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Market Oracle FREE Newsletter

Trading Lessons

BP's Risky Business

Companies / Oil Companies Jul 19, 2010 - 08:13 PM GMT

By: Jennifer_Barry


Best Financial Markets Analysis ArticleAn oil company ignores standard safety procedures and fails to fix crucial equipment, and a huge oil spill occurs. The corporation minimizes the environmental impact and reacts slowly to the accident. The local community is infuriated by the lack of response. The company is stingy about giving out information and data on the spill. The CEO seems arrogant, and aloof. Instead of appearing concerned about the accident, his statements plead for public sympathy. The Chairman seems unprepared to deal with the emergency and uninformed about the workings of his own company. The corporation seems unable to demonstrate they would avoid this problem in the future, or have a more effective response next time.

While this is an accurate description of the BP disaster, it also applies equally to the Exxon Valdez spill in 1989. Although Exxon spent approximately $2 billion on the cleanup, their reaction was roundly criticized as slow and inadequate. The fisheries in Alaska have still not rebounded 21 years after the Exxon Valdez spill, with the 100% loss of the herring catch costing the economy US$400 million over that time period. Today, the beaches in Prince William Sound are still highly contaminated, and the impact to local fauna is expected to continue for about a decade longer due to residual toxins. 

Sudden Impacts

When the Deepwater Horizon rig exploded, 11 workers were killed and 15 were injured. In addition to the human tragedy, this accident has become an ecological disaster. Admiral Thad Allen is leading the government response to the spill, and some National Guard troops have been mobilized to help with the cleanup. Approximately 35% of the Gulf of Mexico has been closed to fishing by the National Oceanic and Atmospheric Administration (NOAA) due to the poisonous flow of petroleum. In addition to the thousands of birds and other animals confirmed dead, one captain reported that endangered sea turtles were corralled by booms into burning fields and then incinerated along with the oil.

The damage from the leak was apparently worsened by the use of the very toxic dispersant Corexit, which may hide the magnitude of the problem, and was later banned by the Environmental Protection Agency. Cleanup workers have been hospitalized with serious illnesses apparently related to chemical fumes from the spill, which BP CEO Tony Hayward blamed on “food poisoning.”

The economic effects effects of this disaster are also widespread. Gulf Coast tourism has taken a hit as travelers cancel vacations, even to destinations untouched by oil. Many hotels, restaurants, and entertainment venues that depend on the influx of visitors will go bankrupt. Seafood prices have jumped sharply as many fishing boats are sitting idle. Potential homebuyers are shying away from properties that could be contaminated. Oil industry workers remain unemployed as the battle to ban offshore drilling winds through the courts.

Naturally, any company in this situation will have a conflict between remediating the spill, and protecting its bottom line by doing the least amount of work possible. In fact, some residents of Louisiana have alleged that BP is engaging in a farce they call “ponies and balloons,” or only demonstrating an adequate response when officials are present to observe.

Remembering the lessons of the Valdez disaster, where the ecosystem was devastated by the petroleum spill for years, why is BP still in charge of cleanup and containment? Shouldn’t a more neutral third party decide what is an appropriate response and give BP the bill, rather than allowing the company to police itself?

Keeping BP in charge of fixing the problem is even more ludicrous once you look at the company’s attitude towards safety. The oil conglomerate has a culture of silencing whistleblowers and ignoring hazards. Their horrific safety record includes using equipment too long - a corroded pipe was the cause of the 2000 Prudhoe Bay pipeline leak. In 2002, the company settled a lawsuit for $100 million for allegedly falsifying fuel storage tank inspection records.

Even more disturbing was the 2005 explosion at their Texas City refinery that killed 15 workers due to systemic safety violations. Despite promises to remediate the situation, management did nothing and was subsequently fined $87 million by the Occupational Safety and Health Administration (OSHA).

   Black Swans and Risk Management

At first, I assumed that BP had considered a blowout a “black swan” event, and and didn’t consider the repercussions if a remote possibility occurred. After all, the federal agency Minerals Management Service (MMS) which regulates resource drilling agreed that a blowout was so unlikely that an emergency plan wasn’t needed.

However, my research indicates that accidents of this type are unusual but not that rare. During the last decade, there were 72 offshore blowouts which caused significant spills, compared to 15 the previous decade. Although blowout preventers are considered “fail-safe,” a 2009 study commissioned by Transocean, the owner of Deepwater Horizon, found that deep sea BOPs had a failure rate of 45% during an emergency. Naturally, the more wells that are drilled, and the farther underwater that equipment must operate, the more likely an accident is to happen. This makes a blowout a “grey swan” rather than a black one. Despite these facts, BP was so confident that industry risks were overblown that they foolishly cancelled their accident insurance three years ago.

