Thursday, June 10, 2010

BP, Anadarko, and Transocean - Splitting the Bill

I thought it might be interesting to get a better sense of what the total bill for the oil spill might be and how that stacks up to the liquidity of the companies on the hook. Clearly there are a lot of guesses and assumptions here, but I felt it was worth taking a stab at it.

The Clean-Up
I looked at the Oil Spill Intelligence Report to get a sense of what past spills have cost. There is a wide range of factors that go into the cost, including the type of oil ("lighter" is better), the size of the spill (bigger gives economies of scale), how much coastline is involved, and so on. All in all, the costs seem to range from $5,000/ton to $34,000/ton. 

Obviously it's hard to get a firm estimate of how much oil is in the Gulf, as BP's guesstimates have been woefully inadequate. So far, I'd estimate that anywhere from 100K tons to 135K tons has been spilled, and that we're now at about a 4K ton/month rate. So if this spill is plugged by the end of August, we might be looking at something like 125K tons.

I'm going to assume a cost of $20K/ton and a total 140K tons. That's a total clean-up bill of close to $3B. Extending the math, figure on $80M/month if this stretches past August, but at a reduced rate of flow.

Punitive and Compensatory 
History suggests a 1:1 ratio of punitive to compensatory damages, but that ratio may be optimistic and conservative given the tenor of the Obama administration and the changes in the class action legal environment since the time of Exxon-Valdez (the best and closest analogue).

So, how to estimate compensatory damages? I've seen estimates that range from $3B/yr to $9B/yr in terms of the annual economic activity that is imperiled by the spill (and obviously this goes up as the spill lingers on and affects a larger and larger area), but the tourism cost could be even higher. It's also reasonable to assume that the area of effect will linger for a few years, but at a declining rate each year.

I'm going to go with a total educated guess of $10B - $15B in total compensatory costs, so the total of punitive and compensatory could be $20B - $30B.

Fines
Violations of the Clean Water Act, Migratory Bird Act, and so on could easily kick another $500M - $2B into the kitty. 

The Total
That leads me to an estimate of $23B - $32B in total damages, with full admission that punitive costs could be higher (but probably no higher than 3x the compensatory). Maybe the absolute worst-case, then, is something like $65B?

Who Pays?
Clearly, the wrangling has just begun on this topic. BP (NYSE :BP) has already begun paying claims and has consistently acknowledged their responsibilities to pay. One big question is whether Anadarko (NYSE: APC) gets drawn into this, and how deeply. Anadarko has a 25% interest in the well. In a best case scenario, Anadarko escapes by hiding within the Oil Spill Liability Trust Fund that limits liability to $75M. Worst case is that they're drawn in to a proportionate share of the total cost.

Cameron (NYSE: CAM), the maker of the blowout preventer that failed, is not likely to be on the hook here, in my view. The BOP was nine years old and information has come out that Transocean (NYSE: RIG) modified the BOP at BP's direction. That, in my mind, basically gets them off the hook.

Likewise, Halliburton (NYSE: HAL) has the advantage of a contract that limits their liability. As I've said before, I still think there's a chance that HAL gets tagged for a bad cementing job and drawn into this, but that's a big unknown right now.

Last and least, Transocean likewise has a contract that limits its liability, and there has been a fair bit of information coming out that Transocean was just following BP's orders all along the way. Does that hold up? I think so.

The Market's Moves So Far
So what is the market discounting for this mess? Let's look at the amount of market cap lost since before the spill.

BP - $86.5B
APC - $17B
RIG - $16.7B
HAL - $8.3B
CAM - $2.4B
SII - $2B

So, the market has taken out about $133B in market cap ... 2x what I think is a reasonable worst-case scenario.

Can The Companies Afford It?
But can they pay?

BP has $7B in cash and should be able to produce another $6B - $9B in free cash flow per year (and this WILL go on for years...). BP is also relatively underlevered and could probably borrow at least another $10B free and clear. On top of that, BP has over 10B in oil reserves, and those could either be sold or used as collateral if need be. The going rate for oil deals has been around $20 - $25/bbl, so that gives a decent idea of the resources BP can bring to bear.

So, if BP has to go it alone, it'll be a tight squeeze, but BP won't go away. They may have to meaningfully cut the dividend in the meantime, though, particularly if Anadarko does not have to chip in.

As for Anadarko, they have more than $3B in cash on the balance sheet, manageable debt, and can generate about $1B-$2B/yr in free cash flow. So, if Anadarko has to pay up to their economic interest (25%), they could be looking at a bill between $5B and $8B. This would be more of a strain on Anadarko ... enough, perhaps, that an unfavorable ruling that pushes them to pay their 25% might lead them into an M&A transaction with a bigger firm that has the cash to pay up. Of course, Anadarko also has oil reserves that could be monetized.

For HAL and RIG, there is about $3B and $1.5B in cash, respectively. I don't see either getting drawn into this, though, so that should be fine. That said, HAL, RIG, and CAM are all going to suffer from the decline in Gulf of Mexico and deepwater business, so I do not read their declines in market cap as being due to potential liability, but to a decline in business and maybe a dented reputation.

Okay, admittedly this was a long piece, but maybe it will be interesting to a few readers. Looking at this all by the numbers, I end up feeling better about BP, worse about Anadarko, and really no different about Halliburton or Transocean. It would take a total bill of over $60B to bankrupt BP, though admittedly the company will be hurt significantly at lower levels. As for Anadarko, they are going to be hurt by the moratorium and there are definitely some risks to the company with the combination of a high bill bill and 25% participation.

All in all, I still think you can buy BP, RIG, and CAM here. APC is a bit more questionable, and I might be more careful there.

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