HOT TAKE: BP’s LNG hedge turns sour
But ‘exceptional’ gas trading propels earnings
BP took a surprise $10 billion hit on the value of its LNG portfolio in Q3’22 results released today. The impairment dragged the British oil major to a quarterly loss of almost $2.2 billion, eclipsing bumper profits from inflated oil prices.
How did this happen? First, its important to clarify that the loss applies to BP’s results under IFRS (International Financial Reporting Standards), which oblige the company to include certain metrics that don’t reflect underlying profitability. That’s why today’s headlines about BP all focus on it’s underlying profit of $8.15 billion, which excludes this impairment and is double the year-ago period.
Under IFRS bp marks-to-market the value of the hedges used to risk-manage LNG contracts, but not the contracts themselves, resulting in a mismatch in accounting treatment. The fair value accounting effect represents the change in value of LNG contracts that are being risk managed, and the underlying result reflects how bp risk-manages its LNG contracts.
It adds that the $10 billion impairment arose from a “further significant increase in forward gas prices during the third quarter”. This indicates that BP hedged against a fall in future gas prices in 2023 (and maybe out to 2024), but the market moved in the opposite direction – eroding the value of the portfolio. The bet turned sour, or so it seems.
It is worth noting here that the Q3 accounting period covers June to September 2022, a highly unusual period in energy markets when gas prices went utterly berserk in Europe. This dragged up the Asian LNG price:
The chart above shows CME’s future price assessment of the Japan-Korea Marker for delivery in January 2023 (dark blue line), December 2023 (light blue) and January 2024 (orange). The meteoric rise occurred entirely within Q3 (yellow shaded area). BP’s Q3 impairment reflects this, so perhaps we should anticipate an accounting gain in Q4 to reflect the subsequent correction?
Swings and roundabouts
The gas price spike was not all bad news for BP. In fact, rising prices swelled the company’s cash flow and working capital:
“Operating cash flow in the quarter was $8.3 billion including a working capital build (after adjusting for inventory holding losses* and fair value accounting effects) of $6.2 billion, mainly due to the increase in the forward price of LNG.”
The working capital increase will be reversed as BP lifts cargoes from new liquefaction projects that are coming on-stream:
“following the build in working capital as a result of rising gas prices since 2021, we now expect the working capital movement to include a release of around $7 billion, weighted toward the second-half of 2023 and 2024, primarily as LNG cargoes are delivered.”
Moreover, the company reported “exceptional” results from its gas trading division. Some analysts reckon BP earned a cool $3 billion:
Unlike the hedging write down, the trading earnings are real money — not an accounting trick that can be corrected on the ledger later. Make no mistake, BP is rolling in cash and is clearly struggling to find ways to allocate it to best effect.
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Investing for… yesterday?
BP’s capital allocation is always worth scrutinising in light of its intention to metamorphosise into an integrated energy company (IEC). The transformation will see oil production slashed 40% by 2030, and low carbon investments reach a giddying $5 billion per year by the end of the decade.
BP has a way to go to hit these targets. Total capital expenditure is flat at $9 billion over the first nine months of 2022 compared to the same period in 2021. Within that figure, low carbon investments slumped to $447 million over this period, which is less than a third of capex allocated to green projects in the year-ago period. It is also only a fraction of the amount that BP invested in gas projects ($2.2 billion) and oil production ($3.9 billion) over the first nine months.
BP is building its pipeline of renewable investment opportunities so green capex should increase over time, but progress to date suggests its stated target of $5 billion/year of low carbon investments by 2030 will be difficult to achieve unless it continues to fudges its definition of low carbon to include gas (this might start to attract some scrutiny in the future).
Low-carbon capex is of critical importance to BP’s long-term viability considering its intention to reduce oil production, and the need to replace those extremely profitable barrels. But BP seems to be focussed entirely on rewarding shareholders and paying down debt, to the detriment of capex.
The company today launched a fresh $2.5 billion share buyback and has reduced net debt to $22 billion, less than half its pre-pandemic level. That of course makes BP shares more appealing to buy or keep for shareholders, particularly pension funds, which have had a difficult and uncertain few months. But if BP is to realise its goal to reduce emissions and become a low carbon business, it will need to massively increase renewable (not just ‘low carbon’) capex. When will we see that happen?
Seb Kennedy | Energy Flux | 1 November 2022