BP crisis pushes Big Oil further into deep water

As thousands of barrels of oil continue to spill into the Gulf of Mexico, energy giant BP has seen its bond spreads widen to unprecedented levels. What will be the implications for Big Oil, and can investors factor in tail risks of this magnitude?

Firefighters tackle a blaze on the Deepwater Horizon oil rig

After an explosion on April 20, the Deepwater Horizon oil rig owned by BP crumbled and sank into the Gulf of Mexico, precipitating what US president Barack Obama has called “the worst environmental catastrophe America has ever faced”. At the time of writing, the leak in the well had still not been plugged.

Initial BP estimates suggested 1,000 barrels of oil a day were being lost, but that figure has been revised dramatically upwards. On June 15, the US government said between 35,000 and 65,000 barrels a day were spewing into the Gulf, with only around 15,000 being collected by a containment cap fitted by BP. In internal documents released to the media by US congressman Ed Markey, BP’s worst-case scenario for the spill is even higher: 100,000 barrels per day.

As the vast scale of the spill became apparent, BP’s market value plummeted. Between April 21 and June 16, the company’s share price sank 47.7%, from 650 pence per share to 340, prompting speculation that rival companies such as Exxon Mobil or Royal Dutch Shell would step in with takeover offers. Meanwhile, Obama, facing criticism over his handling of the crisis, became more aggressive in his condemnation of the company. This sparked fears BP could be forced into bankruptcy as a result of punitive measures from the US government and potentially crippling litigation claims.

On June 15, Obama expressed his intention to “make BP pay” for the damage caused by the spill, and Fitch Ratings downgraded BP by six notches from AA to BBB, citing uncertainty over the scale of the total costs, in damages and litigation, the company was likely to incur. Additionally, BP’s CDS and bond spreads ballooned to unprecedented levels. Five-year CDS spreads, which traded at 54 basis points on May 3, hit 506bp on June 15, and the yield on a two-year BP bond maturing in August 2011 reached 8.79% (or 552bp over US Treasuries), having been as low as 0.88% on April 20.

Receding risk?

President Obama on June 16 met with Tony Hayward, the company’s chief executive. It was agreed that BP would build a $20 billion escrow claims fund over the next three years in order to pay natural resource damages and state and local response costs. BP said it would suspend dividend payments to shareholders until 2011, and sell $10 billion worth of assets in order to raise funds.

Obama stressed the $20 billion figure is not a cap on BP’s liability, and the costs could yet run in excess of that figure. But the agreement did, at least, bring an end to the political stand-off between the company and the US government that had made investors skittish. While both Standard & Poor’s and Moody’s have downgraded BP since the announcement of the escrow fund, citing continued uncertainty over the final cost to the company and over when the leak would finally be stemmed, they stopped short of Fitch’s six-notch cut: Moody’s lowered its rating by three notches to A2; S&P by two notches to A-.

Adam Cohen, founder of independent credit research firm Covenant Review in New York, says that, although it would be premature to think the announcement of the escrow fund marks the end of BP’s troubles as oil continues to gush into the Gulf, it makes it less likely the disaster will spell the end for BP.

“This is an implicit signal the White House isn’t expecting BP to go bankrupt,” he says. “The government hasn’t said the money has to go in tomorrow, it has given BP three years, and that lessens the risk to the company. That’s a positive thing for bondholders. BP can afford this. While selling assets is a not a good thing for any company, at the end of 2009 BP’s total assets were $236 billion, so $10 billion is pretty trivial from a balance sheet perspective.”

BP says it expects its cashflows will exceed $30 billion in 2010, before taking into account the spill and its related costs.

Philip Adams, senior investment grade analyst at US-based independent research firm Gimme Credit, agrees with Cohen’s assessment. “I was generally pleased with the outcome [of Hayward’s meeting with Obama], because the credit markets had been overcome with the political risk of all this. People were fearing draconian demands that would have generated a liquidity crisis, but that hasn’t happened. The best thing to come out of the agreement is that it gives BP three years to fund the escrow account, and it has the capacity to do that. We’ve seen a significant recovery in the shorter-dated bonds as a result.”

