Should I Invest In, Bet Against or Trade BP??

Should I buy shares of BP? Should I buy out of the money puts on BP betting it will go bankrupt, be bought out for pennies on the dollar by another big oil company like Exxon Mobil, Shell, Chevron, Conoco Phillips, PetroBras or one of the 3 giant Chinese Oil companies like Petro China, CNOOC or Sinopec?

Or, will BP need a bailout from the UK government? Can the UK government even afford a bailout? What do you think about BP’s stock and what else is going on right now in the Gulf and how it affects the entire deep water offshore drilling industry?

I’ve been asked my opinion on these questions or others like it a number of times over the last week or so online and whether or not BP is a good investment, or if its a good candidate to bet on a continued slide towards ZERO so I thought I would address everyone’s questions here on my blog and give you all my opinion of the situation as I currently see it.

Astute Investor and Trader, Barry Ritholtz, just released a similar breakdown for his readers about BP and I agree with a lot of what he says. I will try to extrapolate further and go into even greater detail for my analysis.

The problem, based on my own research into this tragedy and my opinion of the matter, is that right now BP is being anything but honest (are they really this incompetent and inept or have they been intentionally misleading all of us for as long as possible to keep the real truth from getting out?).

Because of a lot of political spin and much “mis-information,” it is tough to tell what the facts really are based on conflicting media, government reports. Despite the research I am about to share with you, I still believe we are all just speculating to a certain extent.

With that being said, we can definitely help try and put the odds of success in our favor by trying to intelligently speculate based on the odds of certain situations and scenarios playing out.

By doing some further in depth research and analysis, I can help you make a more informed investment or trading decision based on some fundamental analysis, some technical analysis and some intelligent analysis of the risk/reward equation based on my opinion of the facts. Then, you can decide what to do based on the likelihood of this scenario or that scenario. Here’s some TA of the BP stock chart courtesy of Wall St for Main St Co-Founder and creator of the Mo Money Blog, Mo Dawoud:

Investing and trading is about calculating probabilities because you analyze what you think are the facts and you try and make the best informed decision you can. Sometimes the best decisions don’t workout as planned and sometimes they do. That’s not just investing, that’s life!

But, if we concentrate on the process and developing great research habits and a step-by-step guide to how we look at a potential investment rather than just the results of “picking winners” and doing a great job of research I am confident we can put the odds in our favor of winning more than we lose.

So philosophy aside, let me lay out the facts in the situation down in the Gulf, as I currently know them that are supposedly accurate up to the minute I started writing this article at 11:23PM on a Thurs, June 10th 2010.

As of now, a bet on BP, up or down, is definitely speculative in my humble opinion and anything but easy money! Buying shares of BP would certainly not be an investment at this point as safety of principle is anything but certain. Here’s why:

For starters, let’s try and decide on what the facts are. 11 people are dead. BP, Transocean (RIG), Halliburton, Cameron International and Anadarko Petroleum were all involved in either owning, operating, managing or running the deep water rig before it blew up.

When this many companies are involved, you can bet courts will assign blame comparatively in a civil lawsuit. This is US Tort law 101. We are looking at negligence charges and perhaps even gross negligence charges (at least I think so) which mean potentially substantive amounts of punitive damages could be awarded by a jury.The US military might also need to get involved and if nothing else works, including relief wells, the last option a few months from now is a “nuclear option.”There is also speculation by some scientists that the Gulf of Mexico could turn into a Dead Sea of sorts where it is not possible to sustain any kind of ocean/marine life. That would not only be disastrous for the Gulf States, it would also be disastrous for the entire United States!

I have even read that there is now an underwater volcano! Another leak from BP’s cracking of the well bore has sprung another giant plume 5-7 miles away that is releasing 120,000 or more barrels/day of oil at a 2nd leak from the same drilled well! So let’s try to figure out what’s fact and what’s fiction…

Here’s a 7 part documentary on You Tube for you to watch called Blood of The Earth- The Gulf Spill. It summarizes things fairly nicely:

Here’s video commentary from some other Peak Oil and Energy experts:

There is also what seems like a daily debate about the amount of oil estimated to be leaking out from underneath the ocean floor. In fact, estimates have just been revised upwards again!

The estimates of amount of oil being leaked by the spill has gone from 1,000 barrels/day to 5,000 barrels/day in the past month and I believe we are now over 20,000 barrels/day officially on the mainstream media and from BP.

The problem, based on my own independent research, is that those estimates are in fact low and the real amount might be 120,000 barrels/day or more and it has been spilling that amount from day one! What a lie!

