In the previous update, I covered highlights of Chevron’s (NYSE: CVX) earnings and dissected the company’s cash flow. In this article, I will do the same for portfolio holding BP (NYSE: BP).

BP and Royal Dutch Shell (NYSE: RDS-A) both have dividends around the 7% mark, and the sustainability of these dividends has been questioned. BP raised eyebrows following the previous quarter’s earnings release when the company said it needed $60/bbl oil prices to break even. Given that oil just broke back below $50/bbl, that looks like a problem for the company. So let’s see how they did in Q1, with oil prices averaging in the low $50s. 

For Q1 2017, BP reported revenue of $55.86 billion, which beat analysts’ consensus estimates by nearly 12%. Revenue was 44% higher than for Q1 2016. The company reported net income of $1.51 billion, which topped analysts’ expectations by 20% (and versus a loss of $583 million in Q1 2016).

Total hydrocarbon production increased from 2.32 million barrels of oil equivalent (BOE) per day in Q1 2016 to 2.39 million BOE/day in Q1 2017. The increase was driven primarily by higher oil production, which was partially offset by lower natural gas production. 

Overall, it looked like a solid quarter, but there was one area of concern. The company continues to have a cash flow deficit:

At first glance, the gap doesn’t appear to be that bad, and it looks much improved over last year’s deficit. In fact, BP reported that “underlying cash flow” increased from $3.0 billion in Q1 2016 to $4.4 billion in 2017. Over the same timeframe, organic capital expenditures fell from $4.5 billion to $3.5 billion. Add in the $1.3 billion in dividends paid out during the recent quarter, and BP comes close to closing the gap between the cash coming in and the cash going out.

That is until we see the line item for the Gulf of Mexico oil spill. BP had to pay out $2.3 billion in Q1 to satisfy its obligations for damage caused by the 2010 Deepwater Horizon disaster. That created a funding shortage that the company had to fill by issuing more debt. BP is targeting net debt of 20-30% and indicated that at the end of Q1 2017 its net debt was $38.6 billion, or 28%. 

What does this mean going forward for BP? For the full-year 2017, BP expects to make about $16 billion of capital expenditures and another $5 billion on Gulf of Mexico oil spill payments. It also plans to divest about $5 billion in assets. The company expects to make approximately the same level of capital expenditures from 2018-2021 and continue to divest $2-3 billion in assets a year. Deepwater Horizon payments will fall to $2 billion in 2018 and then will step down after that. 

BP’s stated objective is to continue to pay the dividend from underlying cash flow while keeping net debt in the 20-30% range. Asset sales should approximately cover the Gulf spill liabilities, at the expense of becoming a smaller company. 

BP has seven project start-ups planned for this year, which they expect to help drive increasing cash flow during the second half of the year. The company expects to add more than one million barrels per day of new oil equivalent production by 2021.

The ongoing liability from the Deepwater Horizon spill is a known, but it continues to weigh on BP’s share price. This liability has resulted in incredibly cheap proved reserves for BP compared to its competitors. That brings me to a point I have made previously. If you take ExxonMobil’s (NYSE: XOM) enterprise value (EV) and divide that by its proved reserves, you get $19.60/bbl. For Chevron, it’s $21.48/bbl. Shell’s comes to $22.31, and Total’s (NYSE: TOT) is $17.18. 

Do the same exercise for BP and you get $8.57/bbl. Thus, you could buy BP, get its reserves for $8.57/bbl, and as a bonus get its massive downstream assets for free.   

Of course, these cheap reserves have not escaped the attention of BP’s larger peers. It is certainly an attractive takeover candidate, especially now that the Gulf spill liability is a known. A takeover would be a challenge due to its size, potential opposition from the British government and antitrust concerns. However, the value is there. BP’s discount to its peers is simply too large to last.

BP’s twelve-month total return of 15.4% is the best of its peers. The 7% dividend looks safe for now based on the company’s guidance and assuming oil prices don’t spend most of the year under $50/bbl. The company remains a takeover candidate due to its deep discount, with the caveat that it would be a challenging bite to swallow. BP remains a Buy for conservative investors up to $42. 

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