When I think of oil major BP (LSE: BP) (NYSE: BP.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.
1) Operational risk
Health and Safety is a big issue at BP and no wonder, the company’s operations are inherently dangerous. In a worst-case style outcome, the Gulf of Mexico blowout disaster of 2010 shows the world what can happen when things go wrong: loss of human and animal life, environmental pollution, and almost devastating on-going financial consequences for BP. Since the disaster occurred, BP has stumped up some £42.7 billion to service costs related to the oil spill, yet claims keep coming in, and multiple litigation against BP lumbers on. The share price has yet to recover to its pre-Gulf-crisis levels almost four years after the event.
There’s no doubt that the Gulf-of-Mexico disaster was a body blow for BP, but the frightening thing is that no matter how careful the firm is with its operations, a similar disaster could happen again, any time, any where. When you’re dealing with the forces of nature, outcomes can be unexpected. That’s one reason that BP’s share price will never trade at a high P/E rating. The share price is accounting for the risks.
2) Commodity pricing
Oil and gas producers need an economic prevailing market price for the end commodity if they are to show a profit return. The trouble is that firms like BP have little influence over market rates, which tend to follow the laws of whole-world supply and demand equations.
Those are onerous terms of business. You wouldn’t want to start a factory producing goods over which you had no control of selling price. Under such conditions, it could be uncertain whether you would cover your costs, never mind make a profit.
All commodity producers operate like that. The industry is characterised by undifferentiated products between companies, little pricing power, and variable output prices. The best that resource companies can do to optimise their returns is to allocate asset investment in accordance with supply and demand cycles such that money is put to work when the pricing environment is favourable and trimmed back when pricing is low.
Happily, the price of oil has been high for some time, which encourages firms like BP to plough money back into oil exploration. However, commodity pricing is another reason that BP’s share price rarely trades on a high multiple to profit.
What now?
Despite such concerns, BP’s forward dividend yield is running at about 5.2% for 2015, which looks attractive. However, I’m mindful of the cyclicality inherent in the oil industry, which could hold back the firm’s share-price progress.