath.
However you look at it, the potential rewards of owning shares in Shell seem nearly identical to those offered by BP, but without the extra risk.