BP offers the perfect example of the cost of environmental risk and how it can impact even the largest oil and gas companies. The massive company's stock remains 20% lower than prior to the 2010 Macondo well blowout and subsequent oil spill. Even though BP has a large global footprint in a commodity that we will need in massive quantities for years to come, other risks beyond Macondo could also keep its shares from performing the way its investors would hope.
This article will look at three major risks in owning shares of BP.
But first, why the Macondo oil spill is no longer one of those risks
If I went an entire article on BP's stock risks without talking about the court case in progress, I'm sure many people would think I was missing something. In reality, though, we are at the point at which the Macondo blowout shouldn't have too much of a material impact on the company's future.
Based on the penalties established by the Clean Water Act and the estimates of how much oil was actually spilled, BP is on the hook for anywhere between $2 billion and $18 billion. That might sound like a lot by itself, but for the past couple years BP has been building up a cash war chest in the event of the worst fine. As of the company's most recent financial reports, it had $27.5 billion in cash on hand, as well as a net debt-to-capital ratio of less than 20%. So even if the company is hit with the maximum penalty, it has more than enough cash on hand, along with the financial standing to take on some debt, to cover the fine without needing to sell off assets or impact future capital expenditure plans.
Sure, share prices could go down in the short term due to the court's decision, but that would simply be a knee-jerk reaction from Wall Street that should be ignored by those looking at long-term success.
With that out of the way, here are some ongoing causes for concern about BP.
1) Weak margins means it needs to work harder than its peers
There are two rules of thumb when it comes to integrated oil and gas companies. No. 1: Production -- the upstream side of the business -- is more profitable than chemical manufacturing and refining -- the downstream side. A major reason for this is that margins for refining are considerably smaller than actual production. No. 2: Producing oil is more profitable than natural gas. This isn't always the case, but for all intents and purposes of analyzing a company we'll accept it as fact.
Knowing these two rules makes BP a bit of a puzzler. While it has one of the lowest exposures to the downstream side of the business...
...as well as some of the highest oil output as a percentage of total production, BP has the weakest gross and net income margins of its peers:
|Company||% of production from oil/liquids||Gross Margin||Net Income Margin|
|Royal Dutch Shell||47.1%||15.6%||3.64%|
Weaker margins means it needs to bring more production online than its peers to achieve the same earnings growth. This doesn't mean that shares of BP will actually decline, but it could mean the stock will underperform in comparison to its rivals.
2) High operational risks from deepwater production
One thing that BP hangs its hat on is its leading position in deepwater exploration and production. The company has been responsible for several advancements in this particular aspect of oil and gas production via advanced marine seismic technology and new oil recovery techniques for offshore fields. This focus on deepwater technology has given the company the highest exposure to deepwater exploration by a wide margin.
Some may believe, given its technological advantages, that the company should pursue these types of resources, but there are two major drawbacks to being so exposed to deepwater exploration and production. First, the cost of deepwater operations can be among the highest in the business today, with some breakeven costs as high as $110 per barrel. Second, deepwater exploration has some of the most varied costs, so it can be difficult to predict the outcome during the planning stages.
Having so much of its future banked on this particular type of production could lead to higher production costs per barrel than many of its peers. Unless oil and gas prices remain high this could eat into the company's earnings.
The second part of this risk BP knows all too well: The environmental danger of a spill. BP has already spent over $40 billion related to cleanup and compensation, with more bills to come. This isn't to say that BP will have another spill. In fact the company has gone to great lengths to improve safety to reduce that risk since Macondo. However, more production from deepwater means more wells and rigs working there, which inherently increases the risk of an incident.
3) The geopolitical risk of being a bedfellow with Russia
Russia holds a ton of potential when it comes to oil and gas resources. Some of the shale gas and tight oil formations are measured in the trillions of barrels of oil in place, and the Arctic -- a region where Russia has the largest territorial claim -- is estimated to contain about 20% of the world's undiscovered resources. A 19.75% ownership stake in Russian oil company Rosneft gives BP a level of access to these fields that none of its peers could imagine.
That being said, it also exposes BP to a high level of political risk in the event that relations between the West and Russia sour any further. As of right now, BP's ownership in Rosneft represents more than a quarter of the company's production and proved reserves. If BP was forced out of the country -- especially without adequate compensation -- it could have a profound impact on its future.
What a Fool believes
BP is a little bit of an enigma compared to its peers in the integrated oil and gas space. There has been so much transformation of the business after the Macondo spill that it's not even close to the same company it was a few years ago. Still, some things suggest BP is not done with this transformation, and the risks it carries because of its exposure to deepwater exploration and Russia, as well as its struggles with weaker margins, could lead to some long-term problems for shareholders.
From an investors' standpoint, there are two important metrics to follow to see how the company is mitigating these risks: margins and deepwater production exposure. If margins improve following the corporate turnaround, then BP could kick that risk to the curb, but increasing deepwater production could further open the company to greater operational and environmental risk.