Removing Uncertainty

I am surprising myself by writing about BP once more. This time I am motivated by BP's interesting offer to set aside $20B for reparations, and how that number plays against the company's finances. There is little doubt that they were pressured into agreeing to set up this fund, although it may work in their favour. They likely know this, which would explain their rapid compliance with the "request".

Perhaps the most important factor is to take some measure of control of the situation by demonstrating to the market that there is some possibility of limiting company losses. In actuality there is little reason to believe this too strongly since there is nothing in place to limit their criminal and civil liability.

There is some hope that even if their eventual payouts total higher that the company will survive and perhaps even thrive since there is now some indication that the government's international trade and political risk will motivate them to intervene if litigation spirals out of control. That is, they must keep BP healthy and viable to keep a major ally -- the UK -- happy, and they must not scare other exploration companies out of the domestic off-shore business by placing them, too, at infinite risk. The US cannot afford to let that happen. However, it may be many months before they take those steps, after the immediate crisis is over and the public outrage has dropped down a few notches.

Therefore, with some mitigation of the uncertainty surrounding BP's future prospects, the market is once again in a position to properly value the company. The stock price is stabilizing and may even be ready to bottom since the cost of the disaster to BP could be substantially lower than the impact on their market capitalization.

Investors welcomed the removal of uncertainty which has dogged BP ever since the Deepwater Horizon oil rig sank on April 22, sparking an enormous oil leak.

However that itself is insufficient since the immediate setting aside of $20B is no small matter. If we look at the latest financial summary for BP we see that their cash on hand only about one-third of this amount. In contrast their free cash flow is substantial, but much of that goes towards paying dividends. Like any petroleum producer, BP's cash flow is finely balanced between its quarter-to-quarter uncertainty due to the high volatility of crude oil prices, keeping dividends at a stable level, and retaining sufficient working capital to fund the exploration that will secure future revenue.

They could borrow the money, though perhaps at higher than preferred rates, which could hurt them in the long run unless crude prices climb higher. By instead suspending the dividend they immediately retain (if my calculations are approximately correct) about $10B per year. Therefore by temporarily stopping dividend payments they can recover the cost of the $20B fund by early 2012. This is not as painful for shareholders as it first seems since the dividend over two years is only about $6/share, which is small in comparison to the $30 that the shares have shed since the crisis began. In other words, by removing uncertainty with this reparation fund commitment the company stands to recover far more than $6 in their currently-depressed share price. This is certain to happen but it is likely.

“Overall, we believe this announcement is positive and provides some clarity for shareholders,” said Mr. Jackson [head of equities at broker Killik & Co].

“The stock will remain vulnerable until BP manages to block the spill,” he added.

Creation of the fund also goes some way to repair BP's image from poor behaviour both before and after the spill. All they now have to do is end the leak -- by relief well in August -- then hope for beneficial weather and ocean currents, and make good on the clean-up. There is now potential for substantial returns on BP's shares by year-end, although this is not my preferred type of investment.