A friend recently called and asked if she should invest in BP. My initial reaction after taking a quick look at the quotes was no, it still wasn’t cheap. But then I got to thinking, although I do have data on the Energy Sector companies within the S&P500, and I’ve done extensive research into the sector, and I’ve glanced at BP a time or two, read some of what I’d seen on the spill, etc. I really didn’t know enough about the company to form a solid opinion. I told her I’d look into it, but it would probably take at least a couple days and that I’d write a column about it.
BP plc (BP) (American Depository Shares ADS equaling 6 shares of the BP Oil): Quote / Chart TTM P/E 5.63; Next full year forward P/E (FY2011) 6.73; Current Dividend Yield 0.00%.
Based on June 17, 2010 closing price of $31.71
52 Week price range: 29.00 – 62.38
Full year net income was $ 13.955 billion or $4.67 per share in 2009 compared with a net of $ 25.593 billion or $8.38 per share in 2008 (per share data adjusted for ADS).
They reported 1Q 2010 net income of $ 5.598 billion, or $1.79 per share compared to a net of $ 2.387 billion or $ 0.77 per share in 1Q 2009 (per share data adjusted for ADS).
I’d read a lot of what others had to say, read recent and old news, took a look at the earnings reports (for many years), read the transcripts of the recent investor briefing, and any other news I could find on BP’s site. And I came to the conclusion: BP stock is not cheap. BP has made very good money, has over $6 billion in cash, and made $5.6 billion last quarter, how could I possible say this stock isn’t cheap trading at about half of the 52 week high? Read on.
Basics of the catastrophe:
An explosion at the Deepwater Horizon submersible well drilling platform on April 20, 2010 killed 11 workers and the subsequent failure of a blowout preventer had caused an uncontained leak that was spilling at a reported rate of up to a 60,000 barrels of oil a day (other evidence suggests the flow rate might be lower though) into the Gulf of Mexico. It is considered to be the largest oil spill in US history. BP currently considers the leak to be contained and is recovering most of the oil that is still leaking with existing recovery technology. Two relief wells are currently being drilled to intersect the main line of the leaking well. Once one of these wells reaches the main line, heavy liquid will be pumped into the leaking well to cause a backpressure stemming the flow and allowing the leak to be fixed.
Reports I’ve read on the incident indicate it is likely that there was gross negligence on the part of BP. BP’s CEO Tony Hayward was called to answer questions before a Congressional hearing this week concerning decisions such as the use of a less-robust well design, failure to anchor the well’s casing using a process recommended under industry practices, cutting short procedures to ensure cementing was sound, safety and about the blowout preventer that failed, but failed to answer many of the questions.
There is no way to gauge the damages.
We don’t even know where this oil might wash ashore for sure yet, the places it’s hit so far, might not be the only places effected. At the moment much of the continued spill is being contained at sea, and recovered or flared (burned), the weather could change that. If a storm moves in, it could be pushed out to sea or start washing up in states or other countries that haven’t had damages yet. Even if burned, it doesn’t fully burn, so there is still going to be some reaching shore. It also sinks and kills aquatic life. The damages of this spill could be very long lasting, and the costs associated with it could be devastating to BP.
Oil prices aren’t stable.
If the dollar continues to strengthen, or oil use continues to fall, the price of oil could drop considerably. What they are earning now might not be what they are earning next year. Many countries have begun inspections of offshore wells and they could have other wells shut down or they could be forced to abandon drill sites. Their refiners are running at lowered capacities, and losing money, and although they have seen some increases in capacity, replacements and reductions are taking their tolls on oil.
Actions speak louder than words.
During their meeting with President Obama they agreed to set up an escrow fund in the amount of $20 Billion to pay for claims, but that does not include fines and penalties that will be paid separately. President Obama made it clear to them that this did not cap their liabilities. The payments into the escrow fund are to be made as follows: $3 billion in the third quarter, $2 billion in the fourth quarter and then $1.25 billion per quarter across the subsequent three years.
After the meeting: they suspended their dividend, which amounts to about $7.2 Billion for the three quarters and it was made clear the dividend might not be reinstated after that time, they plan on saving $2 Billion in capex spending this year and next, and they plan to sell $10 Billion in upstream assets, and they applied for $5 billion in additional loans recently. That totals $26.2 Million for what amounts to $10.25 due in payments to the fund over the time frame. That tells me they think they are in trouble.
To add to their problems, Fitch Ratings cut their debt rating six levels from AA to BBB on June 15.
