BP and Investing

June 10th, 2010 by Potato

On the topic of BP and the environment: I meant to focus more on the horrible nature of the situation in my last post, on the Chernobyl-like precedent this tragedy might have in the public mind. How things like the deepwater drilling ban might spur us to say, tax oil a bit more to reflect the costs, or encourage better, faster implementation of crude alternatives in our power and transportation systems.

But I got on the investment thinking train, and that seemed to prove popular, so let me just continue briefly here.

First up, I’ve been trying to pay more attention to the story in the media lately. I was a little surprised to see a guest on BNN the day after I put my last post up saying almost word-for-word what I said about this disaster not killing BP outright, so at some point there must be value in the stock. He followed up by advising people to not catch the falling knife though, which is advice I have a particularly tough time following, so it’s good to hear again.

BP has now successfully cut off the top of the riser pipe down there, making for a cleaner hole. That makes it possible for them to siphon some of the oil off of the gusher and up to a surface ship. It also unfortunately allowed more oil in total to be released, which will be really bad if say a hurricane starts to form and the surface ships have to skedaddle. I thought that net-net, it was a positive move, but that may be a close thing, depending on how close to the upper end of the range we were at for the size of the gusher: if they’re collecting ~15k barrels/day, and the cut in the pipe allowed 20% more oil to escape, then that’s a losing move if the size of the leak was over 75 k barrels/day. I actually expected BP’s stock to jump on that news, but it had another horrible day today (down almost 16%). It’s now under $30, which has me making “Om Nom Nom” noises.

One thing their collection operation proves though is that the early estimates of oil flow were way, way too low. The most-reported estimates of the size of the spill are still climbing day by day in the media, but now seem to be plateauing in the lower range of what the image analysis guys were saying (i.e., in the neighbourhood of 50k barrels/day). Not all of that is making it to the surface, and there’s no way to tell yet whether or not that’s a good thing. Obviously it’s harder to skim/clean oil that for whatever reason is remaining dispersed beneath the surface, but maybe we’ll get lucky and it won’t need to be cleaned. OTOH, it may poison marine life for decades to come. No way to say just yet, I think.

Alongside the climbing volume estimates comes the climbing cost estimates, which are now closing in on my back-of-the-envelope $50B figure. At that point, I still have to think that BP is value-priced now at < $30. Some articles today raised the spectre of bankruptcy for BP, which I think is highly unlikely given the facts on the ground right now — as I said before, BP is a very profitable company, and can afford to make good on even large payments if given time (and litigation will likely give them that time). Even a $100B final price tag wouldn’t kill them if they had 5-10 years to pay out, though it would mean that the stock would have more shit left in it to get kicked out. Despite the fact that I’ve been pretty pessimistic on the scale and cost of this disaster so far, I think $100B is probably the upper-end of the range.

That is, assuming that the relief wells being drilled right now are able to stop the leak before the end of August. A 3rd-party drilling expert was interviewed on BNN the other day, and he gave me hope that this would work. Specifically he said that these kill wells have a greater than 90% chance of success, and are very good at being able to find the borehole underground. With two drills going, there’s a very good chance this will stop before the fall.

In the scenario that the kill wells fail (or to compound a tragedy, one of them blows out) then there is unfortunately no salvation for BP. If this thing leaks for the better part of a year like Ixtoc, then the Clean Water Act penalties and other settlement costs could conceivably bankrupt them. I can’t say that it won’t happen for sure, but I discount it as a very remote possibility.

On the matter of the dividend there has been a good deal of commentary. It’s a tough call. On the one hand, they do have enough cash on hand and cashflow being generated to pay for the ongoing costs of the cleanup at the moment, so a dividend cut isn’t strictly necessary. Plus, it’s a “widows and orphan” stock, especially in Britain, so there’s some pressure to continue to pay a dividend (even if a reduced one). On the other, there are the optics, which can cut both ways. They may seem callous to the situation by paying out cash to shareholders in the midst of the crisis (and powerful politicians are calling for them to cut it). To a lawyer in front of a jury though, a cut and the buildup of a reserve fund may just be a target — however much they build up, a court may reason that they should award more in damages to make the award truly punitive. Giving the cash to their limited-liability shareholders may help keep the court awards/settlements down. The dividend is pretty rich, but I’m not sure that eliminating it for a few years should really affect the investment thesis all that much — the uncertainty in the cleanup costs is much higher than that, so I don’t get the news reports saying that the stock declined on rumours of a cut. I think that they can keep it up, but will probably cut (not necessarily to zero though — probably down to 25-50% of what it was), however either way I don’t think it’s a significant enough factor to affect my value price.

So after looking at it a little closer, my back-of-the-envelope calculation doesn’t seem all that far off to me: BP is likely getting into the buy range now (under $30 for the NYSE ADR), and it might just be a matter of waiting for it to stop being sold in a panic to get in as a long-term value/recovery play. That said, it’s definitely getting detached from the fundamental issues here and trading on emotion in my opinion. It could go nowhere until the relief well connects and kills the leak; it might stay low until a decade from now when the settlement payouts stop and people see the EPS clearly again. It might spring back 15% tomorrow on no news. Some big-name analyst might pan it and it could go no-bid until the vultures start picking it up for pennies. Just no way to say in the short term. That said, the bonds may also be well worth looking at: I haven’t bothered to log into the fixed income side of my broker’s website, but the paper today said that their debt was now yielding 8% — and that was just a 3-year bond! — which plays even better into the “they won’t go bankrupt” thesis (especially if you conclude with “at least not in the next 3 years”).

Another side to the catastrophe that I haven’t seen mentioned yet is the fact that a large portion of the release appears to be methane. As we know from the snickering over cow farts, methane is a very potent greenhouse gas, and here we have a rather substantial release of the stuff going on. I have to wonder if it’s going to be enough to affect the climate records for the next 10-20 years, though I suppose that’s a problem to worry about after the spill is stopped.

One final note on government malfeasance. Some have speculated that the US will simply confiscate BP (or it’s american assets), or create legislation to penalize them post hoc. That is expressly forbidden in the US constitution. However, the US government’s actions during the financial crisis (seizing banks that were not necessarily demonstrably insolvent; arbitrarily making bondholders whole and wiping out common and preferred shareholders without the benefit of a release of their calculation arriving at such a split or orderly liquidation; their continued efforts to keep the GSE’s down with ridiculous interest payments on money that they are forcing them to borrow, which the GSE’s don’t really need — what use capital requirements when possessed and guaranteed by the government?) do not inspire continued faith in the concept of due process.

PS: note that when I say “today”, I mean June 9th (I composed this the evening of June 9th, but held off until June 10th to hit publish).

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