Yields on the two-year bond trading at 8.79% on June 16 came down dramatically in the wake of the announcement: the bond was yielding 6.22% on June 17, while five-year CDS spreads on BP tightened 116 basis points to 467bp.

Despite the decline, these yields were deemed attractive given the improved outlook for the company. Brian Gibbons, senior oil and gas analyst at research group CreditSights in New York, says BP bonds presented a “definite opportunity” immediately after the announcement of the escrow fund, in that yields remained higher than “some single-B rated oil and gas names”. For example, a bond from oil company Forest Oil (rated B+ by S&P) maturing in December 2011 was yielding 4.75% on June 17, significantly lower than the 6.22% yield on the BP bond, despite BP’s higher credit rating.

Attracted by the high returns, investors – including the manager of the world’s biggest bond funds – bought BP debt after Hayward’s meeting with Obama. In an interview with CNBC on June 16, Bill Gross, chief investment officer at Pimco, said his firm had bought $100 million of short-maturity BP bonds.

“While that’s a pretty small amount in terms of Pimco’s total portfolio, people have read that as a vote of confidence in BP’s short-term solvency,” says Cohen.

Increased confidence in the company has been reflected in a further decline in bond yields: BP’s two-year bond was trading at 4.10% on July 5, less than half the yield offered on June 16.

Litigation and regulation

But despite growing confidence in BP’s solvency, uncertainty persists over the scale of the long-term costs to the company. In a press release on July 5, BP said clean-up efforts were being hampered by hurricanes in the region, and confirmed that the response to the crisis thus far had cost $3.12 billion, including “containment, relief well drilling, grants to the Gulf states, claims paid, and federal costs.” The company admitted: “It is too early to quantify other potential costs and liabilities associated with the incident.”

Cohen warns the eventual figure could be far in excess of the $20 billion set aside for the escrow account. Litigation costs, in particular, could be an issue. “To figure out what those bonds are worth, ultimately you’re trying to estimate what BP’s ultimate liability would be and that’s uncertain. Will there be criminal indictments? One thing that’s been made clear so far is that the $20 billion is to go to economic loss claims and that’s it,” he says.

Mark Lieb, fund manager at Spectrum Asset Management in New York, is unconcerned by the prospect of future litigation costs, and insists BP debt looks attractive at current levels. He says the fallout from the 1989 Exxon Valdez oil spill in Alaska (which ultimately cost Exxon an estimated $7 billion) may point to the likely outcome for BP.

“I think BP bonds are very attractive at these levels. This is a big company with massive holdings around the world. I look back to the Exxon Valdez incident. When Exxon bonds and equities were hit after that spill the smart money bought that up and they’ve done very well,” says Lieb. “Everyone said the litigation would bankrupt Exxon, that the legal stuff would go on for ever. But Exxon ended up settling for a fixed amount; it combined all the lawsuits into one master suit and had years to pay into the fund, so they came out of it all right. I’m sure BP’s lawyers are studying that Exxon case very closely.”

Other investors are more circumspect, however. Jamie Guenther, head of US investment grade credit at DB Advisors in New York, says tighter regulation of offshore drilling may be one outcome of this crisis, which would have uncertain consequences for Big Oil.

“From an investor perspective, it is clear that, politics aside, there’s a lot of risk,” he says. “The Gulf of Mexico is a very important territory for these companies and a profitable place to operate, so we’ll have to see how regulation is going to change things going forward. There’s a fair amount of uncertainty.”

A New York-based head of fixed income sales at a major US bank adds: “The oil spill in the Gulf involves the whole energy sector. It wasn’t just BP spreads, a lot of other companies got slammed. The worst-case scenario is that there’s no more deep-sea drilling. Who knows right now? It’s bad.”

