The Fate of BP

Yesterday I participated in an online panel (registration required) exploring the implications of the Gulf Coast oil spill. As the panelists were waiting for the webinar to begin, the moderator suggested a few questions he thought might come up. Although we never got to the one on the future of BP, a quick read of today's news suggests this remains a highly relevant question for the public and for BP's investors, retailers, and suppliers. While I'm not ready to hop on the bandwagon in thinking the company might end up being taken over by a competitor, I don't think we can rule out that possibility. In any case, it seems almost certain to end up a very different company than it was prior to April 20, 2010. That could have implications not just for the oil & gas industry, but also for the renewable energy sector, in which BP has been an active participant.

The first article that caught my eye this morning pondered whether Mr. Hayward was likely to survive as the company's CEO. Anyone presiding over a 34% decline in market value within the space of a few weeks--and not as part of an overall market crash--ought to be concerned about his tenure. Still, I would be as surprised as several of the experts the Wall St. Journal interviewed if the company's board saw fit to fire him before the well was secured and the investigations completed, barring credible evidence of serious errors of judgment on his part. In any case, I find the speculation about a takeover of the company much more interesting.

Even in its weakened state, BP is still a mighty big fish for someone else to swallow. As of this morning's trading, its market capitalization stood at $119 billion. As an article in today's Financial Times highlighted, that rules out all but a small handful of possible acquirers. For me the potential of an acquisition hinges less on the relative size of BP and the various firms that might be able to absorb it, than on the underlying "industrial logic." The fact that the firm is about $68 B cheaper than it was in mid-April doesn't make it a bargain, because it has acquired a large new set of liabilities, the value of which can't be accurately assessed, yet. That's true even short of a finding of criminal negligence, which various politicians have hinted at, but that remains entirely speculative at this point. I believe the real issue is whether after all damages and claims are paid the lasting harm to BP's brand and reputation is so severe--and so tangible--that its assets and operations would clearly be worth more within another large energy company.

First consider BP's capacity to cover the costs of the spill cleanup and pay all the claims accumulating against it. The media and politicians have focused mainly on the company's first quarter 2010 profits of either $5.5 B or $6 B, depending on how you measure them, though I believe that its annual cash flow and the disposition of that cash flow provide a clearer picture of its ability to pay for damages. A quick look at the financials in its 2009 Annual Report shows that from 2007-2009, BP's annual cash flow from operations averaged $30 B per year. This was spent roughly two-thirds on its capital projects budget and one-third on paying dividends to shareholders. At the end of 2009 the company held just over $8 B in cash and cash equivalents. I also scanned the report for any indication that BP had external insurance coverage for such events. I couldn't find any, and media reports indicate they were self-insured. However, even without insurance, BP could potentially pay out many tens of billions of dollars of cleanup costs, damages and penalties, if any, over a period of 3-5 years.

That's not to say that all of that cash flow would be available for such purposes--some maintenance investments would be required in any case--or that this could be done without a significant impact on both the market valuation of the company or its underlying long-term enterprise value. In effect, this is probably a big part of what the market is discounting into the stock price: a sort of rough consensus estimate of the expected value of the impact on the company of the likely payouts. This includes things as simple as the reduced value to investors of a stock paying a lower dividend (or none, as several lawmakers have suggested) to the consequences of constraining its reinvestment in hydrocarbon production that depletes a little bit every day. Other concerns weighing on the value include the perceived effect of any consumer boycotts--there's apparently one gathering strength on Facebook and in multiple YouTube videos--or the loss of government contracts as a result of the possible findings of the various investigations. That could run the gamut from losing contracts to supply the US military with fuel to losing leases to develop new resources. These are also some of the elements that any potential acquirer would assess, to gauge how much of the discount on BP is attributable to factors that could be quickly reversed under other management and an untainted brand.

Based on my experience working at Texaco, Inc. following the Pennzoil verdict, which led to the company's bankruptcy and the payment of a multi-billion dollar settlement, even if BP weren't subject to an acquisition in the short term, its future trajectory might still be so altered by this event and its costs that it would eventually end up much smaller, or perhaps as the subject of an acquisition much later. I see several relevant analogies to Texaco/Pennzoil. First, this matter will continue to occupy the attention of management long after the well is finally plugged. Claims and lawsuits will drag on for months and probably years, and top executives will be testifying before a series of investigations, tort actions, and perhaps even criminal trials. Day-to-day operations probably wouldn't suffer, but it would be very difficult to keep the firm's strategy sharply focused under such conditions. I'd also be surprised if BP didn't miss out on critical opportunities along the way.

Then there's the question of how to pay for claims and damages. At some level, if they exceeded cash on hand and easy borrowing capacity, it would likely make more sense to management to sell assets--or transfer them directly to plaintiffs--rather than funding payouts at the expense of the investments on which the future of the company would depend. The firm will also be under considerable pressure from investors to continue paying out strong dividends, or to resume them if they are suspended at some point in the process. But regardless of how BP chooses to cover its spill-related liabilities, its future capital budgets seem likely to be constrained, and projects with longer payouts or less attractive returns would fall below a higher cutoff line. Given the relative returns of renewable energy projects compared to oil & gas projects, BP's renewables could be an early casualty, unless they are deemed crucial to rebuilding the company's reputation.

While an acquisition will remain possible as long as BP's stock is this depressed, it seems likelier that the company will survive and eventually rebound, though perhaps not to former levels. But even if none of its competitors is willing to take on the big risks an acquisition would entail, let alone navigating anti-trust regimes that are likely to be much less flexible in the wake of the financial crisis, this possibility will have BP's management looking over their other shoulder--the one that the US government isn't already camped out on, adjacent to the "boot on the neck"--until this entire episode is behind them.

I'd like to close with a reminder that a consumer boycott of BP stands a much bigger chance of harming one of your neighbors than it does of hurting BP. Most of the service stations in the US aren't owned and operated by the company whose brand you see on the polesign; they are mainly independent businesses that have a supply contract either directly with the company, or with a regional distributor who has such a relationship. So if you boycott your local BP station, chances are you are not affecting BP, which will resell the product on the wholesale market, but a local business owner who is struggling in a very tough business with slim margins. And in the case of BP, many of these retailers didn't even choose BP. Depending on how long the site has been in their families, many would have originally signed up with Amoco, ARCO, or even Sohio (Standard Oil of Ohio, which BP acquired in two stages in 1978 and 1987.)