Where Is BP Headed: $70 or $0?

bendzhao

I normally don’t post anything on SA that is in the current issue of Investor’s Edge ®. It’s only fair that our clients and subscribers should hear our suggestions first. But since they’ve now had the chance to act if they choose to, let me provide the following from our June issue. I think this is too timely to postpone:

Many people will tell you BP is a walking bankruptcy. But I believe the media has castigated “BP the company” based on the idiocy and arrogance of its current management, without reviewing the logical outcomes of what might happen with BP. Let's see if we can't assign a reasoned probability to those outcomes.

Clearly, current BP management has had a culture of conceit mixed with a cockiness that passes for aggressiveness among wildcatters. “Let’s push the frontiers,” was their ruling creed. “After all, we are the best.” I think if they were ever asked, “What about responsible stewardship?” their response might have been, “That’s what the PR Department is for.” Well, no more. This shoot-from-the-hip management team is on its way to oblivion.

But now let’s take a look at BP, the company. The company directly responsible for the oil spill cleanup is BP subsidiary BP America. A reminder: BP America grew its resources and distribution network hugely 10 years ago when it acquired 100% of ARCO, from whom many of us in the Western states still buy our gasoline.

Worldwide, BP is a company that generated $145.4 billion in cash flow from operations over the past 5 years. Credit Suisse has analyzed the most likely outcomes for the cost of the oil spill cleanup, liabilities, obligations, fines and penalties. While we can count on the media to try to out-do each other with estimates of $50 billion, $70 billion, $140 billion, etc., Credit Suisse has done actual "analysis" and believes the cost will be up to $37 billion. Let’s bump that up by another third and say it will be even higher, at $50 billion. If that’s the case, the total cost to BP will be about 20 months of current cash flow.

Credit Suisse further estimates that BP the company (ex, I imagine, Tony Hayward and a few others) will generate $184.7 billion over the next 5 years. If their estimate is close to accurate, that reduces the cost of the cleanup and extended liabilities to about 16 months of cash flow.

Could BP be forced into bankruptcy by lawsuits, fines and penalties? It could be, but given the above cash flow numbers, I see that as unlikely. In addition, if backed into a corner by an administration more interested in finger-pointing and finding a scapegoat than in partnering with energy providers, BP could say “Enough. We cannot stand idly by as your whipping boy while you drive our company into bankruptcy.” If that happens, and they are forced to play hardball to survive, we need to remember that the value of the “responsible party” (BP America) is about $25 billion. Anytime the US government decides to finance its deficit spending and its various gifts to Wall Street by riding BP into the ground, BP “could” simply declare BP America insolvent and let everyone pick among its bones. That would still leave BP the 75% of its business conducted beyond US shores, with roughly 75% of its current $30 billion annual cash flow intact. I see the bankruptcy of the entire company as unlikely and assign only a 10% probability to that occurence.

I also can’t agree with the scenario envisioned by the most wild-eyed optimists. In a nutshell, that viewpoint is that 536 engineers working on this problem are likely to achieve better results in solving the problem than 536 politicians only interested in being photographed picking up tar balls and looking seriously concerned (true,) that the capping process will soon succeed in stanching the flow (not likely, though it should get better every week from here forward,) and that we’ll be so happy to have it behind us that BP stock will make a V-shaped recovery to $70 or more (not gonna happen, in my opinion. I give this scenario a 10% chance, as well.)

Another possible outcome is that BP is wounded to the point that they are taken over by another company. With cash flow the past 5 years of over $145 billion? Who has that kind of petty cash lying around? Not Warren Buffett. Not Carl Icahn. Only Exxon (XOM), Royal Dutch Shell (RDS.B) and Chevron (CVX) come to mind, roughly in that order. Exxon is still digesting its $31 billion takeover of XTO Energy (XTO) and may not have the appetite for trying to bite off a $105 billion market cap (plus premium) takeover. Chevron still remembers the merging pains when they acquired Texaco. That leaves Shell as most likely. But I don’t think Britain’s flagship company will willingly walk down the aisle with any suitor; that would mean a hostile takeover -- and those are much more expensive. I doubt it will happen, but I think it places a floor below which our investment would not penetrate and provides comfort at these low price levels. Hostile takeover? I put the odds at no more than 15%.

