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UPDATE-2 BP Risk Assessment

June 20th, 2010
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06.20.2010
01.16.2011 repaired broken links

UPDATE-2 BP Risk Assessment

updated from 06-09-2010. original article written by Net Advisor

Over the years I have heard many people talk about buying a stock because “it is so low” or “it is a giant company,” or “it was once 200 and now it’s 14,” or “it was 75 now it’s 30,” etc.

The price of a stock has nothing to do with value. A stock that is $90,000 could be undervalued compared to a stock that is over-valued at $1.00. Stock price is not to be considered when making an investment.

The underline fundamentals are most important for the long term growth of a company. In the short run, technical factors such as using charts may suggest where stocks may trend. However over the long run, if the fundamentals have changed materially or significantly, then that stocks should be carefully reevaluated.

The following were all companies that once had lofty stock prices, or were major leading corporations, dominating their industry at some point in many cases, yet they all have one thing in common: They are all either bankrupt, near bankrupt, technically insolvent, or have technically failed, and were required to be bailed out by government or a competitor in order to insure survival: They are:

Lehman Brothers

Circuit City

Wachovia

Fannie Mae

Freddie Mac

General Motors

Washington Mutual

Conseco

New Century

PG&E

Enron

Global Crossing

World-Com

Indymac

Delphi Corp

Adelphia Communications

Delta Airlines

UAL (United Air Lines)

Pan-AM

virtually every .com company in 1999-2000 to date except AMZN,

and this giant oil company called Texaco.

Now several of these companies failed in part due to fraud such as Enron and World-Com, but the point is no matter what the reason was, they all failed at some point.

Companies that fail but still have a decent business can return from bankruptcy after a restructuring of their debt, which frequently also wipes out all the equity (stock value).

On June 9, 2010 I discussed in some detail citing credible sources that BP may, not will, but may be at bankruptcy risk. This does not mean they will go bankrupt, only that the possibility of this risk exists.

A BP restructuring is not a foregone conclusion, only that there are continuing developments with the company that has led to an increase in this probability over say the next 1-3 years or so, depending on the eventual size of the oil spill, and litigation process. The Exxon-Valdez case took 19 years to complete.

Here are some of the current risks for BP:

Credit Risk:
Credit risk is the risk of default by one party to repay another party. Corporations have credit rating agencies who evaluate the risk of default. Naturally, the higher the “rating”, the lower the probability of a default, or so it goes in theory. Recently, BP has faced credit downgrades by all three major credit rating agencies.

BP’s credit has been downgraded by all three major corporate credit rating agencies: Fitch, S&P, and Moody’s:

06-15-2010:
“BP credit hit by six-notch Fitch downgrade.”

— Source: Reuters

06-18-2010:
“S&P downgrades BP’s credit rating on future costs of oil spill.”

— Source: News.com Australia

06-30-2010:
“BP credit rating downgraded (by Moody’s) over oil disaster.”

— Source: Times Online, UK

What this means is the cost of BP’s credit or to get more credit or loans will go up sharply.

Counterparty Risk:
Counterparty risk is when there is a business to business contractual relationship, and there is risk that one or both parties could default on their contract, otherwise one side does not pay. If enough lending institutions seek to limit their exposure to the counterparty, it can make it difficult for the counterparty to do business.

Reportedly, Bank of America (BAC) has told their traders to limit trading exposure to BP.

06-17-2010

“U.S. bank tells traders not to sign long-term deals with BP after credit rating dives.” (Sources: independent.UK and Reuters)

In 2008, counterparty credit risk was a key problem for many companies when Lehman Brothers failed causing massive financial damage the credit markets. The size of this market where credit default swaps are traded to help protect defaults by counterparties was $62 Trillion. (Source: Bloomberg)

Earnings & Cash Flow Risk
Some people might suggest that BP makes billions of dollars, which they do, and because of that they assume the company will continue to make the same money in the future, and that is a reason to buy the stock. False.

Aside from the fact that BP will pay out an unknown number in the mega-billions in damages and other compensation, BP’s current, near term and intermediate future earnings and thus cash flow is likely to be reduced as a direct result of the Gulf oil spill.

1. All of the cash flow from Gulf Operations has gone to ZERO under the Obama moratorium.

“President Obama…is suspending action on 33 exploratory drilling operations in the Gulf and canceling or temporarily suspending pending lease sales and drilling in Virginia and the Arctic.”

— Source: Wall Street Journal

The result of this move will prohibit all Gulf oil operations from generating revenue. However, because of Obama’s 6 month moratorium, reportedly oil drillers are moving their business outside of U.S. waters. (Source: Fox Business News)

Further, governors and legislators have cited reservation about future off shore oil drilling altogether. (Source: Telegraph.UK)

If the U.S. moves to decrease or eliminate off shore oil drilling, the result would be an increase in job losses from those working in the U.S. industry, and those supporting ancillary jobs. The result would also increase foreign oil dependence, and increase in gas prices to U.S. consumers. One expert has called the moratorium (current drilling ban) “misguided,” and the move will end up increasing American’s dependence on foreign oil.