Those are some rather large discrepancies if you ask me and it’s obvious someone is intentionally lying.  From most technical expert’s opinions who have spoken to people involved and other industry experts, the overwhelming if not all of the blame rests on BP’s shoulders!

At least that’s what I am hearing from energy experts like Matt Simmons, Byron King and others. Here’s a long collection of articles and videos I have compiled for you over weeks of researching this. Note in the videos and articles the expert’s opinions of this accident, what caused it, who’s at fault, how we can stop the oil spill and if BP and the other companies involved will go bankrupt:

• BP: Soon it Won’t Stand for ‘Big Payout’
• Kent Moors: Oil And Energy Investor… The Impact of the Oil Spill: What Investors Need To Know
• Oil Volcano Pressure Too Strong For Containment
• The BP Mess is a Natural Punishment
• BP Not a Public Company By The End of Summer?
• Simmons Says Obama Should Detonate Nukes to Seal Oil Leak; Obama Suspends Deep Water Drilling Programs; Scientists Locate Another Vast Oil Plume
• The Gulf of Mexico Oil Spill is Now Turning Into a Catastrophe
• Will the BP Oil Spill in The Gulf of Mexico Make That Company Disappear?
• Is BP Collapsing?
• Nuclear Option on Gulf Oil Spill? No Way US Says
• Deep Water Disaster Doesn’t Change Need for Deep Water Drilling
• Deep Water Drilling and Expensive Oil
  

The way I see things, most of the uncertainty is based on the amount of lawsuits and amount of legal liability BP is going to face. Will there be a limit on the amount of damages victims can ask for? How much punitive damages can be awarded by a jury to the victims in a civil suit?

These are the most important questions that I believe one needs to know the answers to or at least have a very good idea of the answers to them before you risk any money, up or down, concerning BP.

Your interpretation of US Tort law and how liable and (grossly) negligent a jury will find BP will need to be factored into any investing or trading decision if you want to be as thorough as possible and go for the bigtime investment or trading gains!

Here’s my breakdown of the large lawsuits and other legal liabilities, fines, etc BP is facing from major parties (more will be added as we go and the longer this spill goes):

1. All of the Gulf fisherman who no longer have viable occupations in the area and will need to be retrained or helped to be relocated. This industry was the 2nd largest fishing and seafood industry in the US behind Alaska and it was estimated to bring in over $2 billion a yr in revenue! That’s a lot of money to just magically disappear!
   
2. The tourism industry for the Gulf who’s beaches are now ruined and are unsafe for swimming, etc making it extremely unlikely that they get any tourists down there until things are cleaned up A LOT. You are looking at years worth of damage to that industry!
3. Environmentalists- You will see every environmental group in the US coming out of the woodwork to sue BP! These groups and their shark lawyers smell blood in the water and want to take one of Big Oil’s oldest to task! This is a chance for these guys to make up for the less than desired results they got in the Exxon Valdez spill up in Alaska over a decade ago.
   
4. Home Owners- This spill will make it exponentially tougher to sell homes down in the Gulf area as the warm Gulf waters was one of the main attractions of owning a place down there.
   
5. State Governments- Attorney Generals from the Gulf States will sue on behalf of the state for cleanup feeds and perhaps also lost tax revenues from business BP caused to cease. With many activities in the Gulf no longer possible, that is a tremendous amount of tax revenue those states were counting on.
   
6. The Environmental Protection Agency (EPA)- I believe the EPA is also allowed to sue and/or fine BP a humongous amount of money to pay for the cleanup
7. Shipping Vessel Companies- The BP spill could make it close to impossible for shipping vessels carrying important commodity cargoes like natural gas, crops, etc to go through those waters. A group of shippers could join together to sue BP if this spill restricts, limits or stops them from conducting business
   

Now, after naming a good amount of the possible victims (some are real victims who have had their lives devastated, some are suing mostly on moral and environmental grounds and some are really just legal opportunists looking to make some quick and easy money in a settlement outside of court) in this hypothetical case against BP, let’s get into a very quick lesson on some US Tort law.

Some of you might be aware that I spent one semester in law school. I got my lone A in Torts and I also took a Civil Procedure class (that class was my first law school final and I didn’t do as well as in torts but I knew the material!).

First off, it is going to be VERY tough for BP to get a fair trial anywhere in the US with an unbiased jury! Everyone has seen the images on TV of animals covered in tar and thick oil either dead or struggling to hang on! These lawsuits will be filed in either state court (in any of the Gulf states affected) or US Federal District Court.

