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Underwater: The Ripple Effects of The Gulf of Mexico Oil Spill with Respect to Investors
The catastrophic explosion of the Deepwater Horizon oil platform on April 20th and its sinking shortly thereafter has resulted in the most devastating environmental disaster in the nation’s history, sure to be a defining moment in this young century. Most Americans will be touched by this event, the vast majority in a harmful way. On the front lines, of course, are the players directly responsible for the disaster that killed 11 men. Then come the innocent fishermen, seafood processors, hotels, beach and tourist attractions, restaurants, and coastal residents. Further down the line are the consumers of fuel, plastics, chemicals, and other petroleum-based products, assuming oil prices will be higher than they otherwise would have been. Below, we consider the added complexities from an investor’s perspective.
As the manager of the drilling project and owner of the spilt crude oil and natural gas, BP p.l.c. (BP) will bear the brunt of the clean-up and financial loss claims. From the date of the accident through June 1st, the company was spending about $7 million per day and had doled out $25 million each to four coastal states for cleaning. Including expenses to cap the leaking well, BP is out close to $1 billion, to date. It has also set aside $20 billion in a fund to compensate victims of the spill. This is a figure that we think will go higher.
By June 21st, the BP share price had fallen about 50% from its 2010 peak. Some of this decline was, no doubt, related to a precipitous fall in both the broader stock market and the price of oil. Through May 3rd, before oil prices began to slide significantly (but also before the extent of the spill damages was anywhere near being fully known), the stock was down 12%. Some analysts have suggested that the sell-off was overdone. And BP did recover nearly 7% on May 27th, the day that the “top kill” procedure to stop the flow showed early signs of progress. (That effort ultimately failed.) Too, shares of Exxon, now Exxon Mobil (XOM) recovered fully and quickly soon after the Exxon Valdez spill in 1989. Let’s examine this disaster more closely.
At the time of the Alaskan tanker spill, Exxon had a debt-to-total-capitalization ratio of 13%, and was committed to $375 million in annual interest expense. In 1988, its operating income was about $13 billion. Exxon ultimately paid $3.5 billion in clean-up costs, over $507 million of which was covered by insurance, and $507 million in punitive damages after years of legal challenges. And its share price flat-lined through the first half of the 1990s as costs mounted.
At the time of their respective accidents, BP was much larger than Exxon (a market cap of $184 billion, versus $59 billion for Exxon). And BP generated cash from operations of over $27 billion in 2009. Its debt-to-total cap was 20% at the end of last year, however, and annual long-term interest expenses are $1.7 billion. And, while it’s way too early to tell what final clean-up costs for the Gulf spill will be, we’ve seen estimates as high as $30 billion. BP is self-insured, meaning all costs will come out of its (shareholder’s) pockets. Under the Oil Pollution Act of 1990 (enacted as a result of the Exxon Valdez spill), economic damage liabilities beyond cleaning are limited to $75 million, but some lawmakers are trying to raise the cap to $10 billion. Moreover, under the Clean Water Act, there is a possibility that BP could be fined $4,300 per barrel per day for oil spilt. Under the most conservative estimates, that’s a liability of $1.8 billion through June 1st, but it could be up to five times that amount. Too, states, municipalities, private businesses, and individuals may not be restricted in claims. BP is bracing for a Tsunami of lawsuits. It has also been suggested that BP be banned from further drilling in the U.S., offshore. We would be very cautious about picking a bottom on BP stock.
Others may share liability, of course. BP leased the Deepwater Horizon from Transocean (RIG, market cap $17.4 billion, down 43% since April 20th), which also employed most of the platform workers. (The insured 10-year old platform was worth $650 million before sinking, but will cost well over $1 billion to replace.) And Halliburton (HAL, market cap $24.9 billion, down 22%) performed the cement work, which failed to prevent a surge in gas up the pipe, an early culprit in the disaster. BP, Transocean, and Halliburton are, respectively, the world’s largest offshore explorer, driller, and platform cementer. The blowout preventer, which also appears to have failed, was manufactured by Cameron International (CAM).
Operations will become much more expensive. Deepwater operators, including Chevron (CVX), Petrobras (PBR), and Royal Dutch Shell (RDSA), can expect expensive new safety requirements and more rigorous inspections. Congress is set to quadruple the taxes on a barrel of oil, both domestically produced and imported. Levies such as these will ultimately be paid by the consumer, but they can also put smaller players, such as Seahawk Drilling (HAWK), at a competitive disadvantage. For instance, insurance costs for offshore drilling in the Gulf are already up 15% to 50%, increasing the deeper the water. That expense alone could cripple an independent driller.
The industry may be permanently damaged. The sinking of the Deepwater Horizon came just weeks after the Obama Administration announced it would not restrict expanded drilling activity in the eastern Gulf and along the Atlantic seaboard previously negotiated by the George W. Bush Administration. But in the last few days, a moratorium has been placed on new drilling off of floating platforms’, scheduled drilling off of Alaska has been canceled; and planned exploration off the coast of Virginia has been nixed.
There may well be some investment opportunities in the clean-up of the Gulf mess and preparation for other potential spills. There is suddenly an acute shortage of boom used to contain floating oil slicks. The biggest supplier of this material is Applied Fabric Technologies, a subsidiary of Desmi RoClean of Denmark. Meanwhile, Nalco (NLC) has already sold over $40 million of dispersant used to break up the oil, though BP is being pressured to find a less toxic chemical. And the appropriately named Clean Harbors (CLH), a provider of environmental and hazardous waste management services, will likely find a lot of work.
Investors may also want to take a look at companies with little or no exposure to offshore operations and a focus on natural gas. Chesapeake Energy (CHK), Quicksilver Resources (KWK), Southwestern Energy (SWN), and Ultra Petroleum (UPL) come to mind. All else being equal, restrictions on offshore production will support higher prices for oil and natural gas. President Obama has seemed reluctant to promote natural gas; maybe that is about to change.
The probable consequences for the ocean tanker industry are mixed. Offshore services, like shuttling, floating production, storage, and offloading, have become some of the most promising opportunities for the maritime industry. Teekay (TK) has banked much of its future on this market. Although it has no operations in the Gulf of Mexico, negative repercussions from the spill may become global. On the other hand, the company has an excellent reputation for safety and service, and may find itself in greater demand. Too, long-haul carrier demand should increase to the extent that offshore production is curtailed. Two of the biggest beneficiaries would be Frontline (FRO) and Overseas Shipholding (OSG).
Offshore oil and gas exploration and development has become one of the fastest-growing segments in the energy industry. In fact, almost the entire 6% rise in U.S. oil production last year (the first increase since 1991) came from offshore sources. Any curtailment or expensive restrictions on this business would lend to higher prices for oil and its derivative products and boost the near-term earnings of the suppliers. But that will come at the expense of intermediate and longer-term growth and earnings. Certainly, investing in this arena has just become a whole lot more risky.