The $150 Billion Question: Is BP Too Big to Fail?

May 24, 2010
Dear Outstanding Investments Reader:

The oil blowout in the Gulf of Mexico continues. The world's third-largest publicly-held oil company, BP (BP: NYSE), is squarely at ground-zero -- literally and figuratively.

Can this blowout also blow up BP? Or put another way, is BP too big to fail? That's the $150 billion question. And sooner or later, we're going to find out.

Getting Worse, for How Long?

How bad is the oil spill? It's bad and getting worse. I said a few weeks ago that this oil spill would get worse before it gets better. We're still in that "getting worse" phase. The continuing oil spill is so bad that it's hard to say how truly bad it is.

Conventional wisdom is that oil rises through water and floats on the top. Conventional wisdom is also wrong. In a May 19th alert, I discussed how much of the gushing oil remains deep underwater in the Gulf of Mexico. No one knows much about where the underwater oil is, or where and how it's harming aquatic life in the water column. Meanwhile, topside, we have oil washing ashore in significant, gooey amounts, into the coastal marshes and other fragile ecosystems. It's just awful.

According to Roger Helm, of the U.S. Fish & Wildlife Service (and quoted in the Washington Post), "We've never really seen this kind of thing. This one's coming in a way that has a lot of us working to understand, what is going to be the longer-term impact? […] How do we get our brain around this?"

The Aliens Have Landed

"How do we get our brain around this?" Well, first you have to understand what it means to have a deepwater blowout. This has NEVER happened before. It's an entirely new form of chemistry and physics. Throw out the old books.

Deepwater work involves extreme risks and events that are difficult to foresee. Just the mechanical tolerances for equipment -- down to the smallest of components like seals, gaskets and wire bundles -- are close to basic, atomic, physical limits of strength. Yes, the technology is impressive. That's because it's at the far edge of the envelope, at the limits of industrial capability.

Add to this that in the deep sea, strange things happen. There are bacteria that eat iron (look at the remains of the Titanic, for example). Natural gas forms into solids called clathrates. Other kinds of materials -- metals, coatings and fluids -- behave unpredictably.

When you're in deepwater, you cross over something like an "event horizon." You're not just dealing with complicated systems any more. You've gone from complicated to complex – which represents a big difference in terms of predicting things. Small inputs can trigger large, asymmetrical responses.

The allegory is that the aliens have landed, and they're tearing up the place. It's like First Contact or something. No one has ever had to deal with this scope of disaster before.

We're facing a deepwater super-well, spewing immense volumes of oil under immense levels of pressure into freezing water, through badly damaged equipment. Uncontrolled, this thing could blast oil into the benthic regions of the Gulf of Mexico for years. Science fiction has become science fact. Wrap your brain around it.

Kill the Well

The best hope for the near term is that BP kills the well this week. BP has moved pumping equipment, drilling mud and cement into position. The total energy available for pumping is in the range of 50,000 horsepower. That's the equivalent power output of ten standard railway locomotives.

In some respects, the pumping power is similar to a "fracking" job, like with fracturing the Marcellus Shale or Bakken Shale. The plan is to inject drilling mud into a series of valves at the bottom of the blowout preventer. The idea is to "out-pump the well," in the words of one BP representative with whom I spoke last week.

If the well won't take the kill-shot, then we might see uncontrolled oil gushing for up to three more months. That's how long it will take two different rigs to drill "relief" wells to intersect the existing hole, and pump it full of cement. Here's the BP graphic.



Will the relief well work? It ought to. These kinds of things have worked in the past. But it's going to take time -- three months or more -- and every day of blowout is more oil pouring into the Gulf, with more environmental damage.

Plus, keep in mind that under the best circumstances the relief well won't be easy to accomplish. For example, when the relief well gets near the bottom of the existing well, they'll have to "steer" the bit precisely, so as to bust through the cement and steel casing. It's like hitting a coffee can at 18,000 feet.

How Much Oil?

