What the BP spill means for investors

Published by Fiona Bond on 02 June 2010.
Last updated on 02 June 2010

What the BP spill means for investors

The BP crisis took a turn for the worse when the oil giant admitted that its latest efforts to halt the gushing oil leak in the Gulf of Mexico had failed.

Shares in the company tumbled 15% as investors mourned the news that its much hyped "top kill" operation had proved futile.

The company, which has seen almost a third of its value wiped off since the explosion six weeks ago, is racing against the clock to salvage both the MC252 well and its reputation in the process as the costs hurtle towards the $1 billion mark.

But with mounting pressure from the US government and fears for the future of deepwater drilling, we ask what this spill means for investors in the oil industry.

When will this spill be cleaned up?

The failure of BP's latest "top kill" operation has sent the market into a spin. It was given a 60-70% success rate, fuelling hopes that the oil major might have found the answer to its prayers.

Peter Hitchins, analyst at Panmure Gordon, says: "Everyone was braced for good news, but this turn of events has left investors nervous. The fact the top kill effort failed, despite such a promising chance of success, has caused apprehension in the market as to whether the group's Plan B can really work."

BP's next desperate attempt to stem the flow involves deploying the lower marine riser package (LMRP) cap containment system. Robots will slice through and separate the damaged riser from the LMRP, before placing a containment cap over it in the hope of capturing "most of the oil and gas flowing from the well."

It anticipates that the LMRP cap will be connected in about four days' time, but warned that such an operation at depths of 5,000 feet below sea surface has never been tried before and carries no certainty.

In cutting the pipe, BP could also run the risk of allowing an even greater volume of oil to gush out if the containment dome fails to attach properly and White House energy adviser Carol Brown warned that 20% more oil was likely to escape before the new cap has been mounted.

What's the damage?

So far, at least 20 million gallons of oil have spilled into the waters, forcing the closure of some 61,854 square miles in the Gulf of Mexico to fishing activities, the National Oceanic and Atmospheric Administration said.

Fears are now growing that BP's greatest shot of halting the 5,000 barrel a day (bopd) leak will come from two relief wells currently being drilled, which are not due to be completed until end of July/August.

Tony Shepard, analyst at Charles Stanley, says: "After the disappointment with the top kill operation and failure with other attempts to halt the flow, we feel the best hope of stemming the leak lies with the relief wells. With the prospect of several more months of pollution, BP and the oil industry will come under increasing pressure."

What does this mean for the oil industry?

While BP itself has faced a barrage of abuse, the oil industry as a whole has come under severe scrutiny since the explosion in April, amid fears that this disaster could repeat itself.

President Obama has suspended deep-water drilling in the Gulf of Mexico and exploratory drilling off Alaska, as well as extending a moratorium on deep-water drilling permits. The announcement signalled a sharp turnaround for the President, who just two months ago called for an expansion of offshore drilling.

Shepard of Charles Stanley believes there will be ramifications for the whole industry: "This environmental catastrophe will have global implications for the whole industry in terms of new deepwater drilling regulations. In the Gulf of Mexico, the US authorities have already implemented a moratorium on new drilling and new regulations will lead to higher industry costs."

As scientists estimated that the rate of oil flowing into the sea was far higher than official estimates of 5,000 bopd, Obama said his greatest mistake was to trust that oil companies had their act together in responding to disasters.

Evolution Securities believes that that changes are "inevitable" and cites tougher permitting laws, tougher inspection regimes for safety equipment, higher specification for key safety components and more redundancy features.

What does this mean in terms of costs?

There has also been talk of removing the $75-million liability cap. The cap limits the company's costs for direct economic impacts of the spill, but campaigners are pushing for the cap to be scrapped to stop companies escaping liability for such disasters.

Evolution Securities says: "It's unlikely that many of the companies operating in the US could afford or justify the insurance premiums if the liability cap was lifted to $10 billion. In reality it would shut down activity rather than expand it and deter small and mid-sized E&P companies from offshore activities."

Furthermore, it believes that potential drilling and project delays could also have implications for the service sector recovery in 2011. Most vulnerable, according to the group, are those service companies with asset heavy deepwater exposure such as Saipem and Acergy.

The Gulf of Mexico region also faces falling under attack, as the US government is shown to be trying to avert another disaster of this magnitude.

