The One Number Every Investor Should Know about BP

Here’s the most important number you need to know today: $8 billion. That’s the amount of cash that BP (NYSE: BP) is likely to generate, year-in and year-out, assuming energy prices stay where they are right now. And that number should be kept in mind as investors tally up all of the energy company’s mounting liabilities. BP will be on the hook for millions and millions of dollars, but will still emerge from this debacle in a fairly strong financial position. That may not be fair, and many of us are despondent over the ecological impact of this oil spill. But as an investor, you should make an informed decision.

Bills, bills and more bills

Make no mistake, BP’s liability appears to grow by the day. In just the last 48 hours, the company has:

  • Announced a $360 million fund to build six massive berms along the Louisiana coast.
  • Been asked by Florida to provide $50 million for shoreline protection
  • Been sued by several law firms
  • Been handed a $69 million bill for clean-up efforts by the Federal government
  • Acknowledged that a temporary drilling ban will curtail output — and profits — for the next year or two

BP has already spent $1 billion on clean-up efforts, and during the next few years, total liabilities could approach $10 billion, $15 billion, or even $20 billion. That’s a lot of money. But for a company generating $8 billion in annual free cash flow, the financial blow can be absorbed within a few years. And when the dust settles, investors will begin to realize that a $60 billion reduction in the company’s market value is a vast over-reaction.

To be sure, some believe that BP’s liability will be far higher, closer to $40 billion. But those include worst-case assumptions on virtually every variable. More than likely, BP would be able to get any extremely punitive fines reduced by a significant amount, as Exxon did after the Valdez crisis.

BP’s next moves

At this point, there is almost nothing more that BP can do than simply work aggressively to cap the leaking well. In a worst case scenario, a pair of relief wells that are currently being dug will come on line by August. An estimated 600,000 barrels of oil have already been leaked, and by the time this over 1.5 billion barrels of oil may have poured into the ocean. That would be five times the size of the Exxon Valdez spill. You can be sure that the Obama administration is going to go after BP to underwrite clean-up costs for a few more years, probably to the tune of $1 to $2 billion.

But there is also a chance that the output from the well can be severely reduced by current containment efforts. If so, the company’s liability may be well less than the figures cited above. And shares would likely quickly move back toward the $50 mark from a recent $38.

How will BP pay for all this? Well, right now all of that cash flow goes in support of the company’s dividend, which offers a seemingly tempting 7.8% yield. You should forget about that dividend in the near-term. It’s hard to see how it can be sustained, not only from a cash requirement perspective, but also from a public relations perspective. But longer-term investors shouldn’t forget about that dividend. After a few years, when the liabilities have been fully addressed, that dividend is likely to be fully restored.

BP may also look to shed some assets to raise cash. Doing so would likely boost shares as well, as it would highlight the underlying the company’s balance sheet strength. BP owns a world class set of assets, most of which will likely stay in the fold and throw off ample cash well into the future.

My greatest concern is that a major hurricane will hamper any well-capping efforts. Any damage to the relief wells being drilled would push an end-date for the oil flow into the fall. But investors should note that management intends to have the relief wells completed by early August, whereas most major hurricanes strike in the late summer. Also of note: those relief wells have a very high probability of success, as they have been drilled successfully in similar conditions in the past.

The other main reason you might be wary of shares regards oil prices. All of these numbers assume that oil prices stay above $70 a barrel. If we get a global economic slowdown, and oil prices fall back toward the $40 mark, then BP’s cash flow generation will no longer be sufficient to cover costs and asset sales will become imperative.

Action to Take –> You may choose not to own BP for ethical reasons. But if you see this company simply as poorly managed and ill-equipped to deal with the current crisis, know that current management won’t likely survive, but the company’s powerful set of assets will. Shares have probably fallen by the twice the rate that they should have. ExxonMobil (NYSE: XOM) survived the Valdez crisis with its reputation intact. And so will BP. Even if it has to change its name. If you are comfortable dealing with all of the noise around this story, then you may want to jump in before events calm down and other investors pile back into the stock.