Some critics see anti-British bias in the focus on BP’s mistakes. They point to Transocean’s recent safety record, owning 33% of the deep water rigs but investigated by MMS for 73% of the incidents. The company was also cited in 2006 for using BOPs too long without proper maintenance.

Nevertheless, as BP purchased the underwater lease and was in charge of operations on the rig, it was ultimately their responsibility to drill safely. However, they clearly decided to save time and money at the expense of safety precautions. If management didn’t feel comfortable with the amount of emergency equipment, they could have insisted that Transocean install more. Their contractor Halliburton recommended using 21 centralizers to secure the casing in the well, but BP overrode this advice and only used 6. Schlumberger was supposed to test the quality of the cement bond but BP didn’t want to spend the 12 hours necessary so the contractors were sent away. Tragedy resulted from the confluence of these bad decisions.

A Cloudy Future

Although BP originally reported the crude leak at 5,000 barrels per day, current government figures estimate it could be as high as 60,000 barrels. Considering that BP has minimized the spill from the beginning, the problem is likely to be even worse. Now that the cap has failed, the relief wells are not expected to have any effect on the flow until early August, if they work at all.

BP's clean up spending has skyrocketed to $4 billion so far. However, the price tag could get much higher should powerful storms stir up the Gulf of Mexico and deposit contaminated water far inland. Although Hurricane Alex tracked west of the oil slick, we are still at the beginning of a hurricane season that’s predicted to be more severe than normal.

Already, BP’s stock has fallen more than 40%. The corporation’s credit default swaps remind me of failed banks like Washington Mutual, not a strong company having a bad summer. Gaffes from CEO Hayward like “I’d like my life back” are only putting another nail in the coffin, and should lead to his replacement before August is out.

Despite BP’s strong cash position as a producer of a resource everyone needs, no corporation can survive this level of bleeding from the balance sheet. I expect the cost of remediation, penalties, and litigation will far surpass their $20 billion claim fund. As Matthew Simmons said, “There isn't enough money in the world to clean up the Gulf of Mexico.”

I expect BP will file Chapter 11 bankruptcy later this year to gain some relief from creditors. I wouldn’t be surprised if a reorganization of the company is arranged by the US government which caps BP’s liability for the spill. This would avoid a messy liquidation of assets which would be very disruptive to petroleum production. It would also pave the way for another oil company to merge with or take over BP’s assets, which are sizable.

With the reckless disregard for safety, the conflicts of interest, and the arguments between contractors foreshadowing a dramatic explosion, the oil spill would make an excellent movie. Unfortunately, it’s a waking nightmare we are all living through.

Even if the relief wells are successful, there is plenty of pain to go around. Pension funds and other shareholders will watch their investment in BP evaporate. If the spill is pushed into the Gulf Stream, pollution could end up on the shores of the Eastern Seaboard and even the UK. The inevitable limits on offshore drilling will cause higher unemployment for oil workers and higher fuel prices for everyone. Seafood prices will continue to rise as a massive amount of ocean life dies. Finally, most of the Gulf Coast will have its economy and environment suffer for decades.

by Jennifer Barry
Global Asset Strategist

Copyright 2010 Jennifer Barry

Hello, I'm Jennifer Barry and I want to help you not only preserve your wealth, but add to your nest egg. How can I do this? I investigate the financial universe for undervalued assets you can invest in. Then I write about them in my monthly newsletter, Global Asset Strategist.

Disclaimer: Precious metals, commodity stocks, futures, and associated investments can be very volatile. Prices may rise and fall quickly and unpredictably. It may take months or years to see a significant profit. The owners and employees of Global Asset Strategist own some or all of the investments profiled in the newsletter, and will benefit from a price increase. We will disclose our ownership position when we recommend an asset and if we sell any investments previously recommended. We don't receive any compensation from companies for profiling any stock. Information published on this website and/or in the newsletter comes from sources thought to be reliable. This information may not be complete or correct. Global Asset Strategist does not employ licensed financial advisors, and does not give investment advice. Suggestions to buy or sell any asset listed are based on the opinions of Jennifer Barry only. Please conduct your own research before making any purchases, and don't spend more than you can afford. We recommend that you consult a trusted financial advisor who understands your individual situation before committing any capital.

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