Additional Thoughts on BP

I felt a nice compliment to the T2 Presentation might be an explanation of a trade that I beleive could yield a nice return. Would love any feedback.

Now that BP has put the cap on the well its all gravy from here. Well....maybe not but the good news is this idea doesn't really depend on stellar out-performance. I am recommending a 1X1 vertical call spread. I would advise using the 1/20/2012 Calls at strikes of 42.5 and 45 (to avoid confusion I am advocating buying the 42.50s and selling the 45s at a 1:1 ratio). Based on midpoint pricing as of close on 7/15/10 the 42.50s trade at 6.90 and the 45s are at 6.13 this represents a $0.77 spread. So using simple math if at anytime up until 1/20/2012 BP's equity goes to 45 or above the position will have an intrinsic value of $2.50/share versus a cost of $0.77 or a nice profit of 3.25x invested capital. For frame of reference BP's equity closed trading today at $38.92. That means we have the potential to make 3.25x our money if the stock just goes up by 15.6% by 1/20/2012 - sounds like a pretty manageable gap to me.

Now for the nitty-gritty. Obviously BP will have to pay substantial sums for the damage they have caused to the Gulf Coast. Given our populist president and the current business hating environment I imagine these fees will be quite large. The ultimate cost to BP is impossible to know currently. The 1989 Exxon Valdez spill of 250 kbls cost Exxon US$3.8 bn. Assuming that a spill of similar size in the GoM could today cost $10 bn, allowing for inflation and the greater impact of this spill (a more highly populated and more economically relevant area). However, this estimate is subject to great uncertainty, as there is no useful recent comparison for a spill of this size in such a populated area. To be conservative we assume that BP (as an operator) bears 100% of the clean-up and legal costs, despite owning only 65% of the license. However, this is another key area of uncertainty; we do not know yet the exact reasons for the failures that led to the spill and which company might be responsible for it.

Just for fun lets make some nice round estimates on what the spill could ultimately cost. At $40,000 per barrel spilt, or $10 bn per 250 kbls (backed into by inflating Exxon’s US$3.8 bn costs relating to the Valdez spill in 1989 by 5% pa). Then a apply this cost to the total number of barrels spilt, and do not adjust for those barrels
that have been dispersed or evaporated, which could be as much as 50% of the total
volume. We also attribute 100% of this cost to BP, as the operator of the license, although it owns only a 65% stake in the block (and bless BP's heart they have been sending bills to their partners as incurred - payment of such bills is another topic all together). Lets be draconian, the well leaked for 85 days, lets assume the well leaked all in 1.65mbls (about 19kbls per day while there have been a number of outliers on estimates out there I decided to shoot the middle on this one). We then take that number multiplied by our $40,000 per barrel split to arrive at a total cost of $66B. Quite a staggering sum. However even using this amount the stock the stock would trade on an EV/DACF of 5.5x in 2010E and 4.5x in 2011E.

How would BP pay for this: BP has announced an intention to raise $10bn from non-core asset divestments over the next 12-months. This compares to BP's 'normal course' level of non-core divestments of $3-4bn per annum. There is an overhang of unsold refineries on the market - we count at least 25 with a capacity of 2.9 million bopd. So, we doubt BP will seek to compete in that oversupplied asset market. Retail asset divestments are always an option – given the damage to BP’s brand, it is possible that a buyer may see greater value by rebranding some outlets. Excluding Russia, BP has 22,400 retail sites. An exit from specialty (acetyls and aromatics) chemicals is possible – given capital employed of $5-6bn, this could be a useful ticket which would complete BP's exit from the chemicals segment following the sale of Innovene. Upstream, we sense that it more a buyer’s market for gas oriented assets and we doubt BP will U-turn following its recent build up in the US gas shale ($3.7bn acquisitions in H2 2008). This leaves oil biased upstream assets. We doubt BP will want to sell growth oriented (undeveloped) assets; we suspect it should rather sell more mature producing positions which are more straightforward to value and for which there is a relatively buoyant market. Such assets could include pieces in the UK North Sea, the Lower 48 (onshore USA), Canada and perhaps Colombia. We very much doubt BP will look to reduce its exposure to Angola or TNK-BP given their resource depth and long term growth potential. BP has three listed investments which have an aggregate market value of approximately $2.6bn that it might consider selling – a 1.3% stake in Rosneft (market value $880m), a 20% stake in China Aviation Oil Singapore (market value $150m) and a 71% stake in Castrol India (market value $1,600m). Aside from just the raw cashflow producing power of BP there are a number of avenues for additional cash.

There is a lot more I could talk about on the company and its cash producing prospects but I will leave that to the reader to discover.

While the dynamics may be unappealing to some - 100% loss versus 325% upside. I personally find a 3:1 trade with reasonable safety and a long life quite appealing.