BP Stock Reacts Well as the Obama Administration Helps Craft Framework for Spill Cost Outlays

Once the decline in BP plc (BP) stock reached 20% after the Gulf spill I was in the camp that felt that BP’s stock price drop was overdone given the oil giant’s financial strength. However, as the oil has continued to gush despite repeated efforts to stem the flow, BP shares have continued to fall, which at its worst levels amounted to a market value loss of 50% or $95 billion. While my initial nibbling in the stock was premature (I, like many people, figured BP would have better success containing the well after 2 months of trying), I still believe the stock market reaction has been excessive.

Thus far on this blog I have resisted providing specific financial projections to back up such an assertion, due mostly to the fact that the oil continues to pour out of the ruptured well, making the potential liability unlimited and unknowable. That said, Wednesday’s meeting between the Obama Administration and BP executives was helpful for value investors looking at BP. During the meeting they were able to agree on a timetable for cash outlays to cover the spill’s economic damages, which gives us a lot more clarity as to the financial impact on BP in the coming months and years.

As a result, I will run through some of these numbers and show why I still believe that BP can survive this spill somewhat easily, simply due to the size and financial strength of the entire company. We must remember that BP is one of the world’s largest and most profitable companies (we are not dealing with accounting games at Enron or 30x leverage at Lehman Brothers).

Let’s start with the costs of the containment efforts and the clean-up of the oil. So far BP has spent $1.75 billion in the two months since the Deepwater Horizon rig exploded. Industry experts expect this run-rate of expenses (about $1 billion per month) to drop once the well has been capped (evidently undersea robots drilling with diamond studded saws are pretty costly), but to be extremely conservative I have been assuming that the containment/clean-up costs continue at $1 billion per month through 2011 before the drop. This equates to $12 billion per year in containment and cleanup costs as a conservative estimate.

The White House and BP agreed Wednesday to a $20 billion escrow account to be used for economic claims from businesses. BP has announced it will pay $5 billion into the fund this year and an additional $1.25 billion each quarter beginning in 2011, until the $20 billion has been fully funded. This comes to $5 billion per year for 2010 through 2013.

It is also important to understand that BP will be subject to additional fines and penalties under the U.S. Clean Water Act, based on how much oil ultimately is determined to have been spilled into the ocean. Because the oil continues to flow from the broken well, this aspect of the cost equation is still unknown, as is the exact daily flow rate. Current estimates are 35,000-60,000 barrels per day. If we assume the oil flow is completely stopped by September 3oth (the current expectation is sometime in August) and a penalty of $4,300 per barrel is assessed, these fines could amount to about $30 billion. However, those fines and penalties will likely be fought over in court and therefore the amount will be unclear for a while. Still, because of this unknown liability, I likely will not be buying more BP stock until the well has been capped completely.

The question for investors, obviously, is whether or not BP can afford these projected costs. We are talking about $17 billion per year in containment, clean-up, and damages, plus fines. Let’s look at some of their first quarter 2010 financial metrics to get an idea of their financial capacity:

Operating Cash Flow: $7.7B     Capital Expenditures: $4.3B     Free Cash Flow:  $3.4B     Dividends Paid: $2.6B

The dividend has been scrapped for now, so we can expect that BP’s ongoing operations will generate about $14 billion per year in free cash flow. However, we must keep in mind that these costs are pre-tax figures. BP paid about $8 billion of income taxes in 2009 and all spill costs will be able to be used to offset operating profits and therefore save the company billions in taxes. On an after-tax basis, $17 billion in annual spill costs comes out to an adjusted figure of about $12 billion of cash outlay. As you can see, BP should be able to handle these clean-up costs without dramatic capital expenditure reductions (they have announced a 10%/$2 billion annual reduction in capex).

Additionally, BP has said they have about $10 billion in available credit facilities and also expect to divest $10 billion of assets over the next 12 months. Undoubtedly that money will be used to help pay the penalties and fines that it will ultimately be forced to pay, as well as serve as a cushion if claims come in higher than $20 billion or the well gets worse rather than better. Unlike some energy firms, BP has a very strong balance sheet, with $8 billion of cash and a debt-to-capital ratio of 20%, at the low end of their 20-30% target range. As a result, the company could take on up to $17 billion in new debt and still be within that range.

Finally, we cannot forget that BP only owns 65% of the ruptured well. They will almost certainly ask Anadarko (APC) and their other partners to foot their portion of the bill, although we can expect the court system to play a major role in that process.

All in all, the financial strength and size of BP makes it possible for the company to use normal business activities and a bit of financial management to pay for the spill. Even using an aggressive estimate $50 billion in total spill-related costs over the next few years should not force BP into dire financial straits. Not only that, but the last Exxon Valdez spill claims were settled quite recently, about 20 years after the accident occurred. Even if costs are higher than current estimates and take longer to resolve, BP should be okay given that the company brings in about $30 billion per year in operating cash flow.

I figured it would be helpful to go through these figures because some people on Wall Street have been talking about BP being forced into bankruptcy due to the Deepwater Horizon disaster. Barring some unforeseen, unexpected, or simply unheard-of developments, it certainly seems that BP’s reputation will be hurt far more from this spill than their finances will be. Obviously things can change, but these are the kinds of numbers I have been looking at in recent weeks and I think they are very interesting, even if one has no interest in bottom-fishing in BP stock. Less aggressive investors might want to look at BP bonds, which recently yielded between 8 and 10 percent in the 1 to 5 year maturity range.

Full Disclosure: Peridot Capital had a small long position in BP stock at the time of writing, but positions may change at any time

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One Thought on “BP Stock Reacts Well as the Obama Administration Helps Craft Framework for Spill Cost Outlays

  1. Andrew on July 5, 2010 at 12:55 PM said:

    Of course Obama would help BP. BP loves big government and the favors. Hell they support the cap and trade system because it benefits them.

    I doubt they’ll lose leasing spaces like what was reported a few weeks ago.

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