Why takeover target BP plc should beat the FTSE 100 in 2017

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BP

BP (LSE: BP) shares have risen by 35% over the last year, reaching a 52-week high of 521p at the start of 2017. But BP's £5 price tag didn't last long. The stock has already been marked down by more than 10% to 460p, as investors question how sustainable the oil market's recovery really is.

If you invested in BP during last year's downturn like I did, you may be tempted to sell now and to lock in a profit. However, I think this could prove to be short-sighted. I've decided to hold on to my shares in the hope of bigger profits.

Peak oil? I don't think so

Last week saw the price of Brent Crude fall by 8% to $51 per barrel, as investors took fright after US oil inventories rose by more than 8m barrels. Some analysts believe the market will remain oversupplied for the foreseeable future, because recovering US shale oil production is cancelling out OPEC supply cuts.

The main argument for selling BP and other oil stocks today is that the firm is currently operating with negative cash flow. Like most of the really big oil producers, the firm needs an oil price of about $60 per barrel to balance spending and outgoings. If this doesn't happen, then BP's profits and dividend could come under pressure.

My view is that gloomy speculation that the market will remain in surplus indefinitely is unlikely to be true. The data suggest that the market has already started to rebalance. I believe this will continue and that last week's sell-off is just a short-term blip.

Serious value credentials

BP shares look quite cheap to me, based on the group's historical profits. The stock currently trades on nine times the firm's 10-year average earnings per share. This ratio, known as the PE10, is a useful metric for judging how cheap a company looks based on its long-term profit potential.

Another big attraction for value investors is BP's dividend yield of 7%. However, while this is tempting, it isn't without risk. BP is only expected to generate adjusted earnings of $0.37 per share in 2017. That would leave the firm's $0.40 per share dividend uncovered by earnings for the third year running.

BP's earnings are expected to cover the dividend in 2018, but until this happens, the risk of a dividend cut remains.

Takeover potential?

BP shares rose sharply last week after the Evening Standard published a report suggesting that US oil giant Exxon Mobil had "sounded out BP's major shareholders" about a takeover deal.

This isn't the first time that rumours of an Exxon-BP tie up have been reported. But nothing serious has ever come of this takeover chatter. I'm certainly not banking on a bid.

What I find more interesting is BP's plan to become a low-cost oil producer, with a break-even point of $35-40 per barrel by 2021. If the firm is successful, then BP shares could look very cheap at current levels.

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Roland Head owns shares of BP. The Motley Fool UK owns shares of ExxonMobil. The Motley Fool UK has recommended BP. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.