BP would prefer these lawsuits are moved to the US Federal District Court system as once the cases are moved there, BP can ask a judge to move the cases outside the Gulf area to another US Federal District Court location in a state outside of the Gulf region to get a fairer trial. Will this happen? What are the odds of BP getting a preferential move?

Honestly, it depends on the judge who is hearing their argument to move the case. So this would be another important unknown variable it is currently tough to account for.

But, the bottom line is it will be nearly impossible for BP to get a fair trial from an unbiased jury that has not seen any of the “carnage” and devastation on the news on TV or read about it. People might not know or care to know all of the details but everyone has seen the pictures of animals suffering for survival and covered in oil and tar and being killed by harmful dispersants.

This bias will be very widespread against BP across the entire US from coast to coast in my humble opinion. Because of this, BP is already behind the proverbial 8 ball before it ever steps into a court room, $1,000+/ an hr attorney or not!  Add in the fact that BP is considered a foreign multinational corporation and that’s 2 strikes. The court of public opinion is not in BP’s favor and that will probably never change.

BP is going to be a dirty 2 letter word here in the US for the rest of my life.

Now let’s do some fundamental analysis analyzing BP’s balance sheet to determine what kind of a hit the company can afford to take and still keep itself from going bankrupt, needing to issue many millions more shares to dilute its shareholders to raise cash to pay for the cleanup and lawsuit damages and how many assets BP will need to divest itself of to stay in business long term.

Obviously these are just my opinions, but I want to be as thorough as possible for everyone and show you how a professional investor thinks and analyzes all of these variables. My answers will all be conditional because variables, such as amount awarded for punitive damages by a jury, can vary very significantly.

First, let’s analyze BP’s balance sheet. To analyze a Balance Sheet, you need to know the Accountant’s Equation.

The Accountant’s Equation for Balance Sheets is:

ASSETS – LIABILITIES = OWNER’S OR SHAREHOLDER’S EQUITY OR ASSETS= LIABILITIES+ OWNER’S OR SHAREHOLDER’S EQUITY

You can shorthand these as A= L+O or A-L=O

As of their most recent Q1 2010 10K filings, BP has Total Assets of $240 billion, Total Liabilities of $136 billion and Shareholder’s Equity of $104 billion. These numbers must add up according to the accounting equation I just mentioned above. So 240= 136+104 or 240-136=104.

These estimates are supposed to be conservative, but as Lehman Brothers, Enron and many other banks have proven recently, companies can and do often heavily overvalue/overstate their assets and understate their liabilities to try and cheat people and keep the share price up. For the sake of keeping this article from getting unbelievably long and from reading through a full annual report, we will take BP’s word about these estimates and do some analysis of them.

Another important figure is BP’s stated Cash and Cash Equivalents position on its Balance Sheet of about $8.34 billion dollars as of the end of 2009. This cash position is probably even lower today as BP was not getting large production out of its wells and has many, heavy CAPEX (capital expenditures) ahead of it.

This seems like a giant amount of cash, until we start guesstimating at how much money BP will have to pay out in fines, cleanup fees and lawsuits.

My estimation is for BP to have to pay many, many, many billion in total fees, liabilities, etc. Let’s put it this way. The Exxon Valdez spill, which occurred over a decade ago and was under 1/10th the size of the current BP spill in Alaska with limited inhabitants cost Exxon about $7 billion in today’s dollars adjusted for inflation after decades of lawsuits, appeals and settlements.

What do you think a spill magnitudes greater and still ongoing perhaps for months or years will cost BP?

I don’t think it is unreasonable at all for BP to have to pay $70-150 billion easily in fines, cleanup fees and lawsuit settlements.

There is a lot of argument from the talking heads on the mainstream financial media about whether BP should cut its dividend? I think BP should but the CEO and their Board of Directors is refusing at least right now even though that would be the smart and prudent thing to do for the long term future of the company! Wouldn’t you want to preserve cash if you knew you had a lot of highly unpredictable and possibly very large bills coming due in the near term future?

Why are they refusing? Because the executives of BP don’t want to get fired, voted off the BOD, etc even though the odds are very high of that happening anyways. BP’s higher ups also know if they get rid of the dividend or cut the dividend, people will start dumping the stock even faster than they are now!

Ok, back to the analysis of BP’s balance sheet. BP obviously has assets. That’s not the problem.

The problem is BP’s shareholder’s equity, the amount of debt they have used to fund growth (mostly earnings growth), profitability and to replace lost production and lost reserves due to depletion.