Lets look at debt first. Debt as of Q1 2010 was a little over $34 Billion (with another $5 billion in loans after the report). I don’t like European Earning reports I can’t find a debt interest expense on the report. Let’s say it’s averaging to the lower end of what I’ve seen on other reports, or about 4% on the total debt giving about a $340 Million interest payment per quarter (although it’s probably higher since most is long term debt that generally pays at a higher rate).
The level of debt did not appear excessive considering they had been doing very well paying it down prior to the spill and had a AA credit rating. The drop in their credit rating is going to increase interest payments on this debt, if they need to restructure it, or on any future debt. This debt now seems huge considering it is unclear how much they are going to be able to pay on it due to obligations they will have to meet with the spill. If they can’t make the payments on this debt, they will have to reissue senior notes, or sell more shares diluting the share base, or sell more assets, or all of the above.
Lets say their average rate of interest increases to 6%. At that rate the interest on their debt increases to $510 million a quarter. It could build from there.
Earnings per share for the past ten years are as follows:
NOTE: Earnings are adjusted to reflect ADS per share earnings.
From the earnings reports I’ve looked at, many of the years where earnings increased after a low earnings year, they cut costs. This year was no different, so the great earnings we seen in the first quarter were not so much an improvement in sales, but they aren’t investing as much into the company. They normally gradually increase these investments until the next time they need to improve earnings. The problem is, they already made the cuts, and in order for profits to continue later, they will need to start increasing these investments again next year, but instead, they plan on cutting both this year’s and next years more, and not increasing as they normally do. It could hurt their income stream down the line.
The next concern is they plan to sell upstream assets to generate the $10 billion. It’s not surprising since they have been trying to sell the downstream assets (refineries in Europe) with no success for about three quarters. No buyers though, because the downstream assets are losing money. Europe and the US saw a slight increase in throughput in the refineries, but their refineries in the rest of the world dropped. Even though they did well in reducing costs, all three sectors are still losing money.
Damage Cost Estimates
Estimates I’ve read on potential costs that range up to a “worst case” $70 billion. Each day the oil continues to flow, the damaged area increases and the cost to clean it up increases. There are already 220 lawsuits, but it’s still early and the lawsuits could continue to filter in for many years. It depends on when they can cap it and how much of an area is effected, but I looked to get some kind of an idea how much I’d think it could run. I thought the $70 Billion seemed high, so I made some estimates myself based on data I collected and that the spill remains largely in the present area.
Here are the things that BP is required to compensate for under the Oil Pollution Act:
· Property damage
· Net loss of profits and earning capacity
· Subsistence loss and natural resource damage
· Removal and cleanup costs
· Cost of increased public services
· Net loss of government revenue
Crude oil is very corrosive. Docks, boats, even houses could be damaged. Property values are affected for those who are selling their homes now. Even those that stay could face devalued property due to oil washing up on beaches after the cleanup is complete since much of this oil has sunk and could be washed ashore with tides or storms. I estimated cost based on shoreline damages during the hurricanes, some property values I could find and probable devaluations.
Estimated of damages: $1 billion
Subsistence loss and natural resource damage:
According to a recent report by the NOAA and FDA, 32% of all federal waters are banned from fishing. Finfish metabolize crude oil fairly quickly, so once the oil is gone, these fish will become edible again not too long afterwards. Shellfish (calms, oysters, crabs, shrimp, etc.) don’t metabolize oil quickly. These shellfish grounds could be “dead zones” for many years. The oil is currently in some of the best shrimp waters in America. There is also untold damage to other forms of aquatic life that could damage the ecosystem in the Gulf for many years to come. I looked at some of the actual damage awards in the Exxon Valdez to get some idea how the fishing grounds might be affected and for how long. The effected area was smaller and fishing supported fewer people there though, and prices are higher now.
Estimate of damages: $8 billion
Net loss of profits and earning capacity:
One report stated the Gulf produces 40% of all the seafood consumed in the US. According to the Louisiana DOA, Louisiana produces 25% of all the seafood consumed in the US, about $1.9 billion pounds a year. Using the two I calculated that the Gulf of Mexico produces about 3 billion pounds of seafood for consumption in the US yearly. The oil is expected to harm the most prized seafood the longest. Based on a year to complete the cleanup and two years of no fish zones.
Estimate of damages: $8 billion.
The businesses that depend on the fishing industry will have losses too. This includes processors, distributors, markets and restaurants. I based the numbers on markup formulas I’d used in the past and then reduced it by $4 billion due to overlapping or gaps in the supply chain.
Estimate of damages: $20 billion.