The US government instigated a six-month moratorium on deepwater drilling after the incident. But for Harald Eggerstedt, credit analyst at RIA Capital Management in Edinburgh, concerns over tightened regulation once the ban is lifted are unfounded. He says that, given the importance of oil to the world economy, any regulation is unlikely to be so severe as to prove a problem for the larger companies.

“If regulation is tightened up, and exploration activities get toned down, oil supply will remain constrained, which will support [high] oil prices. So the risk to the industry of tightened regulation is actually quite limited. The product these companies are dealing in is just so important to the world economy. Either the companies do the job [of looking for oil] or the government has to do it itself, with tax-funded exploration activities, as is the case in Russia. That’s not something anyone wants or can afford given the economic situation western economies are in. So we really need these companies to function. Regulatory risk, on that basis, is quite limited.”

Cohen adds that stricter regulation might even strengthen the larger companies by making it more difficult for smaller oil firms to compete.

“Tightening regulation increases costs. So companies that are already junk rated or have weaker credit may have to merge or be acquired to survive this. Look at a company like Nabors, a big offshore driller: there’s no question that company will survive and thrive over time. But if you look at smaller companies like Parker Oil and Hercules Offshore, so much of their business is in the Gulf of Mexico that those regulations may suddenly change their entire ability to be profitable. One of the outcomes of this may be the large oil concerns getting larger, because they bought out the smaller guys who couldn’t keep up with the regulatory costs,” says Cohen.

Whatever the regulatory environment, it seems likely deepwater drilling will continue. On that basis, a repeat of the Deepwater Horizon incident cannot be entirely ruled out. So is there anything bond investors can do to hedge against tail risk of this kind?

Buying CDS protection is an option existing bondholders of BP debt have exercised in recent weeks as the crisis has escalated. There were 2,072 outstanding CDS contracts written against BP bonds in the week ending June 18 worth a gross notional of $12.6 billion (net $1.7 billion), compared with 1,399 contracts worth a gross notional of $9.1 billion in the week ending May 14. But as CDS prices have increased, the cost of protection has become prohibitively expensive.

“For existing bondholders, the opportunity to hedge themselves has already gone. If you try to hedge in the CDS market, the cost is too high: CDS prices have exploded,” says Eggerstedt. BP’s five-year CDS spreads have remained high despite the decline in bond yields, trading at 478.7bp on July 5.

At a premium

Some commentators suggest increased risk premia will need to be applied to oil companies across the board to protect investors from the effects of such events in the future.

“I think the market tells us the increased risk premium is already being applied,” says Adams at Gimme Credit. “Take an offshore driller like ConocoPhillips: its bonds due in 2019 went from 53bp over Treasuries on April 20 to a peak spread of 95bp over on May 26. While they’ve since declined, they’re still around 85bp over Treasuries. That company had absolutely nothing to do with the oil spill, and yet its spreads are out 40bp. That shows you where things may be going.”

CreditSights’ Gibbons notes that, while a well-diversifed portfolio helps negate risk in normal circumstances, diversification may not be of any use when a single company faces a disaster of this magnitude. “I’m not aware of any way investors could hedge against oil spill disasters. Diversifying always helps: if you were solely exposed to BP in the energy space then you would have been crushed by this. But then again, diversifying helps only marginally when something like this happens, because the broader industry suffers too.”

Gary Jenkins, head of fixed income research at Evolution Securities in London, believes the disaster is a reminder there are some eventualities for which it is simply impossible to prepare.

“Aside from trying to depreciate the cashflow to get to a different value for the company, based on the idea that a particular company is in a sector where something huge could happen every 10 years, I’m not sure there is any way you could factor this into pricing. This is something which is very difficult for analysts to compute,” says Jenkins.

“Up until a few months ago anyone analysing BP would have looked at the normal metrics you do for any corporate – cashflow and the strength of the balance sheet – and would probably have concluded that BP was one of the healthiest companies in the world. Now its very existence is being questioned in some quarters. There has been no fraud; there has been no new invention that has changed oil consumption. This is purely one accident. It’s quite a frightening reminder that the way we analyse does not – and perhaps cannot – take into account these kinds of tail risks,” he adds.