BP (LSE: BP) shares have fallen by 28% over the last year.
Except for a brief spike down in 2010 following the Gulf of Mexico disaster, BP shares are now cheaper than theyve been since October 1996.
Are things really that bad, or is BP now a screaming buy?
In this article Ill explain why I think theres a good chance that BP shares could deliver big gains in coming years, and could potentially double in value.
Earning power
BPs earnings are inevitably linked to the oil price. As such, they tend to vary widely. This means that looking at one or two years only can be misleading.
An alternative way of looking at BPs valuation is to divide the current share price by BPs ten-year average earnings per share. This ratio is known as the PE10. Its useful for getting an idea of whether BP shares are cheap compared to the firms long-term average profits.
Ive crunched the numbers, and BP currently trades on a PE10 of just 5.5.
The reason this is so low is that BPs earnings are currently well below their ten-year average of 61p per share.
If BPs earnings move back towards their historical average and the shares maintain a P/E ratio of about 10, then the shares could climb to more than 600p. Thats 78% higher than todays share price.
What about the dividend?
Another issue holding back BPs share price is uncertainty over whether the dividend will be cut.
BP shares currently offer a prospective yield of 7.7%. Thats too high to be sustainable either the payout will be cut, or the share price will rise.
My view is that a dividend cut is unlikely, unless oil market conditions fail to improve in 2016.
I suspect that things will improve moderately, and BP will maintain its dividend. If Im right, Id expect BP shares to gradually rise, bringing the dividend yield down to a more normal level.
This could generate some big gains. Based on BPs 2015 forecast dividend of $0.41, a 5% yield would equate to a share price of around 525p, 55% higher than todays price.
Costs are falling
The price of oil is unlikely to return to $100 anytime soon, in my view. But BPs profits dont only depend on the oil price.
The firms operating costs and capital expenditure are also a big factor in its profitability. Many of the firms costs, such as labour and drilling rig hire, are falling fast. The IHS Upstream Capital Cost Index, an industry index which measures the cost of producing oil, has fallen by 15% so far this year. Further falls are expected.
As one of the global supermajors, BP sits at the top of the oil industry food chain. It has terrific negotiating power with its suppliers.
I expect that from 2016 onwards, well start to see the full benefits of lower costs and reduced spending feed through to BPs profits.
Theres one more thing
The Gulf of Mexico oil spill has cost BP around $55bn.
Following this years settlement deal, that cash outflow should finally start to slow. This should help BPs profits and its cash flow, making it easier for the firm to maintain the planned dividend payment.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.