My final scenario, which I see as most likely, is that US government fines and penalties, civil lawsuits from injured parties, and BP’s actual costs of cleanup will be counted in the tens of billions and will hurt its earnings in the short term. But with awards likely to be paid out over the long term as cases are solved or settled, the dollars paid will be worth far less than the dollars BP will be receiving in the future.

This viewpoint, admittedly not shared by most others, rests on two assumptions:

   1. The US government will knowingly and purposely continue to depreciate the value of the US dollar. You think BP’s spill is big? BP is a drop in the bucket compared to the gusher of borrowed money the US has squandered while looking for love (or campaign contributions which, to a politician, amounts to the same thing.) The trillions our nation has borrowed simply cannot be repaid merely from increased productivity any more. So our government will depreciate our currency via inflation. As we do so, all dollars will be worth less, including the dollars BP will pay to the US government in fines and penalties! So the government will get, instead of 25% of BP’s net worth, more like 6 or 12 months of their actual cash flow. Why? Because…
   2. One thing that will not decline substantially in constant US dollars is oil. China may experience a hiccup, or India a slight cough, but over the next few years the emerging world will continue to use more and more oil, gas, and coal. So BP owns something that does not depreciate -- oil -- which it can convert into something that is being purposely depreciated rapidly -- dollars -- to pay its fines and penalties. The US government will know the dollars it allows BP to pay over time are worth less and less but the BP fines are decimal dust compared to the amounts at stake by purposely depreciating the value of the US dollar in order to pay its creditors (including lots of British institutions that count BP as their biggest holding.)

I assess this possible outcome as most likely and assign it a 65% probability. In this scenario, BP’s stock may decline again based on some temporary setback but it is clearly in a bottoming area. This scenario encompasses the recognition that there were two other joint venture partners, Anadarko (APC) and Mitsui (MITSF.PK), and a whole host of subcontractors, of which Transocean (RIG) , Halliburton (HAL) and Cameron (CAM) are only the best known. It also recognizes that BP pays out $10.5 billion a year in dividends. They may reduce that dividend, if need be, to conserve even more cash and increase their ability to pay claims quickly. The more rapidly those claims are paid, the more likely it is that BP will rise from its current valuation of 5.3 times current earnings.

This scenario also takes into account the US government can < bully > BP into paying the salaries of other companies' laid-off workers, but they cannot < legally > do so. It was the US government that told the other companies they couldn't drill, not BP! This is America, and Americans have always had a sense of fair play. Sure, we want some justice here, but we don’t like bullies that kick people – or companies – when they’re down. As the Financial Times noted a couple days ago, our government dawdled in working with BP so now they are over-responding with inflammatory rhetoric like, to quote the President, finding out "whose ass to kick."

(As I wrote recently in a comment here on SA:

    "Bashing BP management is appropriate -- they've been doody-heads. But there are also thousands of rank-and-file BP and BP America U.S. employees working as hard as they can to solve this problem even as the government is threatening to bankrupt their employer. Couldn't we postpone the finger-pointing until AFTER we do everything we collectively can to solve the problem? That should take center stage, not who's to blame for what. And there's plenty of blame to go around -- from BP's too-far-forward leaning stance in drilling in deep waters to the government regulators who rubber-stamped the requests for accelerated development to the US environmentalists who demanded no drilling in technologically-simple and clearly safer shallower waters.")

Concluding the article I wrote for subscribers and clients:

    Mindful of Warren Buffett’s advice to “Be fearful when others are greedy and greedy when others are fearful,” BP looks good in the long-term.

If you disagree and think BP is a goner, then at least do what we are doing: buy the other oil, gas and other resources giants that declined along with BP but have no, zero, nada liabilities for the spill. I have written about Exxon, Royal Dutch Shell, Statoil (STO), Conoco (COP) and Chevron so frequently in the past it would be a disservice to long-time subscribers to make this case yet again. For new readers, just note that all the oil companies are cheap right now, so there is no need to gamble on BP’s recovery if you don’t share my analysis. Buy XOM, RDS.B, STO, COP and CVX instead or in addition to BP.

My logic is simple: dollars will decline in value; oil won’t. Dollars are expensive now; oil companies aren’t.

Author's Disclosure: We now count the big integrated oil firms among the special situations regular SA readers know are about the only things we are buying rather than liquidating into this rally. We are now long BP, XOM, RDS.B, CVX and STO.