In a note, Societe Generale comments: "The US Gulf of Mexico may now be perceived as bearing a higher risk than before and the costs of operations in the area are likely to increase in future as the industry spends more to minimise the technological risks, both voluntarily and due to increased government pressure and risk premiums."

Can BP stage a comeback?

The disaster is a nightmare for BP. So far, the group's clean-up costs have totalled $990 million and it admits that it's too early to quantify other potential costs and liabilities associated with the incident.

David Hart, analyst at Westhouse Securities, comments: "BP's stewardship of the environment will now become a major issue for the company as it attempts to operate elsewhere in the world as a preferred partner by governments and national oil companies, not least in Russia, where the TNK-BP joint venture represents nearly a quarter of the group's output."

And the bad news doesn't stop there. Independent experts have insisted that BP's 5,000 barrel figure is inaccurate and have said it could be anywhere between 20,000 and 95,000 barrels a day. Should the true figure turn out to be somewhere within this range, the Gulf spill would become the largest in history.

If BP fails to stop the flow before mid-summer, it faces possible deterioration in its long-term prospects in the US due to a hostile public environment, which could include its possible ineligibility from its lucrative projects with the US government.

However, Egveny Solovyov, analyst at Societe Generale, believes BP has the power to turn events around.

"The downside risks are numerous: failure to arrest the leak until the relief wells are completed, uncertainty about the glow rate, an unclear US legal environment with retroactive changes possible and lack of complete clarity on where the fault lies and how financial responsibility will be shared.

"Indeed, longer term BP may be facing increasing operating costs in US deepwater. While this is not limited to BP alone, the company is more dependent on the region for its oil production than any of its major competitors," he says.

Hitchens of Panmure Gordon agrees that although BP has a long slog ahead, it is not battling unknown territory.

"It all looks absolutely horrible at the moment but take a look at Exxon following its massive spill - it is now one of the biggest oil majors. BP has been dealt the majority of the blame because it is a well known name, but BP had been doing a good job at improving their record and now faces a setback with this freak accident.

"BP can most certainly come back from this, the way it has rebounded in the past."

What next for its shareholders?

Hitchens says that despite the mounting uncertainty and series of failures over the past month, BP's shares still pose an attractive option.

"We believe that until the flow of oil from the well can be halted there will remain considerable uncertainty over the potential damages that will be done to the environment and hence the financial impact on BP. Although we believe that the market has overreacted to the bad news, we feel that there will be little stimulus to the shares while the leak continues to pump oil into the sea.

"We maintain our 'buy' recommendation with a price target of 600p, but we realise that this will not be achieved until the well is under control."

So far, BP has seen almost a third of its market value wiped off, but many analysts believe this is a grave over-reaction to events.

Solovyov of Societe Generale says: "The market seems to be assuming that total accident-related costs to the companies involved would amount to over $50 billion and that BP's share will be in the region of $40 billion. We see this as an over-reaction."

Instead, he sees BP spending $6.2 billion in direct accident-related costs over 2010-2014 and possibly settling the bills for many years beyond that, given that Exxon had its final Valdez-related case nearly 19 years after the accident.

However, he estimates that if all options fail and the leak is only stopped through the relief wells, BP's clean-up bill will amount to $1.8 billion.

But investors have naturally grown anxious about the group's dividend payout, as well as its financial condition. At the close of March this year, BP has $6.8 billion in cash and net debt of $25.2 billion, while its annual dividend amount to $10.5 billion.

Shepard of Charles Stanley says: "At the end of March, BP's net debt ratio was 19% which was below its 20-30% target level. BP will publish its second-quarter results in July and clearly these will give more clarity on potential costs and liabilities. BP's share price has fallen by 25% over one month - although we believe that BP has the capacity to survive this crisis."

However, in a boost to shareholders, Solovyov deems it unlikely that the dividend will come under attack this year as a result of the spill.

"Even assuming BP does not cut its 2010 capex and still completes its acquisition of the Devon assets by the end of the year, we estimate the company can absorb up to $20 billion in extraordinary costs this year before it reaches the upper limit of their gearing range of 20-30% putting the dividend at risk," he says.

"As none of our scenarios envisage BP paying anywhere near this amount, we believe the risk of BP cutting the dividend this year is insignificant. Therefore, BP's 2010 dividend yield at the current share price has increased to 8%, which is generous for a mature major company," concludes Solovyov.

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