The 2010 oil spill is still haunting BP (NYSE:BP) and the ongoing court cases are keeping the company's stock low. Is this high penalty justified? Let's explore this issue in further detail.
Is BP out of the woods?
The main issue that continues to adversely affect the company's stock is the uncertainty around the company's settlement over the 2010 Deepwater Horizon oil spill disaster. Up to now the company has allocated $42.5 billion toward covering the cost of cleaning, fines and relief concerning this spill. Since 2010 and up to the second quarter of 2013, the company has recorded (listed in the income statement) more than $31 billion as a loss. Regarding the oil spill, the company is facing two battles.
Against the U.S, the point of argument is how much oil was spilled and not collected by BP soon after. This question could determine just how big of a fine, under the Clean Water Act, BP will have to pay; this fine could range between $11.5 (according to BP's take) and $18 billion (based on U.S officials). This issue is still in court.
The second issue BP faces is the amount of relief it has to pay for businesses due to the damages caused from the oil spill. BP has the Deepwater Horizon Oil Spill Trust that includes $20 billion; its purpose is to pay individual and business claims, state and local government claims resolved by BP, final judgments and settlements, state and local response costs, and natural resource damages and related costs.
According to BP, Patrick Juneau, the person in charge of the program, was approving claims too loosely resulting in businesses receiving compensation due to misinterpretations of the agreement and fraud. On this matter, BP got a partial victory last week: The federal appeals court ruled in favor of BP; the court sent the agreement back to Judge Carl J. Barbier of United States District Court to reconsider and clarify the terms of the agreement. Some analysts speculated a few months back these States' claims are for an additional $34 billion for economic and property damages. Initially, BP allocated $7.8 billion for these private claims. But now with the judgment pending by Judge Barbier, the company isn't capable of providing a clear estimate.
Let's take the near-worst case scenario in which BP will have to pay $18 billion for the fines under the Clean Water Act and, say, $14 billion (nearly double BP's initial estimate) for private claims. These two figures come to $32 billion, or nearly $14 billion of excess funds the company will have to pay (i.e. on top of its already initial estimates). Let's even say the company would have lost on sales of assets in order to pay these funds with an additional couple of billion of dollars. This puts the total excess lose of $16 billion. Is this the current market expectation?
To determine BP's valuation, I will use enterprise value and EV-to-EBIT ratio in order to compare BP's valuation with other leading oil and gas companies such as ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX).
The table below shows the summery of data of all three companies and the industry average.
This calculation accounts for these companies' different financial structures, including their debt and cash. The yearly EBIT is based on the past four quarters (ending in the second quarter of 2013). As seen, BP's EV-to-EBIT ratio is the lowest at 4.13, which is also much lower than the industry average. On the other hand, Exxon has the highest EV-to-EBIT ratio, which is also higher than the industry average. Chevron is in the middle of the pack. This means, BP's valuation is very low and thus might be an investment worth considering. The only problem is to determine how the market has estimated the uncertainty around the company's court cases of the 2010 oil spill.
BP's current market value is set at $131.7 billion. How much would the company's value be without these law suits? If we were to match BP's ratio with Chevron's, the second lowest EV-to-EBIT ratio, this would mean the company, assuming all things equal, would have a market value of $182 billion, which comes to a stock price of $58. Taking into account the potential $16 billion of excess losses from the court cases mentioned earlier, BP's market cap drops to $167 billion – a stock price of $53.
Again I don't claim this will be the price of BP once the dust settles over these legal procedures. Moreover, these companies aren't exactly alike; this calculation is just to provide us a ballpark for the losses BP has had from these litigation procedures. It also shows that the market may have been a bit harsh in valuating BP's potential losses. After all, these harsh circumstances might not come to fruition, which could mean BP's stock price has a reasonable chance of reaching an even higher level.
I think BP is currently undervalued compared to other leading oil companies. The uncertainty around the company's losses over the oil spill aftermath should adversely affect the company's stock price, but it may be overblown.
Lior Cohen has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.