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The Observer: At BP, can small ever be beautiful?

A report from Cazenove, financial adviser to the UK's biggest company, says a demerger may be in everyone's interest, writes Richard Wachman
Sunday March 19, 2006
Oil giant BP is Britain's largest company and one of its most profitable, so why would anyone want to break it up? The issue is all the more intriguing because the question has been raised by JP Morgan Cazenove, BP's financial adviser.
'There is no way that Cazenove would come up with something as radical as this without being egged on by BP management. They are flying a kite to gauge market reaction,' says one observer. But could BP really be considering a radical revamp of its global empire in what might appear to the outside the world to be a wanton act of self-destruction?
It is not beyond the realms of possibility, say analysts. BP chief executive Lord Browne, who has won more business awards than any other corporate leader in Britain, is not renowned for his timidity. As Cazenove says: 'BP is the one company that might consider taking such a bold step.'
Browne is unhappy about the group's lacklustre share price performance. Although he has delivered record profits, – albeit off the back of sky-high oil prices – as well as promising to return up to $65bn of surplus cash to shareholders over the next three years, the shares are roughly where they were five years ago. BP has underperformed the oil and gas sector by 40 per cent since 2002. Why?
Bruce Evers, oil analyst at stockbroker Investec says: 'It is difficult to say. To the outside world, BP is rolling in it, but in the City, people keep thinking that the oil price has peaked, and that the next move will be down.'
Last month Tony Woodley, head of the Transport and General Workers Union, suggested that a portion of the oil companies' record profits could help workers who lost their pensions when their companies went bust. But in the Square Mile, BP's shares fell despite the firm notching up a profit of £13bn in 2005. Shareholders were spooked by production losses that followed in the wake of the hurricanes in the Gulf of Mexico in the summer, costing BP $950m. More recently, the company lost output from its Texas City refinery, where an explosion killed 15 people. The incident was investigated by the US authorities who handed out a fine of £21m for safety violations.
But something else has affected BP's share price. Rightly or wrongly, BP is viewed as a lumbering giant when compared with more nimble-footed competitors such as Cairn Energy, which has focussed solely on oil and gas exploration. Cairn, whose shares have done far better than BP's, doesn't get involved in expensive refining, processing and distribution operations.
So could BP extract value for investors by restructuring its operations and demerging exploration from the rest of the business? Yes, says Cazenove, which challenges one of the industry's most sacred orthodoxies – that it makes commercial sense for multinationals such as BP to have both an 'upstream' research, exploration and drilling arm and 'downstream' businesses that process, refine and deliver gas and oil products to customers that range from power generation firms to garages which sell BP petrol to motorists.
The practice was first put into operation 100 years ago by JD Rockefeller, who was keen to protect his growing oil empire by controlling every aspect of the supply chain. In modern times, oil giants have argued that owning upstream and downstream operations makes sense because when oil prices are high, downstream earnings fall, and vice versa; in other words, integrated businesses offer a hedge against volatile oil prices.
Cazenove shoots down this argument. Researcher Fred Lucas said: 'Financial data for Exxon, BP, Shell and Chevron shows that upstream and downstream earnings are actually very positively correlated. The arguments for adhering to an integrated structure have lost much, if not all, of their historical validity.'
Lucas's proposed solution is to demerge BP's downstream business from its exploration activities, offering investors shares in two companies. Lucas reckons that a demerger could yield $35bn of lost value to shareholders.
He said: 'This restructuring could address the 15-20 per cent equity value gap that we believe BP suffers and that, we understand, is a growing concern for its top management.'
A BP spokesman commented on the plan: 'We have seen [Cazenove's] paper which is interesting, but the plan is not under active consideration.' He added that it made financial and commercial sense to remain 'a single company'.
Institutional shareholders are not as dismissive. 'Investors prefer focused businesses; if Lord Browne can demonstrate it makes economic sense, he will have an audience and my guess is that shareholders will back him,' said Stuart Fowler, head of equities at Axa investment management.
Robert Talbut, chief investment officer of Royal London Asset Management, said: 'The company has been trying to satisfy the market but, to date, they have not been well rewarded. This would be a radical move; we shouldn't dismiss it out of hand.'
If Browne were to grasp the nettle, he would be moving against the tide of economic protectionism in Europe where the French and Spanish governments are trying to promote national energy champions to ward off foreign competition.
But Cazenove said that BP would be the winner if it took advantage of Britain's more open economy and sought to split itself in two.
Lucas said: 'Nationalist energy tendencies are contrary to European law and have no place in today's competitive markets.'
As for the argument that integrated oil giants are a protection against unwanted bids, he added: 'Companies typically perform better when exposed to the disciplining threat of takeover.'
Britain's oil baron
He has turned BP into the seventh-largest company in the world and Britain's biggest, with a market value of £131bn. Lord Browne, 58, has been at BP for most of his working life and is one of the most feted businessman in the country. He is also one of the best paid: his pay and perks package rose by 14 per cent last year to £6.5m.
But nothing can take away from Browne the honour of transforming BP into a goliath. When the oil price was at rock bottom at the end of the 1990s and assets were going cheap, he went on an acquisition spree, buying Amoco and Arco of the US for about $80bn, and Britain's Burmah Castrol.
More recently, Browne stole a march on his American rivals by forming a 50/50 joint venture in Russia with TNK, giving BP unrivalled access to new resources. The Russian offshoot now accounts for a quarter of BP's daily oil production. Now Browne is knocking at China's door, seeking 25 per cent of Sinopec, the country's largest producer. He retires in less than two years' time – cementing a deal with the Chinese would be a good way to go out.

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