BP (LSE: BP) shares have fallen by 28% over the last year.
Except for a brief spike down in 2010 following the Gulf of Mexico disaster, BP shares are now cheaper than they’ve been since October 1996.
Are things really that bad, or is BP now a screaming buy?
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In this article I’ll explain why I think there’s a good chance that BP shares could deliver big gains in coming years, and could potentially double in value.
Earning power
BP’s earnings are inevitably linked to the oil price. As such, they tend to vary widely. This means that looking at one or two years only can be misleading.
An alternative way of looking at BP’s valuation is to divide the current share price by BP’s ten-year average earnings per share. This ratio is known as the PE10. It’s useful for getting an idea of whether BP shares are cheap compared to the firm’s long-term average profits.
I’ve crunched the numbers, and BP currently trades on a PE10 of just 5.5.
The reason this is so low is that BP’s earnings are currently well below their ten-year average of 61p per share.
If BP’s earnings move back towards their historical average and the shares maintain a P/E ratio of about 10, then the shares could climb to more than 600p. That’s 78% higher than today’s share price.
What about the dividend?
Another issue holding back BP’s share price is uncertainty over whether the dividend will be cut.
BP shares currently offer a prospective yield of 7.7%. That’s too high to be sustainable — either the payout will be cut, or the share price will rise.
My view is that a dividend cut is unlikely, unless oil market conditions fail to improve in 2016.
I suspect that things will improve moderately, and BP will maintain its dividend. If I’m right, I’d expect BP shares to gradually rise, bringing the dividend yield down to a more normal level.
This could generate some big gains. Based on BP’s 2015 forecast dividend of $0.41, a 5% yield would equate to a share price of around 525p, 55% higher than today’s price.
Costs are falling
The price of oil is unlikely to return to $100 anytime soon, in my view. But BP’s profits don’t only depend on the oil price.
The firm’s operating costs and capital expenditure are also a big factor in its profitability. Many of the firm’s costs, such as labour and drilling rig hire, are falling fast. The IHS Upstream Capital Cost Index, an industry index which measures the cost of producing oil, has fallen by 15% so far this year. Further falls are expected.
As one of the global supermajors, BP sits at the top of the oil industry food chain. It has terrific negotiating power with its suppliers.
I expect that from 2016 onwards, we’ll start to see the full benefits of lower costs and reduced spending feed through to BP’s profits.
There’s one more thing
The Gulf of Mexico oil spill has cost BP around $55bn.
Following this year’s settlement deal, that cash outflow should finally start to slow. This should help BP’s profits and its cash flow, making it easier for the firm to maintain the planned dividend payment.
