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Potential Outcomes for BP Shares

Jeremy Glaser

Jeremy Glaser: I am Jeremy Glaser with Morningstar.com. As the Gulf oil spill crisis escalates, the uncertainty surrounding BP stock continues to increase. I'm here with Associate Director, Eric Chenoweth, to discuss potential outcomes for BP shares. Eric, thanks for talking with me today.

Eric Chenoweth: Thanks for having me.

Glaser: So, first off, can you give us an update on where BP is in trying to contain the spill, and if you think some of the current actions that they're taking are actually going to be successful or not?

Chenoweth: Sure. Last week, we finished off the 'top kill' effort and it was unsuccessful. The company is really going through a couple of, kind of, long shot procedures now; current one being cutting the riser, trying to place a new cap on top of the current blow out preventer. We'll see how that goes. It's not a high probability chance that will fix it right away.

Some of the more likely candidates are further down the road. The relief wells, there are two currently drilling, and they're well under that process. There's still a chance that those won't be a 100% successful, which I think is important to understand, which is why they are drilling two, and hopefully they don't have to drill a third and a fourth one, but it's a very, very technically challenging process.

Glaser: Do you think that BP has been somewhat overestimating the chance of success of some of these operations?

Chenoweth: I think, we got a little ahead of ourselves last week with the top kill. This was something that has been used in shallower waters and other places successfully, but it was kind of an unprecedented attempt at these depths. And when they came out with I believe a 60% to 70% chance of success that seemed a bit high for something that was such a new attempt.

Glaser: You mentioned that the relief wells, the first one probably coming online in August might not work. If you saw that didn't work either, what would be the potential for liabilities for BP?

Chenoweth: First off, if it doesn't work, this could be very challenging. We have the hurricane season coming up, which could also disrupt additional relief wells getting drilled, so it could step it out, and we could be talking about this at the end of the year, which I would think would be very much a worst case scenario.

Last week, we updated our cost estimates, and our high case at the time was assuming a 180 days of spill, so that would obviously be a bit longer. Under that scenario, we thought the total oil spill cost will be about $60 billion. So that's our high, high case. Our mean case is about $31 billion. BP is on the hook for 65% of that, so just keep that in mind when you're thinking about those numbers. Those are big numbers. Obviously, it'd be bigger if we went to the end of the year.

The other challenge too I think is that you got to stack that up relative to how BP's shares have sold off, and since the beginning of the spill, they've sold off close to $70 billion to $80 billion. Last I checked, it changes very quickly, but in the markets, obviously sold off as well. So you could, kind of haircut that down to maybe a 40-ish type number, if you want to try to isolate the event sell-off.

So obviously the market thinks this is a bigger deal than even some of the estimates we have come up with, or other analysts you hear in the press have come up with. So, it's raised questions I think with us to about what could we be missing, or is it there really that much more fear in the market than what we can point our fingers at, but you stack that $70 billion up against a $40 billion-ish BP share of our worst case scenario.

Glaser: So, how much have you adjusted the fair value for BP so far?

Chenoweth: We've adjusted it $5 per share down, which is closer to, kind of, a little bit above our low-case estimate. Our low case, if we thought everything went right from here, would be about a $4 billion hit. That's looking quite light compared to what the market thinks at this stage, and we've actually ratcheted a bit down more than that.

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Glaser: What would you like to see before you would lower that estimate even more or raise it, what factors are you taking a look at?

Chenoweth: Sure. We're paying attention to a lot of factors. First off, when does the spill get stopped? When can they plug the well? That event would be a turning point, so we can start to quantify at least the well itself.

Other things we're looking at are civil penalties, and there is a bit of give and take here. Civil penalties in our estimates could range anywhere from $1 billion-ish up to $31 billion, so there's a big range there. So that's something that's going to evolve over time.

So there are factors that we can identify in the short term like the spill itself, what are those damages, and then longer-term factors are going to play out over a few years. Civil penalties, criminal penalties, and what other lawsuits might come out of that, and that will take us longer to really get our arms completely around.

Glaser: It'll be challenging to call the stock cheap at the moment then, when do you think investors would start to get interested or could start to take a closer look at it?

Chenoweth: I think, once the spill is contained, answers will start come in much more quickly. Again like I said there will be that civil and kind of litigation that lingers on, but that's something that will be easier to estimate once we have the spill contained.

Glaser: For investors who already own BP shares something they might be worried about is the dividend, do you think that the dividend is sustainable at today's levels?

Chenoweth: We did a pretty big analysis on the dividend last week. And there is no immediate risk when you look at the company's financial position there. They have a 30% kind of debt limit they like to run. They are below 20% at the moment.

When you stack that – Devon, they recently announced a $7 billion deal with Devon to buy properties, and you add that on, they are a little bit over that 20%. So they have some leeway to borrow more.

They also do have solid operating cash flow. We think that's going to fluctuate between $30 billion and $40 billion over the next few years. Their capex budget is around $20-ish billion this year, and we think that'll escalate up to $25 over the next few years.

So there is some cushion there for the dividend. The dividend takes about $10 billion a year. So it's very close right now. If you look at their capex budget plus the dividend, it's very close to their operating cash flow, but they can borrow a bit. But again if things get worse, that very narrow cushion we see could evaporate and lead them to possibly consider cuts. We definitely think dividend increases would be very unlikely just given how tight things are, and the liability that's unknown at this stage.

Glaser: For current shareholders then, do you think now is the time to hold on to shares or should they be selling?

Chenoweth: I think, it's a tough question if you own the shares right now what do you do? We presently have a 5-star rating on ExxonMobil. So if you don't like having this unknown liability hanging over your head, if you can't handle that sort of uncertainty, Exxon's clearly a safer choice in our opinion and a much better run company of a major, and while the upside may not be as great if you think that BP is going to survive this and thrive at the other end.

That's a choice we are recommending right now, 5-stars. We currently don't have BP at 5-stars. The company had a lot of – had a challenging operating history going into this. So if this were an Exxon that had gone through a disaster, we'd be much more encouraged to recommend it than a BP where the track record had already been weak going into this. The odds, they lose future business is much higher because of this weak track record.

Glaser: Great, Eric, thanks for talking with me today. For Morningstar.com, I'm Jeremy Glaser.