Meanwhile, how bad is the ongoing oil spill? It's likely that the oil volumes coming from the blown out well are more than the previously-advertised 5,000 barrels of oil per day. Just consider that BP is recovering anywhere from 2,500 to 5,000 barrels of oil per day, via the 4-inch wide "insertion tube" -- add that to the additional crude spilling directly into the water and it’s pretty clear to see the total could be more than 5,000 barrels a day. The amount varies, day to day, because the oil is mixed in with gas slugs. Sometimes the tube sucks up a lot of oil. Sometimes it's mostly gas.

To my mind, it's no big shock that the oil volumes have apparently increased over the past month, since the blowout occurred.

Initially, there was probably crud or debris down in the pipes that choked-back some of the oil flow. Then over time, those blockages were blasted out of the way by the continuing pressure of the oil blowout.

Now, we have oil and gas coming out of the reservoir, and up the casing pipe at high velocity. It's likely there are small bits of rock, sand, clay and whatever else in that fluid stream. So the continuing flow is essentially sand-blasting the innards of the blowout preventer and pipe system. The flow of oil may actually be widening its own path. That's why we see increased amounts of oil and gas over time.

Ugly Images

You want to see something ugly? Here goes.



This image is oil billowing out of the cracked riser pipe. It's just above the blowout preventer, manufactured by Cameron International (CAM: NYSE). This uncontrolled oil plume is in addition to the other oil that's moving "up" the riser piping (on the left of the photo).

As I've mentioned, some of the oil is being sucked out of the broken riser. (It's further along the pipe system.) This oil and gas moves up a long pipeline to the surface. There, it gets processed for temporary storage aboard a drilling ship named the Discoverer Enterprise, owned by Transocean, Ltd. (RIG: NYSE) . In addition to recovering the oil, the Enterprise is flaring about 14 million cubic feet of natural gas per day.

We can see a lot of what's going on via streaming video from the deep-sea remotely operating vehicles (ROVs). Some of these remarkable systems are manufactured and serviced by Oceaneering International (OII: NYSE). The ROVs show hard evidence that large volumes of oil are still entering into the water column, despite the physical recovery of the 5,000 or so barrels per day.

Too Big to Fail?

The continuing BP oil spill has prompted many comparisons with the Exxon Valdez oil spill, 20 years ago. Exxon shares took a big hit, and then recovered. So by analogy, a lot of handicappers are wondering if BP shares are taking the same kind of hit, and will come out of this and recover.

Well, Exxon Valdez was then, in Alaska. This is now, in the Gulf of Mexico. So every day, as things unfold, I ask myself how bad this can get for BP. BP management has stated that the company can weather this crisis. But let's ask it another way. Is BP too big to fail?

Right now, BP is paying through the nose. So far, BP has spent over $500 million on response-related costs, just in the first month. This deepwater blowout is unprecedented in so many ways -- expensive is just one of them. I've seen numbers like $10 billion, eventually, just for the out-of-pocket costs for well-control and oil spill abatement. Truth is, nobody knows and no one will know for many years.

Meanwhile, the U.S. plaintiff-lawyer community is lined up to take a chunk out of BP. So are the state governments, as well as the federal government. The Department of Justice is reviewing the facts, with the possible end of filing criminal charges against BP. Just recall what a criminal conviction did to the fortunes of, say, the late Arthur Anderson Co.

BP Is Important

Keep in mind, though, that BP is a critical part of the U.S. energy system. By extension, BP is important to the U.S. government and national energy policy.

The fact is that BP is the largest oil producer in the U.S., at over 400,000 barrels per day just from the Gulf of Mexico. Up north, BP has a dominant position at Prudhoe Bay, Alaska, a field that lifts about another 400,000 barrels of oil per day.

BP has a controlling interest in the Alaska Pipeline.

Then there's BP's nationwide, downstream refining and product-marketing system. Think about how many cars, trucks, buses, railway locomotives and airplanes run on BP fuel, delivered under one contract or another. Try sorting that mess out if BP goes down hard.

