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Peak BP: will Russia spoil the oil giant’s party?

Peak BP: will Russia spoil the oil giant’s party?

Things had been flowing so well for BP. At the end of June, shares in the world’s third-largest energy firm topped 520p – their highest level since the Deepwater Horizon disaster in 2010.

Moreover, in the year to that point in June BP had significantly outperformed the market: up by 7.3% while the FTSE 100 had gained just 0.6%.

But since then all that progress has been wiped out: BP has lost 7% in a month and has now marginally lagged the index in the year to date.

At face value, BP’s quarterly results released last week would not justify this sell-off. The group posted a £2.1 billion profit for the three months, beating market expectations and representing a 34% increase year on year and 13% higher than in the prior quarter. Operating cash flow also jumped by 46% compared with last year, to £4.7 billion, and BP hiked its dividend by 8.3%.

The reason for BP’s sliding share price has more to do with the suite of sanctions imposed on Russia by the US and EU, which target principally the country’s financial sector but also touch on its energy firms. Although oil and gas trading is still permitted, the provision of extraction technology has been curtailed.

This is of greater relevance to BP than others thanks to its direct 20% stake in Rosneft, which is 70% owned by the Russian state. Other oil majors operate instead through joint ventures in the country.

In its update last week, BP specifically warned that ‘any future erosion of our relationship with Rosneft, or the impact of further economic sanctions, could adversely impact our business and strategic objectives in Russia, the level of our income, production and reserves, our investment in Rosneft and our reputation’.

Rosneft is certainly proving a cash cow for BP: it contributed £608 million, or almost a fifth, of BP’s second-quarter profit as well as nearly half of its oil production. In July BP also received a £410 million dividend from Rosneft in respect of its 2013 earnings.

That payout is based on 25% of Rosneft’s profit, so anything that makes it harder for the Russian company to pump oil or makes its financing more expensive would have a direct impact on BP. And that is to make no mention of persistent Yukos hangover, after last week’s court decision in favour of that company’s shareholders who saw their assets absorbed into Rosneft.

So who would continue to hold BP despite such risks? Citywire AAA-rated Martin Walker is one. BP is the third-largest holding, with a 5% weighting, in his £1.2 billion Invesco Perpetual UK Growth fund, which has returned a top-decile 61.2% over the past three years compared with the peer-group average of 32.2%.

‘If that dividend stream was to stop,’ Walker said of the Rosneft cash, ‘it would not be ideal but it is not going to be a huge issue for the cash performance of the business.’ BP’s own dividends, for instance, are amply covered by the group’s non-Rosneft income.

Adrian Frost, AA-rated co-manager of the Artemis Income fund, is also standing by BP. His Citywire Selection fund has returned 40.8% over the past three years, versus the average of 37.3% from his UK Equity Income sector.

‘BP has, partly through necessity and partly through a renewed approach to its portfolio, been stripping out the underperforming areas of its business and driving hard to improve cash flow, with a balance sheet that is only modestly indebted. This is fundamentally an attractive story.’

Walker added that the Rosneft holding was ‘already discounted’ from BP’s share price. Jonathan Jackson, head of equities at Killik, estimates that the Rosneft stake is now valued at around 40p per BP share, down from 46p in February.

Frost notes the discount too. ‘The near 20% holding in Rosneft will obviously be affected by the current sanctions and any worsening of the situation. The market has rightly removed some value from the share price to account for this, yet it remains worried.

‘Assuming the worst case – that there is no value in this shareholding – the Rosneft stake accounts for about 8% of BP’s market value and the profits and dividends are currently only 2% of the company’s cash flow.

‘So in the near term the Russian situation would not restrict BP’s ability to pay a high and rising dividend. From our perspective, we see the newspaper headlines as being disproportionate to the negative impact on BP.’

For Walker, then, the current fright reflects too short term an attitude. ‘I suspect BP will be taking a long view on this,’ he commented, with a timeframe extending past 2020.

In the meantime BP should benefit from a stable pool of income-orientated shareholders, the expected strengthening of the dollar, and the fact that by dealing in oil it offers what Walker terms ‘a natural hedge’ against any market volatility.

It is furthermore now very conservatively managed, being ‘very focused’ on shareholder value and with a net debt ratio of around 15% – down from a historic range above 20% – that in Walker’s opinion is ‘testament to the hard asset backing of an oil major’.

Jackson too rates BP a buy, while acknowledging that ‘the situation in Russia needs to be watched’. He argued: ‘The shares currently trade on a discount to net asset value, offer an attractive 4.7% prospective dividend yield, and are being supported by the share buyback programme.’ Jackson observed too that there was ‘plenty of scope for the group to accelerate dividend growth further’.

In any case, Walker notes that a business which can survive the Gulf of Mexico oil spill – which has cost it £26 billion so far – without having to raise equity is a remarkably robust one.

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