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.)

Another Tumultuous Year?

Whether or not next week's inauguration of the 44th President of the United States marks the true start to the 21st century, as a Washington Post columnist recently suggested, 2009 could herald momentous changes in long-term energy trends. While a return to the extraordinarily high oil prices we experienced last summer looks improbable, we could yet see a significant price spike as a result of geopolitical events--or a further slide towards $30 per barrel. Developers of alternative energy technologies and projects will be watching Washington intently, in hopes that the expected stimulus bill or separate energy legislation will boost their fortunes and unlock access to persistently tight credit. And against that backdrop, the behavior of consumers in a new economic environment bears watching, as the ultimate source of energy demand.

In no particular order, here's my list of energy trends and events to watch as the year gets underway:

• Oil prices are being squeezed between the weight of accumulating inventories, especially at the Cushing, OK storage that comprises the New York Mercantile Exchange's main delivery point for West Texas Intermediate crude oil, and the anticipation that a combination of OPEC discipline and resurgent demand will tighten markets appreciably later in the year. The resulting contango remains very wide. The prompt contract, for delivery in February, has fallen below $40 per barrel, while oil for delivery in July sells for well over $50/bbl, with next year's crude going for more than $60.
• As I noted on Friday, the gap between oil and natural gas has closed, even as gas has fallen below $5.50 per million BTUs, a level that is providing an energy-price stimulus for industrial and utility customers similar to the one that sub-$2 gasoline gives consumers. Gas is in contango, as well, though hardly as steep as oil. How long will the present US gas supply bubble persist, given the rapid decline rates of many gas wells and the weak finances of many of the big producers?
• The influence of government over energy looks certain to expand this year. Will the stimulus bill satisfy the wish list of alternative energy and environmental advocates, including assistance for struggling ethanol producers, cash subsidies and loan guarantees for wind and solar firms, and big investments in infrastructure, including new long-distance power transmission and a down payment on the "smart grid" of the future?
• An article in this morning's Wall Street Journal raised the prospect of a new wave of energy industry consolidation, similar to the one that created the "Super-Majors" (Exxon-Mobil, BP-Amoco-ARCO, Chevron-Texaco, Elf-Fina-Total) starting a decade ago. The industrial logic is probably there, though any merger would play out in a political context that seems much less likely to be receptive to such combinations, even if the publicly-traded oil companies do account for less than 10% of global oil reserves and less than 20% of production.
• If the financial crisis has pushed geopolitical risk into the background, the conflict in Gaza and the revelation over the weekend that Israel had asked for US assistance in an attack on Iran's nuclear complex should remind us that it hasn't vanished entirely. Although the oil market is in a much better position to forgo Iran's oil exports than it would have been for the last several years, taking 2 million barrels per day off the market--a likely response to any attack on Iran--could still be good for a quick pop of $15-20/bbl, or an extra $0.40 or so per gallon at the pump.
• Last year's weakness in the US dollar contributed to the summer's high oil prices, and the late-year dollar rally helped to unwind the residue of that spike. As the US deficit expands past $1 Trillion next year and into 2010, between fiscal stimulus and falling tax revenues, could the dollar begin falling again, and if so, what would that mean for energy prices? Economists tend to view these deficits as a manageable fraction of GDP. However, in absolute terms they are enormous, and they will compete with deficit spending all over the globe, taking us into uncharted territory.
• Finally, we can't forget about consumers. If the sharp drop in demand--around 6% year-on-year--was the pin that popped the oil-price balloon, will low gas prices begin to revive it? But while today's average pump price for regular gasoline of $1.68/gal. is a whopping $1.42/gal. less than last January and $0.62 lower than the same week in 2007, it surely doesn't look quite so cheap as a fraction of average purchasing power, between declining home values that have dried up the home equity loans with which many consumers were supplementing their income, and rising unemployment. It will take some time to see whether the weak economy and vivid memories of $4+ gasoline have altered consumption patterns permanently, or just temporarily. That will have important implications for environmental policy, too.

It's going to be interesting, for good or ill, and I look forward to continue sharing my perspective on energy and related environmental matters with you, as Energy Outlook begins its sixth year.

Short Memories

One of my ongoing themes here is that, despite high energy prices that now rival those of the last energy crisis, we are not experiencing the second coming of the 1970s. Unfortunately, we do seem fated to revisit every bad energy idea from that period, and today we have two on display. First, a columnist in the Washington Post proposes establishing a national oil company (NOC) to promote expanded supply, new refineries, and "hyper-competitive" pricing. Then later this morning the Joint Economic Committee of the Congress is holding a hearing on whether to pursue breaking up the largest US oil companies. At this rate, I'd better make room in my closet for the paisley shirts and leisure suits that must surely be on their way.

In his column Steven Pearlstein anticipates all sorts of oil industry opposition to the idea of a chartered national oil company set up to compete with them, and given all sorts of breaks on refinery siting and permitting and production from federal lands. Never mind that if the existing oil companies had been given those breaks when energy prices were low, we might not be in the present pickle. While I'm sure Mr. Pearlstein's plan would provoke the expected response from energy companies and trade associations, the biggest complaints ought to come from taxpayers and watchdog groups. This approach was tried all over the developed world in the 1970s, and with very few exceptions, it was given up as a bad idea. The successful NOCs are all in big net-producing countries, not net consumers. The history of Petro-Canada, founded in 1975 and 80% privatized in the early 1990s, illustrates this cycle. Mr. Pearlstein probably isn't serious, of course. His contrasting portrayal of a hypothetical NOC seems mainly intended to shame the publicly-traded oil firms for being profitable and rewarding their shareholders. But in today's climate, I wouldn't be surprised to see some legislator take up this mock cause.