BP’s Debt:Equity ratio is one of the worst of any of the major oil companies especially when BP is not able to increase its reserves or its production. Here’s a table of some calculations and a breakdown I did of “Big Oil’s” balance sheets and showing you a comparison of the other companies’ Debt:Equity ratios relative to BP’s:

What this comparison table tells me is that, in my humble opinion, relative to many of its peers, BP management is bad at correctly deciding if and when to take on debt and where and when to invest its capital!

I would also be willing to bet BP’s ROA, ROE and ROIC are poor relative to the other Oil Majors as well. BP and also Shell, who has a somewhat lower Debt:Equity ratio than BP, are in my opinion “treading water” as they are forced to take on heavy debts to try and grow earnings in the face of declining production and declining oil reserves.

This is not the way to successfully grow a healthy company. A healthy company should be able to grow from its own free cash flow as that cash from operating profits is reinvested back into the business to grow organically or is used smartly for acquisitions. Oil is a very cash intensive business, but BP seems to be misusing its cash and also taking on heavier and heavier debt levels to try and produce better earnings.

This is a warning sign that current and prospective BP investors and traders need to monitor.

BP management needs to take on lots of debt and when they take on debt, they are unable to produce or return a dollar of equity for shareholders for every dollar of debt they take on.

Exxon Mobil just made a very major acquisition, XTO Energy, which is an unconventional oil and gas producer here in the US. They are not wasting as much money as BP is out drilling holes miles below sea level to look for a needle in the haystack elephant oil fields, cutting corners to save money and not caring about industry wide safety standards. Exxon’s recent acquisition should be immediately accretive to its balance sheet or if not immediately, very shortly and will produce earnings and a handsome ROIC.

BP management seems to be using its capital differently and a lot more poorly!

Conoco Phillips had similar problems to BP as they took on way, way too much debt the last few years and their management has been working very hard to clean up its balance sheet.You cannot say the same thing about BP’s management!

That $8.34 billion cash position BP has might look like enough now, but that’s before every lawyer and offended party has gone after them and there are a lot of offended parties!

Any way you look at things, I think BP management will be forced to cleanup its Balance Sheet. I think some assets will have to be sold no matter what.

The total fallout from all of this mess only has to be $104 million or greater for shareholder’s equity to get wiped out completely! Once shareholder’s equity is wiped out, to prevent bankruptcy, the balance sheet will have to be restored somehow and all 3 major options are not good ones. If/when that happens, BP is left with very few options to protect itself from going bankrupt.

It can:

1. Sell off some or many of its assets to raise cash to shore up shareholder’s equity
2. Issue millions or billions more shares and dilute their existing shareholders
3. Go to the bond market and ask for some loans (corporate bonds)

All 3 options I just mentioned will not be desired by long term shareholders of BP. Option 3 means BP takes on a lot more debt and will not have the cash producing assets to be able to easily service those debts.

It’s one thing to buy cash producing assets with debt. That’s considered good debt. But, taking on debt to pay off litigation, fines and lawsuit judgments will not put cash back into BP’s “pockets” so that’s not good debt. That’s bad debt because BP is not using the cash from the loans (bonds) to buy assets (good debt).

Option 2 is heavily dilutive and shareholders, in general, HATE dilution by management for really anything! Think Citibank which has around the same market cap as it did when it was a $40/share stock but now it has many, many, many millions more shares out in circulation as it did beforehand years ago. It’s one thing to dilute your shareholders to buy an asset and another to dilute your shareholders in a resort to stave off what could be inevitable bankruptcy anyways.

Option 1 is the least dilutive and also the least painful. But, that option assumes BP can get full value for selling its assets. Competing companies are like sharks who smell blood in the water when they see a fire sale. What if BP sold many of its assets off and only received pennies on the dollar for them? Would that upset you as a shareholder? I know I’d be upset.

Because of all of these scenarios, and the legal noose about to be fitted upon BP’s neck, I’m of the opinion to stay away from buying BP stock for anything other than a short term trade on the long side until more of the upcoming bad news is actually priced into BP’s stock.

BP is not longer an investment. It’s purely a speculative stock because of the uncertainty! In fact, there are much better odds of making money buying out of the money puts on BP as hopefully you can see all of the humongous uncertainties and potential for more losses and bad news coming out of the Gulf.

With that being said, BP would look a lot more attractive as a long term investment and a lot more of a bargain if a lot of the uncertainties I mentioned throughout this article are clearer and a ton of bad news was priced into the stock.

BP’s market cap, or market capitalization or the value the market is giving the company is currently about $106.35 Billion.That’s an overvalued market cap or value the market is giving BP for the risks and uncertainties the company faces in the present and future!

