So far in November, Brent crude oil prices are down almost 20%. This is a steep move, and it has caused some related stocks to fall. One example of this is the BP (LSE:BP) share price. Even though the stock is still up 18% over the past year, it has fallen 13.5% this month. Here’s my forecast for the company if oil prices keep falling.
A hit to profitability
The first thing I’d highlight is the direct impact on BP’s earnings. As an oil producer, the company benefits from higher commodity prices because it can sell its output at more attractive margins. The reverse is also true. Of course, this shouldn’t come as some crazy revelation to investors. But the exact impact is more interesting.
BP’s own sensitivity estimates suggest that every $1 change in oil prices affects annual operating profit by approximately $340m, assuming other factors remain unchanged.
Therefore, a further 20% drop in coming weeks (amounting to around $18) could theoretically reduce annual operating profit by around $6.1bn. That’s a significant amount, although the actual impact would obviously depend on other factors as well. For reference, last year operating profit was $12.64bn.
This scenario wouldn’t be great for the BP share price. However, a 20% fall in oil wouldn’t necessarily translate into a 20% decline in BP shares. Company valuations also reflect future expectations, so some weakness from oil falling may already be factored in.
Reasons for optimism
Despite this risk, I wouldn’t automatically get seriously worried about the stock.
The company’s latest quarterly results demonstrated just how much its financial position has improved. One of its main profit metrics (underlying replacement cost profit) reached $8.46bn for Q3, compared with $2.2bn a year earlier. Meanwhile, operating cash flow totalled $14.8bn, helping net debt fall to $13.9bn.
This matters because a stronger balance sheet provides greater flexibility during periods of weaker commodity prices. So even if oil prices do continue to fall, BP is in a strong position to financially cope.
Another positive is that BP isn’t exclusively dependent on crude oil production. Its refining, trading and customer-facing operations provide additional earnings streams, although these aren’t immune to weaker market conditions.
The longer-term view
My biggest concern would be a prolonged period of lower oil prices rather than a temporary decline. If oil traffic resumes to pre-war levels in the Middle East, along with a peace deal, oil could not only fall but stay at a lower level for a long period.
In that case, BP could face difficult decisions as investors start to scrutinise capital expenditure and other costs more, given the likely lower revenue.
However, let’s not forget that BP has been profitable over the years even when the oil price was below $50 a barrel. So even though the share price might head lower in the coming year based on oil, I don’t see it as a long-term issue.
The other point I’d make is that as we’ve already seen, the BP share price doesn’t move exactly like the oil price. So a 20% move in oil from here might only see a 10% fall in the stock price.
On balance, I’m staying away from buying BP shares at the moment, but feel there will come a point when they’re a smart buy for me and other investors.
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Jon Smith has no positions in the shares mentioned.
This story originally appeared on Motley Fool
