BP Has Time, and Investors, on Its Side
Few institutions understand the time value of money as well as the world's major oil companies. Spending billions of dollars digging holes in the ground in the hope of finding enough black gold to make a profit in the following decades means taking a long view of what a dollar is worth now versus what its value might be years hence. And that, in turn, helps explain why BP shares are rising today even after the company reported its worst profit in at least a decade.
Earlier this month, BP agreed to pay a record $18.7 billion to settle U.S. state and federal claims for the damage done by its Deepwater Horizon platform, the worst offshore oil spill in U.S. history. The company has set aside more than $54 billion against its liabilities, including a $10.8 billion charge in second-quarter earnings that helped reduce profit to $1.3 billion, a 64 percent drop from a year earlier.
While the costs of the catastrophe are clearly astronomical for BP, they could have been oh so much more crippling for the London-based company. BP, for example, will pay $5.5 billion in record federal penalties under the Clean Water Act, far less than the $13.7 billion BP could have been assessed, based on a federal judge's calculation of the potential fine.
The big win, though, is the length of time BP won to pay that $18.7 billion. The agreement spreads the payments over 18 years. BP calculates the maximum it will hand over in any single year at about $1.1 billion, with payments declining to $260 million in the final year. By contrast, after the Exxon Valdez ran aground in Prince William Sound in 1989 and coated more than 700 miles of Alaska coastline in oil, Exxon agreed to a $1 billion settlement that ran for just 10 years.
Here's how Investopedia defines the time value of money:
The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.
The longer BP can hang onto its dollars, rather than handing them to the settlement beneficiaries, the better off the company is. Calculated crudely, at an interest rate of 2.5 percent (about what you'd get investing in U.S. Treasuries for 18 years), that $18.7 billion costs BP about $12 billion in today's money.
Given what's happening to the price of BP's key product, the decision to settle quickly rather than gamble on a prolonged court battle looks even smarter. Brent crude has dropped more than 20 percent from its May peak and is trading at about $53 a barrel, about half its average price in the past five years:
It might get much worse. Brokerage firm PVM Oil Associates reckons oil supply will exceed demand by 2 million barrels a day this year; the last time the gap was that wide, in 1998, oil plunged to less than $10 a barrel. With the U.S. producing oil at the fastest pace in 30 years, the Organization of the Petroleum Exporting Countries pumping hard, and the prospect of Iranian exports hitting the market, the glut of oil may reach "unprecedented" levels, PVM says.
BP says it's "stress-testing" whether some of its existing projects still make sense at prices as low as $40 a barrel, and Chief Executive Officer Bob Dudley says his top priority is maintaining the company's dividend to shareholders. That'll be a lot easier with a completed Deepwater settlement -- and almost two decades to deliver the money.
(Corrects first name of BP chief executive officer in final paragraph.)
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