On Monday, BP (NYSE: BP ) announced plans to divest some of its assets in the Gulf of Mexico in a continuous effort to raise funds to pay for its role in the 2010 oil spill. While the sale of the Marlin hub oil fields represents a non-core divestment for BP, it is expected to transform its buyer, Houston-based Plains Exploration & Production (NYSE: PXP ) from a small developer of oil and natural gas into a major player in the U.S. Gulf deepwater exploration industry.
Since the announcement, share prices of Plains have tumbled 11% amid concerns that it is overreaching with its latest acquisition, and deservedly so. First, Plains will be raising debt and paying $5.5 billion to BP and $560 million to Royal Dutch Shell for maturing oil fields in the Gulf of Mexico deepwater. Alarmingly, this total payout of around $6 billion is more than its current market capitalization of approximately $5 billion. Furthermore, the interest expense generated on the new debt will constrain free cash flows in the years to come.
In addition to raising cash from the debt market, Plains is also expected to fund the acquisition by selling its natural gas assets purchased at a much higher valuation four years ago -- effectively conceding that their natural gas bet has failed. In fact, Plains is buying into oil assets when prices are high and selling its gas assets when prices are low. Just as management made a mistake in investing in shale gas development in the onshore Haynesville basin in 2008 when gas prices were high, some are arguing that Plains is falling into the same trap of investing in oil at its peak cycle.
However, should overwhelmingly negative sentiments depress the stock further, investors would do well to keep an eye out for a value play on a company that has transformed into a pure oil exploration and production operation. Even though the company is taking on immense debt and buying into oil assets at a time of high crude prices, the acquisition has uniquely transformed the company's fundamentals and its growth potential. This is true especially because oil production in the Gulf of Mexico is an extremely high margin and profitable business compared to other deepwater oil fields, owing to lower exploration and development costs. In fact, Plains does not even have to spend on exploration as it is buying into an existing oil producing asset. Lastly, as Dealbook suggests, companies that have previously bought assets during BP’s divestitures have tended to generate a high rate of return on their investments -- Plains could just be next.
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This article was originally published here.
SiHien does not own shares of any companies mentioned in this article.