BP (LSE: BP) shares are trading at a post-Macondo high and have gained more than 16% of their value just since early March. Could they reach 600p by the end of the year, amid a recovery in oil prices and a sharp improvement in profitability?
Recovery in profits
Driven by growth in production and cost savings, profits have staged a dramatic recovery. Underlying replacement cost profit, the company’s preferred measure, came in at $2.6bn in the first quarter of 2018. It’s the highest level for almost three years, and represents a rise of 71% on the same period last year.
Meanwhile, upstream profits have recovered even faster — they are at their highest since Q3 2014, back when oil traded at roughly $100 a barrel. And looking ahead, further gains could still be to come as BP has yet to fully realise the benefit of the recovery in crude oil prices.
Analysts from Goldman Sachs reckon it will benefit from new oil and gas projects coming into production over the next few years, which would add significantly to profits and cash flows. It also believes its portfolio of new projects is more profitable today with Brent at $60 a barrel than it was when oil traded at around $100 a barrel. The investment bank has given BP shares a price target of 640p.
Downside risks
Certainly, much has changed for the company, but there are also a few downside risks to bear in mind. Total costs relating to the Deepwater Horizon oil spill in 2010 are set to soar to more than $65bn, while spill-related payments continue to eat into cash flows. And net debt remains higher than many analysts want to see, delaying any further increase to shareholder payouts.
The biggest concern is whether oil prices could slip again. Production growth is surging on higher crude prices, and there are additional fears on the demand side. Rising US crude stockpiles have been fuelling concerns of a slowdown in demand growth and the risk of a global trade war is an additional source of uncertainty.
Smaller upstream plays
Instead, it may be worth looking at some smaller upstream energy stocks, such as Cairn Energy (LSE: CNE), which may have even more upside potential if the oil rally is sustained. Upstream pureplays should have more to gain from higher oil prices, yet many such companies continue to trade at a discount to the oil majors.
Cairn Energy is particularly worth a closer look because the company could be set be benefit from a few bullish catalysts. The issue that is most keenly watched by investors is probably its Indian tax dispute. The final hearing of the case is set to take place in August and a successful outcome could see the company return a very significant windfall to shareholders.
Developments in the UK North Sea are also going well, with a ramp up in production expected to add significantly to cash flows going forward. Of course, there’s also a great deal of operational and exploration risk involved with the company, but unlike many of its peers in mid-cap E&P space, Cairn has a very solid balance sheet and is almost debt-free.