Based on my analysis of BP’s Balance Sheet and the potential for large lawsuit and cleanup judgments, BP is looking at many billions in losses in for a very long time into the future.

If you are looking to invest in BP, now is not the time!

The Bottom Line:

*UPDATE* 6/17/2010- BP’s BOD has correctly decided to cut/postpone their dividend for at least a year (I called this last week) and will begin to sell assets to setup the $20 billion account Obama and Pay Czar Kenneth Feinberg will be requiring them to setup for victims of the Gulf spill.

In conclusion, based on my research, my fundamental analysis of BP’s balance sheet and their potentially enormous legal liabilites they are going to be facing for many decades in the cleanup, I am of the opinion that BP is NOT a good investment at its current stock price!

I still don’t think this $20 billion Obama has asked BP to set aside in a trust is enough to cover much of the expenses.

However, my opinion about investing in BP changes if the stock prices drops below $20 into the $10-15/share range.

I do not see BP shares going lower than that as another Big Oil company will probably buy them. There’s no doubt about it BP has assets. The odds are just good that BP will have to sell some of those assets to pay back the victims and cleanup.

BP could be a trade to the upside based on rising oil prices and peak oil, but the risk is not worth the reward and my investment money will be staying as far as possible away from BP!

If the market reprices BP’s stock even more significantly and more of the lawsuit risk and bad news gets priced into BP’s stock and the shares fall another 50% or more and BP starts being more honest, BP shares look a lot more attractive

But, my opinion of the facts that I have presented to you in articles from other experts and from video documentaries on You Tube is that BP and the White House has been covering up the magnitude of the problems with the size of the spill, the mishandling of the cleanup, using toxic dispersant that they say is not toxic and improper clean up procedures, etc.

My guess is that as of now BP has a 25% shot at bankruptcy (in the next 2-3 yrs) depending on if/when they can stop the oil from spilling (I have lowered the odds of bankruptcy from my original post as BP has cut the dividend and will start to sell assets to raise cash). This will be a moot point if they cannot stop the oil from spilling.

BP has also brought in drill ships and oil tankers that can help more in soaking up and containing the oil.

The longer this continues, the more likely it is BP will need a bailout from the UK government (UK is bankrupt so money might be printed/funneled backdoor from the US Federal Reserve to the Bank of England and then onto BP) or it starts selling off a lot of its assets. The asset selling will most likely have to happen anyways UNLESS the US and/or UK taxpayer is put on the hook for ALL or most of BP’s legal cleanup and lawsuit judgments.

This scenario would be another bailout of a “Too Big To Fail” where the losses were socialized and the profits were privatized. Can you imagine the revolt throughout the US if it was found out the US government bailed out BP after they ruined the Gulf of Mexico?

I don’t want to even think about that any further than after typing this! That’s how bad things would be! I also wouldn’t want to be a politician from either party in DC if a scenario like this happened.

The bottom line, in my humble opinion, is that BP is the proverbial dividend/value trap and a falling knife that actually should start accelerating even further downwards shortly. I predict good odds of much further downside for the stock based on my fundamental analysis and Mo predicts good odds based on his Technical Analysis.

BP is a good shorting candidate if you are a daring trader although I think the smarter and safer way to play it that way to the downside would be to but cheaper out of the money puts that give you time to let this play out and let the market revalue the company significantly downward. I’d be looking at the Jan 2011 puts or further out.

Be willing to pay a few hundred bucks more per option contract to give yourself significantly more time to let this play out. The odds are good that those relief wells will not completely contain the spill.

The market is going to punish BP further. BP management deserves to pay a high price for the excessive risks they took. It’s one thing to be able to reach the oil and another to pull it out of the ground safely.

It’s a question for me of when and not if BP’s stock gets hammered even more. I don’t see BP surviving this disaster as the same company, if it survives at all. My guess is it will need some sort of bailout regardless. That means more money will need to be printed and the US taxpayer could endup bearing the largest burden again!

If BP is also found guilty by a civil suit jury of gross negligence, you can also throw the idea of comparative damages (for the most part out the window). The tortuous offender who commits gross negligence is almost always found to be 100% liable for an accident where there would have normally been more evenly split comparative damage blame assigned and payouts assigned.

The bottom line is if you want to buy BP shares, the best thing you can do is sit and wait and let things play out further and let more and more bad news get priced into the stock! That’s what I would do if I wanted to buy shares. Mutual funds that are dividend stocks only will also start dumping their millions of shares now that BP has officially cut or suspended its dividend for at least a year.

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