Jun 15, 2010

BP Disaster: Making the Best of a Bad Situation

Andrew Mickey, Q1 Publishing

There’s nothing worse than bad news to drive a tough market lower.

When the U.S. government announced BP should cut its dividend, it wants to hold BP responsible for wages lost due to the Gulf of Mexico drilling moratorium, and the spill wasn’t going to be stopped anytime soon, that’s exactly what the market got – some bad news.

Since then there have been some bits of positive noise in consumer sentiment and China’s exports, but the market is still facing a lot of headwinds.

And right now is a good time to take a look at the lessons BP has taught this week about investing successfully and how we can apply them to the opportunities created by the spill.

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Good Things Come to Those Who Really Wait

At a current price of about $30 a share, opinions on BP are wide-ranging. BP price targets range from returning to $60 or share or falling all the way to $0.

Frankly, as the administration ramps up its attacks on BP, oil continues to gush at an unknown rate, and more coastline is hit with oil, there’s no way to determine the eventual cost or its impact on BP’s market value at this point. We really expect the total cost won’t be known for years as many requests for compensation end up in courts (i.e. should BP be responsible for a hotel that has lost tourist revenues, how fast do you think politicians will be able to blow though BPs treasury, etc).

But that doesn’t mean there’s no opportunity here. You just have to look at it the right way.

As usual, history and sound investing principles will guide us in the right direction.

BP’s current predicament, where it’s facing a massive unknown liability, is very similar to the banking crisis in early 2008.

In January 2008 we were in about the second inning of the credit crunch. Most bank shares had lost half their value or more. Many of them were yielding between 6% and 8% and a few analysts were “pounding-the-table” on buys.

At the time, we wrote:

Most investors looking for current income are starting to pick up shares of the beaten-down banks. After all, these banks are paying out historically high levels of cash to shareholders.

The attractiveness of 6%, 7% and 8% yields are, I’ll admit, quite enticing. But they are completely unsustainable.

The dividend yields were attractive, but anyone thinking reasonably – a tough thing to do when real money is on the line – would have realized banks losing tens of billions of dollars would not be able to make their dividend payments.

The high yields seemed attractive, but dividend cuts are often a sign of more troubles behind the scenes.

More importantly, dividend cuts usually lead to falling stock prices. The big income funds, pension funds, and income investors who primarily invested because of the dividend no longer have any reason to hold on.

That’s exactly what happened with bank stocks. They fell drastically after the dividend cuts as the full story played out.

BP could be in a similar situation. And with a mounting unknown liability, equally distressing times could be ahead. Aside from the $10 to $20 billion clean-up, only time will tell if BP will be legally held accountable for lost tourism, drill operators out of work because of the government-imposed moratorium, and all the other costs that are sure to be realized.

That’s why we must recommend looking at BP as a pure speculation. That means speculation rules apply. So a decision comes down to simple risk and reward.

With BP at $30 per share, a return to pre-disaster highs of $60, would net a 100% gain. A further fall to $20, $10, or eventually $0 if everything that could go wrong does go wrong, would put the risk anywhere between 30% and 100%.

In the world of speculation, risking $1 to make $1 isn’t going to cut it. In a market like this, successful speculators and investors have the opportunity to find much better risk/reward ratios than that.

High Demand and Low Values

The spill also sent ripples throughout the entire oil industry. One of the hardest hit sectors was oil services stocks.

Now, over the last few months we’ve detailed the virtues of oil service stocks. Many of them (especially the ones that focus on deep-water oil) are facing near-record demand. In some cases the order backlogs stretch out as far as 2013. The spill is not going to change this anytime soon.

The reason for the demand is simple: most major oil discoveries are being made deep sea.

Recently in our premium service, Prudent Investing, we looked at three of the most recent big oil discoveries:

In November 2006 a consortium of major oil companies - Chevron, Devon Energy and Statoil - announced a massive new oil discovery had been made in the Gulf of Mexico. The reservoir is expected to contain up to 15 billion barrels of oil. The International Herald Tribune said “[It’s] potentially the largest American oil find in a generation.”

In November 2007 Petrobras discovered the Tupi Reservoir off the coast of Brazil. It contains an estimated 5 to 8 billion barrels of oil.

In August 2009 BP made another massive discovery in the Gulf of Mexico. After drilling the deepest exploration well in history, BP reports the reservoir contains 3 billion barrels of oil.

See a theme?

They’re all deep-sea offshore and big.

On top of that, the offshore industry also has a unique feature – it’s truly mobile. All the rigs, undersea vessels, and specialized equipment can be moved anywhere they’re needed.

That’s why we see little changes resulting from the oil spill. There’s still plenty of demand. The equipment will go where the demand is. And there are plenty of oil companies willing to develop oil discoveries offshore Brazil, Africa, and East Asia as demand in the Gulf plummets.

Much Higher Oil Prices

Finally, the political reaction to the spill is extremely bullish for oil prices over the long-term.

We’re going to see more regulation and government control of all offshore oil development projects.

Although the effects will not be felt immediately, they will over the long term.

Oil has almost everything going for it. The global economy has failed to truly recover, but even slow growth will lead steadily increased demand. Supply will not keep up.

Remember, more than 80% of the world’s oil reserves are controlled by government oil companies. The U.S. was one of the last areas where the private sector dominated the oil industry. And just like in the medical industry, the private oil industry drove innovation. The private companies are the ones taking all the risks creating the technology to develop deep sea, heavy, and other unconventional oil sources.

Increased government involvement will hinder technological development and reduce long-term supplies. For a product that’s demand from China, India, and other emerging markets is consistently rising, significant reductions in new supplies will result in oil prices staying high ($80 a barrel is still a high price) for a very, very long time.

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In the end, the oil spill will have a lot of consequences for a lot of folks.

For investors looking to buy on a dip, they will take an unnecessary risk with BP. Sure, shares could rebound, but just because something works out doesn’t mean it was a good idea.

For the oil services industry, the spill will be nothing more than a speed bump. This industry is growing and specialized, technical services are going to be very in demand for a long time to come because that’s where the new sources of oil are.

For oil prices, the increased regulation and government involvement will only impede production growth. Whether you think it’s worthwhile or not, more inspections, rules, regulations, and associated costs will change the economics of many deep-sea oil deposits. And oil companies will demand higher expected profits before giving the “go ahead” on many new projects.

We’ll let the politics play out as they will, hope for the best of all affected by the disaster, and stick to the opportunities the come along the way.

Frankly, there are likely even tougher times ahead for BP. Shares of the oil company are still a long way from being “too cheap” to pass up. But the spill is not going to stop offshore oil development. And we still like oil services stocks. As a group they have best risk-adjusted returns and the spill will only increase the rewards. And the current correction has only decreased the risks and increased the rewards.

And as long as you’re focused on risk and reward you will be able to make the best of all kinds of situations -even the seemingly bad ones that come in tough markets.

Good investing,

 

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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