Once perceived as a fortress built on low leverage and strong cash flows, BP Plc seems to have managed its balance sheet much the way it ran exploration projects -- dangerously. Projections the company is feeding investors about how much cash it will have to pay claims are finally getting the skepticism they deserve.
Andrew Gowers, the company’s head of communications in London, told Bloomberg News earlier this month that BP needs “to have an unusually strong cash position.” It owes $20 billion over four years to the escrow fund for oil spill victims, along with whatever fines, cleanup costs, other uncapped liabilities and litigation costs it must pay each year. These items will cost tens of billions -- even as much as $100 billion.
It’s obvious why the stock and bond markets are nervous about a possible BP bankruptcy. Last week BP abandoned its no-worries stance that its cash reserves would cover cleanup costs and announced that it had put together a war chest of $20 billion, including lending commitments from banks. This shift didn’t occur because cleanup costs are rising. BP didn’t have enough funds in the first place.
What BP thought it had was time. It’s in the company’s interest to stretch these payments, and the Obama administration also has a vested interest in making sure that BP survives. On the other hand, the government will crack the whip to avoid complaints of slow or inadequate payouts.
In effect, the U.S. government has its hands on BP’s earnings, whereas the company needs the implicit approval of the U.S. to make major capital decisions.
The company’s starting point for managing this burden is an expected $30 billion in operating cash flow in 2010. The amount sounded impressive when BP touted it, and the company had a strong first quarter. Give BP the benefit of the doubt that it can meet this forecast even with diverted resources, distracted employees, and an impaired competitive standing.
With current capital expenditures running $20 billion, BP had anticipated $10 billion of free cash flow this year. That’s in line with an average of $9.8 billion for the last three years. But BP was going to pay all of it out in dividends, before they recently were suspended.
This is the crux of the issue. BP had committed all of its cash flows. That left it only these options when it needed to raise funds: cut the dividend, cut investments, sell assets or borrow. Doing any of these diminishes the value of the company. Doing all of them, so far, has sliced $100 billion from BP’s market value.
With so little room for error, BP must now resort to drastic measures to raise cash. By rapidly disposing of $10 billion of so-called noncore assets, the company may end up liquidating its balance sheet at fire-sale prices.
BP also is planning to cut capital expenditures by $2 billion, or 10 percent, a year, almost to 2006 levels. This seems to contradict Chief Executive Officer Tony Hayward’s 2008 announcement to the World Petroleum Council that BP was investing at least $22 billion that year because of the inexorably growing long-term global energy demand, which made increased investment “not just an optional extra.”
It’s unclear how much BP really needs to spend on capital expenditures to maintain its competitiveness. We do know that the cuts are being made to raise cash, rather than for business reasons.
The same is true for borrowing. Management once referred with pride to the company’s access to funds and its low leverage. BP pays only 1 percent to 3 percent on these borrowings.
Debt Ratings Fall
It must still renew more than $10 billion of debt over the next two years. Any increase in interest expense will further strain its cash flows. The cost to insure BP’s debt hit a record level last week. The three major credit rating firms have downgraded the company’s debt rating in recent weeks. And municipal bonds for which BP acts as gas supplier and provides liquidity financing have seen yields increase to as much as 9.5 percent from 0.5 percent or less.
It shouldn’t surprise investors that BP had so little flexibility. There is a link between a company’s way of doing business and its financial strength, and BP ignored it until shoddy practices finally brought the oil giant to its knees.
In 2006 Congress hauled in BP executives to accuse them of neglecting plant maintenance after the company pleaded guilty to a felony following an explosion at a Texas refinery that killed 15 people. Congress concluded that several oil spills in Prudhoe Bay, Alaska, happened after BP ignored warnings about maintenance and cut corners to achieve what a congressional committee called “draconian” cost savings. The BP Thunder Horse offshore platform in the Gulf of Mexico almost capsized because of an incorrectly installed valve.
Management claimed each of these episodes was an aberration.
BP, though, is the only oil producer with an employee that pleaded guilty to felony conspiracy for market manipulation, and is the only major oil producer that settled with federal authorities over charges of market manipulation and admitted to trading improprieties. Evidence for the employee indictment included a taped phone call in which a trader recommended cornering the propane market because “what we stand to gain is not just we’d make money out of it, but we would know from thereafter that we can control the market at will.”
Too bad BP didn’t exercise that kind of control over its behavior. Instead a company that seems to have cut corners every which way in its business behaved the same way in running its balance sheet, with little margin of safety. BP’s true liability, it seems, was a culture of recklessness and arrogance.
This is a company that was crying out for better oversight. Now, because of BP’s own negligence, it is going to get it from the government.
(Alice Schroeder, author of “The Snowball: Warren Buffett and the Business of Life” and a former managing director at Morgan Stanley, is a Bloomberg News columnist. The opinions expressed are her own.)
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