Merrill Lynch has downgraded BP to an Underperform rating, and price target has been reduced to 330p on the basis of three important considerations

Merrill Lynch has downgraded BP plc (ADR) (LON:BP) to an Underperform rating. Big oil is facing a three-legged “trilemma” in accordance with the need to maintain dividend, credit rating and its reserve basis.

In a note on European Integrated Oil companies, Merrill Lynch projects a fall in the refining margins. By 2016, the decline in the midstream industry is expected to be below “mid-cycle levels.” The fall in refining levels can mostly be contributed to the coming of autumn when refiners schedule temporary shut downs due to the need for maintenance after factories work at full capacity to keep up with the summer’s demand peak.

The fall in refining levels will cause companies to cut down on capital expenditures in order to maintain and deliver dividends on time. The recent downturn of crude oil prices that went low enough to break a six and a half year low has increased the threat to organic reserves of Oil Companies. Organic reserves are oil inventories acquired by companies through exploration and production, rather than purchasing.

Due to reduced profitability, mergers and acquisitions are now more enticing to oil companies. However, the financial position of an oil company is determined through an analysis of its organic replacement in the company’s reserve-replacement ratio. If acquisition of inventory is higher organically, the company is seen as financially strong.

Merrill Lynch also opposes the idea of mergers and acquisitions being funded partially or completely through equity issuances that are easily dilutive. BP’s downgrade is reiterated, keeping in mind that merger and acquisitions have risky executions and require approvals from different regulatory committees.

The downgrade to an Underperform rating comes with a 21% reduction in the price target. Merrill Lynch sees a shortfall in BP’s free cash flow, which is cash left from operating activities after capital expenditure is deducted from it. The oil company’s yield has fallen to less than 1% and seems as if this level will be sustained through 2017.

In comparison, the research firm prefers exposure to Lundin Petroleum and Genel due to the high quality of their exploration and production sectors.

BP’s 7.5% dividend yield has also been diluted to less than 6% due to scrip issuance. This is also known as capitalization or bonus issue, which is a form of secondary issue in which the cash reserves of a company are converted into new shares and distributed among the prevalent shareholders.

In an additional note European integrated oil companies’ price target cuts have been aimed at the following:

• Repsol cut to EU9 after a 25% reduction,
• Eni has been reduced 15% to EU17,
• Statoil’s target price fell by 9.5% to NOK95
• OMV Group has been reinstated at 10% lower; it is now at EU18
• Galp Energia declined 8.3% to EU11.

Furthermore, Goldman Sachs anticipates high free cash flow coming in from Russian oil companies. In extension, Swedbank sees Statoil’s free cash flow per share (FCF/shr) for the year 2016 at NOK8 or NOK9. With BP’s stock price taken at 344.60 pence, and price target reduced to 330 pence, the company has a 4.23% downside.

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