Ken Arnold, an engineer and consultant with 45 years of oil and gas industry expertise called President Obama’s moratorium “misguided,” and that the U.S. will increase their dependence on foreign oil, not decrease it.

— Source: NPR.org (PDF)

2. Obama has threatened to pull BP contracts in the USA, which would effectively kill the U.S. division. That is why I said the U.S. BP division is especially at risk.

3. BP is the largest supplier for fuel for the United States military ships, aircraft, and other hardware.

“BP holds more than $2 billion in annual U.S. defense contracts and continues to be the premier provider of fuel to the world’s largest consumer of oil and gas: the Pentagon.”

— Source: The Nation

If the Obama Administration decided to ban BP from doing business with the Federal Government, this could be another blow to BP’s long term revenue. This is not just theory, but a real possibility.

“The Obama administration is studying options to bar BP from receiving federal contracts – a move that could cost the British oil giant billions of dollars and severely curtail its drilling operations…”

— Source: Telegraph.UK

BusinessWeek has also reported that BP is at risk of losing its oil drilling contracts in the USA. Part of this argument has to do whether BP’s history of safety and environmental issues are satisfactory to U.S. regulators. Aside from the current Gulf spill, there was a previous explosion at a one of BP’s Texas refineries where 15 BP employees were killed in that accident. Also, 200,000 gallons of crude oil was dumped in Prudhoe Bay, Alaska resulting from a 2006 pipeline leak. (Source: BusinessWeek)

I would argue that based on the forgoing, the U.S. division of BP is at a greater risk than the remaining global divisions.

Other oil companies may also be affected by Obama’s move to stop off shore oil drilling. The U.S. had previously allowed Shell Oil to conduct “exploratory drilling” as far as 140 miles off the Alaskan coastline. Those leases are now in jeopardy. (Source: TimesOnline.UK)

General Legal Risk
This is a HUGE wild card:

The legal risk is completely unknown at this time, and it may be years before we know the true costs.

BP’s Gulf oil spill could be looking at huge EPA fines up to $4,300 per barrel per day under the 1990 Oil Pollution Act. Zachs research reports that if the oil spill rate is for example 40,000 barrels a day, at about 50 days, that would amount to currently $8.6 billion in EPA fines. (Source: Zacks Research)

However according to the NY Times, this number is likely to be far higher than Zachs current estimate. The NY Times stated that, “if the spill continues through August, the center calculated that BP’s liability will be about $19 billion.” (Source: NY Times)

One up from this estimate according to the SF Gate, who claims that more than “30 million” barrels of oil may have leaked in to the Gulf thus far. (Source: SF Gate) I could not fine data how this information was calculated. However if this were true, 30 million barrels times $4,500 per barrel would equate to $135 Billion in EPA fines. This would be enough to send any company into bankruptcy.

The problem is that we really don’t know how much oil is spilling in the Gulf; nor do we know for how long this oil is going to spill in the Gulf. What we can assess is that the longer time the spill occurs the greater the liability and fines BP is likely to face.

According to a report, a team of scientists suggests that the PB oil spill is “35,000 to 60,000 barrels” of oil per day. [Source: CNN (PDF)] These figures would amount to $7.8 Billion (35,000 x $4,500 x 50 days) to $13.5 Billion (60,000 x $4,500 x 50 days). This number would likely be higher. Say that just 40,000 new barrels of oil spilled per day could increase PB’s fines to another $180 million per day plus clean up and other costs. BP does not generate this kind of daily revenue to off set these fines. Nor does BP have the cash reserves to pay these fines. That is why the dividend had to be temporary suspended.

Aside from EPA fines, BP’s overall liability could be huge. Under pressure from the Obama Administration, BP will set aside $20 billion for an (unofficial name) “victims’ compensation fund.” (Source: MS-NBC) What is not well reported is that PB is NOT writing a $20 billion check. They are allocating $5 billion a year over the next 3 1/2 years to this fund. Details of the BP escrow compensation plan provided by NBC News. The fund will not be managed by BP, it will be managed by Ken Feinberg, Obama’s Pay Czar.

BP has also set aside an additional $100 million for laid off oil workers due to Obama’s no drill moratorium. (Source: Bloomberg-Businessweek) The Obama Administration gave the order to stop all drilling in the Gulf, including ordering all the other rigs that have not spilled any oil, nor have they caused any damage, and all those workers and related support are being affected. I would argue that BP is really moving beyond their legal responsibility by paying for laid off workers caused by the Obama Administration’s moratorium policy. If an airline were to crash, would Obama order all the other airlines to stop flying so the FAA could investigate what happened? BP is basically paying whatever it takes to show good faith.

