BP - Disaster and Investing

June 2nd, 2010 by Potato

You’d have to have been in a hole the last month to have not heard about the disaster in the Gulf of Mexico leading to huge amounts of oil streaming out of a well after an accident at the rig. The oil under the ocean floor is under a great deal of pressure, so it’s pouring out through the hole, and has been for a month now. And every day, more comes streaming out. The slick on the surface is huge, affecting a large number of fishery operations, and coming ashore now.

This is a massive disaster, and it’s not over yet. It could be another month or two before the gusher is finally brought under control, and then a long time after that mopping up the coastlines.

For some perspective I did a quick bit of reading on the Exxon Valdez spill. The oil was thicker on the coast there, in large part because the tanker grounded fairly close to land (esp. relative to the BP drill site).

As this plays out there may be more realization in the public mind of what the externalities of an oil-based economy are, and we may finally get more of a drive towards alternative energy, public transit, hybrids, etc. Plus of course, stricter regulations on environmental protection for drillers (though like with financial reform, closing the barn doors after the horse has run out).

From an investing point of view, people are looking at the massive decreases in BP’s stock over the last month — 30% over the last month, 15% today alone! — and are wondering whether this is now becoming a value play. I doubt very much that this disaster will lead to BP going bankrupt and the common shares becoming worthless. Thus at some point, there must be value in the stock. However, determining what that point would be is very difficult at this point since there is so very much uncertainty at the moment. To be sure, uncertainty and volatility can present opportunities, and there’s a good discussion about that possibility at CMF right now.

So, a quick back-of-the-envelope calculation: the ultimate costs to BP are probably the largest unknown factor, but also the most important here at trying to guess at the bottom. The Exxon Valdez spill ended up costing Exxon in the neighbourhood of $5B. This is likely going to be about 10X worse (BP has reportedly already spent $1B in the first month on cleanup and well capping attempts — and the litigation hasn’t even started). So I’d start with a guess of about $50B to clean things up. That figure makes me more pessimistic than most of the reporters and analysts I’ve seen in the news, but there’s so much uncertainty here that I think it could end up being more. At the very least, I’d be looking for a margin of safety on top of that before I start bottom-fishing. As big as that number is though, it’s not a killer for BP: it’s a huge company with profitable oil operations all over the world, and it can probably pay out the costs of the cleanup out of operating profits over the next few years (as they’re required for cleanups, or as litigations complete).

Let’s assume that we’re willing to pay a stock price of the sum of the earnings for the next 10 years (i.e. a P/E of 10). Their earnings for 2009 were about $17B, so 10X that gives us a 10-year sum of $170B, or a stock price of about $54, which is where they were trading before the disaster. If we now figure that $50B comes off that 10-year sum, we’re left with earnings of $120B, which would be a stock price (US ADR) of about $38 (which as of today it’s below). On top of that, we want a margin-of-safety of at least 20% (though I think given the uncertainty, a higher margin of safety would not be out of the question). That brings me to a price of about $30-31 before it starts to look interesting to me. I haven’t done a whole lot of research since I’m busy with my real life, but if BP does start getting down into that range, I might give up a Saturday afternoon to sit on the porch and read up.

All that said, the bloody thing dropped 15% in a day. I’m not going to touch it for at least a few more days. Plus there’s the ethical investing issue: even if it is bargain-priced, do I want to own a fractional share of a company that was responsible for such a massive environmental disaster?

4 Responses to “BP - Disaster and Investing”

  1. LinkStuff – Extra Cash And Best Of Blogs Edition Says:

    […] Blessed by the Potato wrote about the BP oil disaster and investing. […]

  2. This and That: Interest rates, Rob Arnott and more… | Canadian Capitalist Says:

    […] Holy Potato takes a stab at estimating if BP is a value play after the beating the stock took in light of the Gulf of Mexico disaster. […]

  3. Brian Says:

    The talk of BP being a good investment reminds me of the good old days of Nortel going down to the $60, $50, $40…$8.00 and lower! Everytime some joker was saying it was a good stock.

    Once the lawyers and the oil is gone (in about 20 years) only short sellers will have made money.

    A clause buried deep in the U.S. Clean Water Act may expose BP and others to civil fines that aren’t limited to any finite cap — unlike a $75 million limit on compensation for economic damages. The Act allows the government to seek civil penalties in court for every drop of oil that spills into U.S. navigable waters, including the area of BP’s leaking well.

    As a result, the U.S. government could seek to fine BP or others up to $4,300 for every barrel leaked into the U.S. Gulf, according to legal experts and official documents.

  4. Potato Says:

    Yes, and it’s exactly that kind of fear that makes value investing possible: some companies go through a troubled period and then recover, providing amazing returns; others fail miserably. But in the early stages of the failure, it’s sometimes tough to tell the difference, and some investors will sell in a panic, providing opportunity for others. Is this a Ford, or a GM? A Nortel, or a Q9?

    So, I’ve argued above that despite the fact that this disaster could be the Chernobyl for deep-water drilling, and that the costs will be huge… but not big enough to bring BP, a massive and massively profitable international oil concern, down to zero.

    Thus, at some point, if it gets cheap enough, it’s a buy. (And Scott Adams has a rebuttal to the ethical issue). It’s just a question of how big the bill will be, and thus how cheap the stock has to get to make it attractive.

    I very roughly ballparked $50B above. That puts me as more pessimistic than many in the media, but I think that might actually turn out on the low side, in part because of the Clean Water Act, and in part because most analyses I’ve seen assume the leak stops shortly after the analysis is written — and it just. keeps. gushing. (the latest manoeuvre opened the pipe up to leak more, but made it easier to collect some of the oil, leading to less net leakage to the environment — but still a large leak).

    Even then, if we take the full $4300/barrel figure, and multiply out by 50k barrels per day (again, higher than most news reports are saying, but the early estimates were way low-balled, and they keep getting revised upwards, so I think 50k b/d is about where it’ll settle, but note that some independent analyses of the size of the plume and of the underwater video footage suggest it could be 100k b/d). Assuming that this gets capped in 150 days total, that’s 150*50k*4.3k = $33B. Other cleanup costs and civil suits will probably get us to that $50-100B range. That’s not going to kill a company the size of BP, the question is whether there are other factors that will make that spiral upwards (e.g., will they lose drilling rights in other countries? Will the leak continue for 10 months or longer? Will one of the relief wells being drilled have a catastrophic failure and double the problem?)