BP (LSE: BP.) shares have lost ground as oil prices slide following the Iran ceasefire agreement. That’s hardly surprising. With the immediate threat to Middle Eastern supply fading, investors have quickly removed much of the risk premium built into crude prices.
However, I think the market may be looking in the wrong place. The bigger story isn’t geopolitics — it’s whether global oil supplies are as comfortable as many currently believe.
The market may be too relaxed
The ceasefire agreement has undoubtedly reduced immediate concerns over Middle Eastern supply disruptions. But I think investors may be overlooking a more important issue.
Over the past few years, one of the world’s largest emergency oil buffers has been steadily depleted. The US Strategic Petroleum Reserve (SPR) remains near levels not seen since the early 1980s after hundreds of millions of barrels were released to help stabilise energy markets and keep fuel prices under control.
That mattered. Every barrel released from the SPR effectively added supply to the market at a time when governments were trying to limit the impact of higher energy costs on consumers.
Today however, that cushion is far smaller.
More importantly, lower oil prices create their own problem. Producers only invest in new drilling when expected returns justify the capital required. If prices remain too low for too long, future supply growth can quickly become constrained.
That’s why I’m not convinced the recent fall in oil prices tells the whole story. While the market is celebrating the disappearance of a geopolitical risk premium, it may be underestimating how tight the underlying supply picture remains.
Why BP stands out
If I’m right that oil markets remain tighter than investors currently expect, then asset quality becomes increasingly important.
This is where BP stands out.
While the market still tends to view it as a broad-based oil major, the company has spent recent years concentrating its portfolio around a smaller number of high-quality assets. Its US operations are particularly attractive, spanning both onshore production through its bpx operation and offshore developments in the Gulf of Mexico.
Beyond the US, BP retains strong positions in regions such as the Middle East and Azerbaijan while continuing to dispose of non-core assets. The result is a portfolio increasingly focused on long-life, lower-cost production hubs capable of generating attractive returns across the commodity cycle.
In my view, the market still values BP largely as an oil price play. But if supply remains tighter than investors expect, the quality of its asset base could become increasingly important.
What could go wrong?
Of course, the biggest risk is that oil markets prove better supplied than I expect. A weaker global economy could reduce demand, while increased production from OPEC+ or US shale producers could keep prices under pressure.
There’s also execution risk. BP has spent the past couple of years reshaping its strategy and refocusing on its core oil and gas operations. Investors may need to remain patient before the benefits of that shift become fully apparent.
While many investors are focusing on falling oil prices, I think the market may be overlooking a tighter supply backdrop over the coming years. Combined with BP’s high-quality asset base, that makes it one I see as worth considering today.
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Andrew Mackie owns shares in BP.