Then there are the charter boats. Some take in thousands of dollars a day, and there are hundreds of them that are laid up. Some could lose their boats due to not being able to pay the loans, and BP will be responsible for these loses too. I based damages on lost income only though. Some of these boats could cost in excess of a seventh of the total damages though, so this one could run up.
Estimate of damages: $750 Million.
If oil starts washing up on Florida’s beaches (more than it has) and starts ruining the tourist trade there, costs will mount quickly. According to the State of Florida, tourism has a $57 billion impact on its economy. The other states in the region that have oil damages had a less defined tourist trade, but it will still be affected.
Estimate of damages: $7 billion.
Estimate of Total Net loss of profits and earning capacity: $43.75 Billion
Removal and cleanup costs
The cost of the cleanup was $1.75 Billion as of the investor briefing held on June 16, but that cost could easily double before the oil flow is even stopped. Much of the oil is still afloat and there is no way to know for certain where it will come ashore. The Exxon Valdez spill cost over $2 Billion to clean up, but that was a smaller spill and many years ago. There were also many complaints that Exxon didn’t finish the cleanup. They left when the weather broke and didn’t return. BP won’t be able to run off, there are too many people in this area. Costs have increased since and the spill area here is much larger.
Estimated clean up costs: $7 billion.
Cost of increased public services
Besides providing personnel to aid with the cleanup there are untold expenses adding up. A few that I’d found include are the NOAA and FDA have increased personnel to test and monitor fish. Each fishing boat has to have its tracking systems checked before it can offload and sell catch. Monitoring of the spill area by air and determining the fishing boundaries. Unemployment compensation expenses and the associated increased services costs. But there are going to be lots of things I missed so I padded this one some.
Estimated public services costs: $1 billion.
Net loss of government revenue:
This is a provision for the government to collect lost tax base, I estimated it at 30% of the above lost income and profits total.
Estimated: $13.13 Billion
Fines: Exxon paid over $1 billion in fines for the Valdez, but there weren’t any deaths in that accident, and it wasn’t company negligence, which this might be. So the fines here are likely to be larger. Often fines are based on time it takes to clean up. This one’s still leaking. It’s a massive spill, and it’s probably going to take nearly a year to clean up after they cap it.
Estimated: $3 Billion
Negligence lawsuits: Most of the 11 killed on the Deepwater were in their 20’s and 30’s. Families can’t sue under worker comp laws unless there was gross negligence. If what I’ve read is accurate, they might be able to sue.
Estimated: $2.5 billion.
Legal expenses: It will depend on how many cases, but from what I’ve seen in earnings reports, a million dollars doesn’t go far. There will also be lots of court costs.
Estimated: $5 billion.
That’s $76.375 Billion. Unlike the report of the $70 being “worst case” I think it might be to the low end. The high end would be if a storm starts washing significant amounts of oil up in places it hasn’t hit yet, like Florida, or Texas or Mexico. Worst case, damages could double.
Other things to consider:
The dividend is a form of hedging against the risks that oil companies have. The suspension of this dividend has to be seen as an increase in risk. The risk that another spill occurs is still there, but there’s no income form the dividend to offset this risk, and the dividend might not be reinstated next year.
Another thing to consider is the company is in Britton and their stock market is open when ours is closed (including our after hour and pre open markets). If they release information during their open market hours that causes their shares to plummet, the shares here will open much lower with no chance to sell.
Can they pay $70 billion? Yes they probably can, it wouldn’t be as easy as many think though and I doubt they pay a divided again until most of this debt is paid off, and I think it could take up to ten years. Can they pay $140 billion? The way I see the sector at this point in time, I think they might run into some real trouble before they are able to pay that amount off.
Considering the area and it’s importance to fisherman, tourism, etc., and the number of people that are being effected, that we don’t know when the crude will be capped or even have a good idea how much the cleanup alone will cost, etc., that the current idea to cap the well might not work since several things they’ve tried to this point failed. Add that the risk is not defined enough and there are too many things that look like they could go wrong, or get worse.
I haven’t got a good feel of what amount tips the scales and sends them to file for bankruptcy or they could sell off assets to pay off debt until they can’t make money. The company sounds sincere that they are willing to pay, but they haven’t been hit with the total bill yet either. At the moment, the $30 share price looks more like a top, than a bottom to me.
Thanks for the idea for the article Ronie, I hope this helps with your investment decision.
Have a great day trading,
Disclosure: I current do not own any BP positions, short or long, and don’t intend to buy any either.
Disclaimer: This article is intended to provoke thought about investment possibilities. Acting on the information provided is at your own risk. You are urged to do your own due diligence, and where appropriate, seek professional investment advice before acting on any information contained in these articles.