Consider that BP is a large, global concern. Every day, across the world, BP produces about 4 million barrels of oil equivalent (BOE). That's about 4.7% of the world's liquid energy supply. Also, BP has 42 major, new oil projects under development, and scheduled to be online by 2015, producing another 1 million BOE per day. Screw that up by putting BP out of business, and we'll probably see those $200 per barrel oil prices sooner than we thought.

Beyond the raw numbers, BP has a critical energy relationship with the government of Russia. BP also has a large contract with the government of Iraq to resurrect Iraq's oil industry. So BP is important to the strategic aims of Russia and the West (certainly to the U.S.). Put BP out of business, and then what? Break out your prayer rug and face Mecca, I guess.

If push comes to shove, you should expect that BP will have the full backing of the UK government. BP is a huge employer in Britain. BP pays an immense amount of taxes to the UK government, and the UK government needs those funds. Pres. Obama may have returned a bust of Winston Churchill to the British, early in his presidency. But the British will want Obama's head on a platter if BP goes down under his administration.

Right now, the dividend yield for BP is 7.4%. That's nice, but the high return probably includes the risk that the BP board will -- sooner or later -- slash the dividend. It would be unseemly for BP to be paying large dividends, at the same time that it's also diverting funds to well-control and cleanup costs, not to mention handling damage claims. So the dividend is no longer safe, in my view.

BP -- Professional Defendant

Here's something else. BP may as well change its business model to include being a professional defendant. In years to come, BP will devote immense amounts of money and management time to litigation.

BP may even have a hard time making future energy development deals, due to the Deepwater Horizon legacy issues. I can hear it now. "Oh yes, you're the company that blew out that well in the Gulf of Mexico." The image problem may extend to BP having a hard time recruiting talent in years to come, due to the stigma.

Back to the Question

So we come back full circle to that question. Is BP too big to fail? I don't think BP will "fail." That is, BP is going to "pay" but not fail.

I'll feel a heck of a lot better about BP's prospects if (when?) BP kills that well this week. I'm not down there on the water, and I only know what I've been told. But I have a good feeling about BP killing the well. They literally have the horsepower to do it, if it can be accomplished at all.

If this week's kill-shot doesn't work, then I believe BP will nail the well in three months with the relief wells. But killing the well now is obviously better, in every way. With an immediate well-kill, there's a HUGE cleanup bill ahead of BP. But the "good" news is that the oil spill will stop. At least there won't be more oil gushing out every day.

Will the Short-Sellers Fail?

There's been a lot of short-selling of BP in recent weeks. A lot of players are betting that the share price for BP will fall, and even that BP will fail. Watch out, boys and girls. If BP kills that well this week, watch for a spike in the share price, with plenty of short-covering.

If you want to sell into that short-covering, then be ready to pull the trigger fast. I think BP shares will pop up after a successful well-kill, and then pull back after the shorts do their covering thing.

If there's no well-kill? If BP has to continue drilling relief wells? Ugh. More oil blowing out for three more months. Bad becomes much worse. The markets will hate BP. And BP stock will slide downwards.

It's Not Just BP That's Down, Lately

Final point. BP shares are way down in the past month. The Gulf of Mexico disaster is a big part of it. But then again, due to world economic issues the price of oil has dropped from the $85 per barrel range to the $70 range. So the entire oil sector is down.

Chevron, for example, is down about 10% in the past month. So is Conoco-Phillips. Exxon Mobil is down about 12% in the same time period. Thus it's safe to say that the BP share slide is not entirely due to the Gulf of Mexico well blowout. If (when) the price of oil goes back up, that alone will lift BP shares.

Is BP too big to fail? Well, BP sure is taking its hits. I'll climb out on a limb and say that I think BP will be around for many years to come. And the company will recover from this horrible mess.

That's all for now. Thanks for reading...

Byron W. King