Turning to today's Congressional hearing, it has become an article of faith in some quarters that the country's energy woes are the result of the industry consolidation that took place in the late nineties and early oughts. Smaller, more aggressive competitors would have apparently increased oil production and expanded their refineries at a faster pace, so that while global oil prices might now be high, at least refining margins would be lower, with consumers paying more like $2.40/gallon, instead of $3.22. But while you're unlikely to find an industry insider less enamored of merger mania than I am, this scenario flies in the face of the economic facts that drove those mergers in the first place.

From 1997-2001 I worked in Texaco's Corporate Planning & Economics Department. During that period, we experienced the disdain of investors for "old economy" industrial firms that needed capital to compete with the growing power of the NOCs in producing countries, which held more than 80% of the world's oil reserves. We just weren't New Economy enough. Then, to add insult to injury, the price of oil collapsed from the $20s to single digits, before recovering. The mergers triggered by these events weren't focused on market domination and pricing power: they were about ensuring the survival of an industry that had just come through a near-death experience.

One of the other concerns that occupied much of my time in that period was refineries. Simply put, they were dogs. Not only were US refineries consistently earning less than the cost of capital, but they were a constant drain on capital, because of wave after wave of environmental investments in reformulated gasoline and ever-lower sulfur diesel fuel, for which consumers didn't want to pay an extra penny. All that management wanted to do was to find ways to reduce our exposure to this awful sector, and that's exactly what we and the other majors did, through joint ventures and outright sales. Is it any wonder that, on the back end of such a cycle--when demand growth has outstripped domestic capacity and our reliance on gasoline imports from Europe and elsewhere has grown steadily--refining margins are finally enjoying a bonanza? If oil companies invested as much in new refining capacity as their critics would like--even if new greenfield facilities could get permits--the result would likely be another protracted cyclical bust. In the face of a 35 billion gallon/year alternative fuels mandate, that may just happen anyway.

I persist in my hope that enough of us actually learned something from the experience of the 1970s and the energy price cycles that followed that first energy crisis. If we want to ensure that the US has access to the oil and gas it will need during a lengthy transition away from fossil fuels, then what we need is not a national oil company, and certainly not a gaggle of smaller oil companies. Instead, we need a strong, dynamic energy sector, led by companies big enough to deal with the NOCs as equals and to take expensive risks on the frontiers of technology, whether in ultra-deepwater drilling or cellulosic ethanol. The times demand something much better than merely recycling the ill-considered notions of the past.

A Mixed Legacy

Major oil companies are rarely home to "celebrity CEOs." BP's John Browne was the exception, and it's ironic that his departure--already in the works after a couple of years of bad results on safety--was hastened by the intense media scrutiny that celebrity status now attracts. Most of the articles about Lord Browne that I've read in the last several days have focused on two areas in which his decisions as CEO of BP put a lasting imprint on the oil and gas industry and the world beyond it: industry consolidation and climate change. I can't resist a few thoughts on both topics, which have had a significant impact on my own career.

Although not everyone sees the outcome as a good thing, Lord Browne generally gets credit for starting the wave of oil industry consolidation that began in the late 1990s. The timeline of major mergers supports this notion, with BP having announced its acquisition of Amoco in August 1998, a year before Exxon and Mobil agreed to merge. BP's acquisition of ARCO followed in 2000, creating the present company. Meanwhile, France's Total acquired first Petrofina of Belgium in 1999 and then Elf Acquitaine in 2000. 2001 saw the last changes on this scale, when Chevron merged with Texaco and Conoco with Phillips. Lord Browne's role fits neatly into a "great man" view of this history. However, for those who see leaders arising in response to events, we can't forget the pressures created by the collapse of oil prices in the late 1990s, following the Asian Economic Crisis. Shrinking oil company cash flows set the stage for consolidation, as did the realignment of the US downstream market, when Shell and Texaco joint-ventured their refining and marketing operations early in 1998.

The value of these mergers remains debatable, as does their "industrial logic." While the merged companies are clearly stronger financially, how much of that is attributable to the transactions, and how much to global market conditions beyond their control? Are the merged entities replacing more of their reserves than their predecessors could have, independently? We will never know, though Mobil, Texaco and Amoco were certainly large enough on their own to have continued participating in world-scale projects, while the productivity of tens of thousands of employees lost to "synergies" might have been helpful to an industry struggling to keep pace with the growth of energy demand. And while I don't subscribe to the idea that these mergers reduced competition by enough to harm consumers, the retail market concentration in many regions is at levels that would have been unthinkable in the 1980s. All in all, the legacy of these mergers is a mixed bag, and I don't just say that because one of them effectively ended my 22-year career at Texaco.

In contrast, I regard Lord Browne's impact on matters such as climate change and alternative energy as generally positive. He was a pioneer in recognizing the importance of these challenges and speaking out about them. Mark Moody-Stuart of Shell may have been saying many of the same things in the late '90s, but for those of us working in US major oil companies, it was different hearing it from BP, which had an operating philosophy closer to ours. Without John Browne's high profile on such issues, it would have been harder for others to break out of the pack. And while BP has not always lived up to the expectations set by its aspiration to move "Beyond Petroleum", we can't discount the subtle effect of that subversive little tagline.

It's too early to say how much Browne's legacy will be tainted by the safety problems that surfaced late in his tenure. They serve as an important reminder to leaders in any organization that big strategies are not sufficient for lasting success, without an equal attention to the details of their consequences. As John Browne departs, no one can say he was cautious or run-of-the-mill. I suspect it will be some time before we see another oil company CEO in his mold.