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MarketWatch: Problematic BP a buy, for some

Lord Browne

Gulf of Mexico exposure, recent share price fall spells opportunity, some say
By Steve Goldstein, MarketWatch
Last Update: 7:00 PM ET Sep 12, 2006

LONDON (MarketWatch) — BP plc has a busted pipeline in Alaska.

It’s facing probes into a shoddy safety record and allegations of trading manipulations, has a lame-duck chief executive and generates a quarter of its annual production from a country that has seized one rival’s assets and allegedly forced BP to invest in another.

The advice from a large chunk of the sell-side community? Buy.

And not without reason.

BP for all its problems, is positioned as one of Big Oil’s leaders for deepwater production from the Gulf of Mexico, a particularly lucrative area since the bulk of the increasingly costly infrastructure needed to extract oil is already in place.

A recent discovery by rival Chevron gave renewed focus to the Gulf as an oil source that still holds plenty of untapped potential.

“The significant resource and acreage positions, proprietary exploration and development technologies and project management expertise afford the [oil] majors an advantaged position and, accordingly, an opportunity for improved volume growth and returns,” said Daniel Barcelo, an analyst at Banc of America Securities.

BP also has fields coming online in Angola and Azerbaijan to bolster production down the road, and it’s embarking on a program to sell assets at a time when oil prices are near record highs.

It’s expecting to generate more than $6 billion this year through the sale of various assets, including a Dutch gas infrastructure unit put on the block in May.

But investors haven’t bit, sending U.S.-listed BP shares down 12% since early May during a period in which crude oil futures came within striking distance of record highs.

True, the sector more generally hasn’t performed that well recently, as investors interested in the energy sector turn to the oil services sector and away from the producers themselves.

But even compared with leading oil exploration rivals, BP’s performance has lagged.  For instance, BP’s decline compares with just a 3% fall from May highs for fellow FTSE 100 index component Royal Dutch Shell.
 
Goldman Sachs analyst Matthew Lanstone, who recently upgraded BP to neutral, pointed out that the company is trading at its lowest level relative to European oil rivals since mid-1997.

Paul Spedding, an analyst at HSBC, also noted BP’s underperformance against leading rivals, Shell in particular.

“We believe that BP deserves to trade at a premium because of its superior free cash flow generation,” he said in a recent note to clients.

Not just Alaska?

For certain, BP’s well publicized troubles are serious.

CEO John Browne, despite what some said was an orchestrated campaign to keep his job, will be leaving the world’s second-largest oil company sometime in 2008. Meanwhile, he’s been ordered to spend at least part of his remaining tenure testifying for a Texas civilian trial after an explosion killed 15 workers at a Texas City refinery in 2005 and injured scores others. (BP is appealing the ruling that Browne and another senior executive must testify.)

He’s also been traveling to Alaska, where severe corrosion was found in pipelines at its Prudhoe Bay project, the biggest producing oil field in the United States.

About half of BP’s Prudhoe Bay production — usually 400,000 barrels of oil a day — has been shelved to make necessary repairs.

Critics, both in the industry and in Congress, have charged the company had plenty of opportunity to address the corrosion before the breakdown. Read about BP’s hearing in Congress.

At full strength, Prudhoe Bay produces roughly 8% of U.S. oil production, or about half the total output from Alaska’s North Slope.

BP said Thursday that it may be able to fully restore production by the end of October, if the U.S. government gives it approval to an alternative network of pipes.

In the warmer climate of the Gulf of Mexico, BP has run into difficulties as well.
Its Thunder Horse platform still hasn’t been able to get up and running after being hit last year by a hurricane just months before production was to start.

That’s leading to questions that the BP problems the market knows about are only the tip of the iceberg.

“We are inclined to believe BP’s facilities problems of the past few years have not all been due to bad luck,” said Jack Aydin, an analyst at KeyBanc Capital Markets, who recently downgraded the shares to hold from buy.

Then, of course, there’s Russia, with its sometimes adversarial nature most amply demonstrated in its wrestling of a key asset from Yukos, the now bankrupt Russian oil company.

The Russian environmental regulator also sued to stop the key Sakhalin-2 project, led by Shell, in what is seen as a move to get Russian gas giant Gazprom in on a foreign-backed project.

Some outside observers — notably an ex-lawyer to Yukos — speculated that BP only invested in the initial public offering of state-backed oil giant Rosneft (UK:ROSN: news, chart, profile) to stay in the good graces of Russian President Vladimir Putin.
For BP, the $1 billion or so it put into Rosneft is a small price to pay to keep the Kremlin from causing trouble. Rosneft’s flat performance since its IPO isn’t as bad as BP’s, either.

Trading arm

The issues at its trading arm could prove even more serious.

According to BP’s annual report, it earned $2.97 billion from trading activities in 2005, or about 15% of its adjusted profit.

That’s up from a still hefty $2.13 billion in 2004 and $1.41 billion in 2003. BP’s trading arm rivals that of top Wall Street banks — Goldman Sachs for example, generated $2.23 billion in revenue from its proprietary trading desk in 2005.

At those levels, even a fine of, say, $100 million by regulators would be fairly inconsequential from a valuation perspective.

Proving BP has acted illegally won’t be a walk in the park either, as commodities trading rules don’t explicitly prohibit trading on insider information. The U.S. government will have to prove the company actively and knowingly manipulated markets in propane, oil and unleaded gasoline.

Still, the bigger question isn’t so much whether BP will be fined, it’s more whether it will be forced to scale back its trading activities in any way.

The precedent on Wall Street, which has lived under regulatory scrutiny for years, suggests that any walls on information BP may forced to erect won’t seriously jeopardize profits.

But then, millions of Americans don’t pump Goldman Sachs products into their cars every day. And penalties against BP will be politically popular, as BP’s hammering in front on Congress on Thursday demonstrated.

Plus, the Commodity Futures Trading Commission and Justice Department may want to take advantage of the BP situation to set out a framework on how companies can act in the largely-unregulated over-the-counter derivatives market.

Where’s crude?

But ultimately, contrary to its advertisements, BP is not “beyond petroleum” — it made 78% of last year’s profit before interest and tax from its exploration and production division, the part of the company that pumps oil out of the ground.

And that means BP’s value is heavily determined by where crude is trading.

The stock market is coming up with significantly different valuations of what’s oil is worth than the futures market.

Even bullish analysts estimate oil prices in the medium-term — say five-year’s time — to be around $45 a barrel.

Futures markets meanwhile are pricing in crude at close to $70 a barrel in 2011.
As Goldman’s Landstone put it: “Oil price correlation suggests upside potential if oil stays strong.” 

Steve Goldstein is MarketWatch’s London bureau chief.

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