BP will also allocate $500 million over the next 10 years to study the effects of oil and gas pollution. (Source: Bloomberg-Businessweek) I think the average person on Facebook could come to a logical conclusion on this question. Here, the CDC already has come up with an answer to this question on their website. Save the $500 million and put that to better methods to plugging the well.

Litigation Risk
Next, we have litigation risk. PB will be hit with countless lawsuits from those in affected areas and everyone holding PB stock who lost money. The amount of these potential damages are not known.

BP has already lost $75 billion of market value from their falling stock price since the spill. (Source: New York Times) One might think that the damage to the stock would be worse than the collective amount of clean up costs, reasonable fines, and litigation claims. However it is difficult to come up with a number other than a hypothetical guess, because the total damage is not known, and the oil has yet to stop spilling into the gulf.

Realistically it could take many, many years before this case is complete. Again, as said earlier, the Exxon-Valdez case lasted 19 years in court. However Exxon fought tooth-and-nail to prevent the company from being hit with unlimited liability in the spill. Drawing out that case actually benefited Exxon, saving them almost a 90% reduction in claims where the initial $5 billion in punitive damages was reduced to about $507 million.

In the case of BP, there has been no hearing, no court ruling, and the company already has committed over $20 billion to potential damages. This is a good Public Relations (PR) move, however from a business standpoint, the company is likely to have exponential greater costs that can impact the value of the business, at least from the U.S. operations.

BP Positives
Aside from the increased PR for committing money to compensate people for losses in advance of any legal hearing, there are several signs that may actually suggest BP could survive this as a company.

1. BP’s stock seems a little more stable compared to the volatility as of late which is a plus. We will need to watch the stock price over the next 3-6 months and see how it performs after the spill is capped.

2. BP’s Credit Default Swaps (CDS) have improved over the last couple days. (Source: Guardian.UK) This is due to market forces, and a stabilize stock for right now. Keep in mind that market forces can change as new information changes.

3. BP’s Chief Hayward did a good job after being grilled for 7+ hours by a U.S. Congressional hearing on 06-17-2010, which can be summarized like this (paraphrased slightly):

BP CEO, Hayward:

“I was not there.”

“I did not make that decision.”

“I am very sorry.”

“It is under investigation.”

In the short run the stock could have a technical bounce again.

4. Capping the well for good I think should produce a sharp technical bounce in the stock. This could last 1-4 days, maybe longer, then reality of calculating liability should bring the stock down.

Long Term Impact on Obama’s anti-oil Policies on U.S. Consumers
President Obama has said we need to end our energy dependence on foreign if not also domestic oil. I don’t know any past U.S. President who said we need to be more dependent on oil, let alone foreign oil. It’s a noble idea, but it won’t happen in our life-time.

Go Nuclear? It can take 7-12 years to build a nuclear power plant assuming an easy move through government regulators, and U.S. citizens not having a problem with having a nuclear power plant in their backyard so-to-speak.

The problem is like wind and solar, cars, trucks, most ships, and commercial planes don’t operate on these kinds of alternative fuels. Sure, increasing technology development in theses areas can help, but it will not solve our energy problems with a passage of some new energy reform bill. Like it or not, 50% of the energy used in USA is still created by the cheapest and most abundant energy source, coal. (Source: PBS.org)

Future of BP’s Stock
The long term impact of BP may have more to do with the Obama Administration seeking greater control and regulation over oil industry, just like the banking, financial, auto, insurance, and health-care industries. Ultimately if one asked me to guess what the longer term impact of all this will be, I would argue that the consumer will end up paying more for gas, heating oil, etc, and experience higher retail prices since with the exception of rail road delivery, virtually everything else in America is imported and delivered by truck, plane, or ship. All of these require fuel, and higher fuel prices translate into high consumer prices, which translate into inflation.

Going Long BP? Bottom Line:
Those entering new PB stock positions are taking on a Las Vegas style odds where if, if, if, BP can cap the well quickly and permanently; and if PB can mitigate the 1,000’s of lawsuits from industry people to shareholders to a cost well below estimated damages; and if President Obama et al, allows the continued drilling in the Gulf, etc., where that business can still be profitable in the USA; and if the Obama Administration doesn’t permanently or severely curtail BP from competing or maintaining future U.S. government contracts; then BP has a chance for a higher stock price.

However, if any of these mitigating factors go beyond current expectations, the risk to BP’s stock could be severely affected. I would argue that the biggest risk in this mess is the threat from the Obama Administration future energy regulatory bills, and other new policies that could end up costing not only BP’s its business in the USA, but it could impact other off-shore drillers and related jobs in the USA too.

Related Stories:
Bureaucracy frustrates Gulf oil spill efforts (Reuters)

BP deploys Costner’s oil machine in Gulf cleanup (Reuters)

Remarks by the President to the Nation on the BP Oil Spill (prepared speech) (Whitehouse.gov)

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