The Guide to Investing in Stocks and Shares

BP

Dan Tebbutt - A Shareworld Contributor

Published - 10th June 2010

Update: 29th July 2010 - Read the follow-up

I believe that, in the long-run, taking a contrarian view will generate better returns than following the crowd. So naturally my attention is currently focused on one company above all others - BP. After all, there aren't many firms that have Barack Obama gunning for their CEO, the whole of America up in arms about their environmental crimes, and one of the world's worst ecological disasters on their oil-stained hands.

BP shares have fallen a lot, but are they cheap? I'm no expert in valuing oil companies - nor am I an expert in US litigation, something that will surely hang over BP for years (decades?) to come. So I'll have to take a slightly oblique approach. First of all I need a similar company that is largely unaffected by the unfolding disaster in the Mexican Gulf.

Shell

Looking at a 3 year share price graph, Shell and BP have moved pretty much in step with one another (until 20th April, when the Deep-water Horizon exploded, that is). From that, and from everything else I know about them, I'd say they are pretty similar. Since 20th April, they have diverged wildly, with BP falling 40% and Shell a mere 10%.

I can deduce from this that the market is rating BP's woes as being worth 30% of their market capitalization on the 20th April. So now I need to answer two questions:

• Was BP's valuation on the 20th April reasonable?
• Is a 30% fall an over-reaction to the disaster in the Mexican Gulf?

Valuing BP pre-spill

On 20th April BP was trading at 640p, or a market cap of $174bn. They're now down to 400p, or $108bn. In recent years their earnings have been around the $20bn mark. So pre-spill they were trading at a price/earnings ratio of less than 9. Not exactly staggeringly expensive.

Looking at the balance sheet I find a net asset value of $102bn, or $82bn after stripping out goodwill and intangibles. Of course most companies trade well above their net asset value, so BP's multiple of 1.7 to NAV or 2.1 to TNAV doesn't look unreasonable.

Now I'm no expert, but I'm willing to believe that the market was valuing BP at a reasonable price pre-spill. It certainly doesn't like it was overvalued.

Putting a price on disaster

BP's potential liability seems to fall into a number of camps:

• Cleanup costs
• Fines and legal penalties
• Civil lawsuits
• Loss of business

It's been widely reported that BP has so far spent more than $1bn on cleanup costs. Presumably it could continue to spend at the same rate for another few months (by which time hopefully the well will be capped) and then at a reduced rate for some years to come, dealing with the long-term fallout. So let's assume $10bn for cleanup costs.

BP's liability in terms of fines and legal penalties seem at least partially capped by the Oil Pollution Act of 1990. Some senators have recently attempted to raise the liability cap to $10bn (via the catchily named Big Oil Bailout Prevention Liability Act of 2010). Let's assume they succeed and BP pays $10bn in damages.

BP will no doubt be inundated with civil lawsuits, and these could result in substantial damages - I'm not sure how much of these will be covered within the $10bn above. The worst-case I've read predicted $14bn, supposedly accounting for all lost fishing and tourist revenue from the states closest to the spill. So let's assume $15bn. We'll also need to take account of their own costs - let's assume 5000 lawyers at $1m a year each, for 3 years, making another $15bn.

Finally there's the loss of business to contend with. I don't believe it's legal in the US to punish a particular company via a specific law just for them - it's called a Bill of Attainder, and is banned by the Constitution. So I don't think they could pass a law banning BP from drilling in the Gulf of Mexico, for instance. While I'm sure there will be some tighter controls of drilling around the US, I expect those to affect other oil companies equally (perhaps accounting for the 10% slide in the Shell share price).

I reckon that lot is pretty pessimistic. It adds up to $50bn. The 30% fall in their share price relative to Shell over the last 6 weeks is worth almost exactly $50bn.

Verdict

It appears the market is pricing in a pretty apocalyptic scenario. I know there's a lot of anger in the US at the moment, but it's in no-ones interests to destroy BP. They employ a very large number of Americans, they have a lot of US shareholders, and they're supplying a lot of the US's oil needs. No doubt they also pay a lot of tax over there. If the US punish BP to an extraordinary extent they will discourage all other oil companies from drilling in US coastal waters, and everyone will lose out.

So I expect that Obama will continue to talk tough, I expect BP to be liable for tens of billions of dollars in cleanup costs, fines and lawsuits, but I don't expect the final bill to hit $50bn. And therefore I conclude that the recent fall is overdone, and that BP shares are worth a punt at 400p.

Update: 29th July 2010 - Read the follow-up