BP’s $20 billion deal with President Barack Obama Wednesday to set up a compensation fund for victims of the Gulf oil spill bought it some time, at a very high price.
But serious doubts remain over the ultimate price the oil giant will pay for the environmental disaster.
In the short term at least, BP didn’t get a bad deal given the weakness of its position. Fears that it would have to pay $20 billion into the compensation fund up front prompted Fitch to downgrade the company six notches to just above junk Tuesday. And blew out the cost of insuring its debt to all time highs.
Instead, BP will pay the money into the escrow account over three and a half years and the payments this year will be entirely covered by the suspension of its dividend.
BP bowed to pressure to pay compensation to oil workers laid off because of the U.S. government’s moratorium on offshore deep water drilling–an unprecedented and legally dubious requirement–but has apparently limited this liability to $100 million.
Equity and credit markets reacted positively to this. BP shares were up by almost 10% at one point in early trading in London. BP credit default swaps were trading at 400 basis points Thursday morning, compared with an all time high of 625 basis points on Wednesday.
This reaction is understandable. The deal leaves BP’s short-term financial position strong. It’s gearing remains below 20% and its cash flow will exceed liabilities this year, building on the $5 billion it already has on its balance sheet.
And Obama’s assurance Wednesday that it’s in everyone’s interests for BP to remain a strong, viable company assuaged fears that his administration wanted to drive the company to the wall to score poltical points.
BP’s Chief Financial Officer Byron Grote, however, did not sound like a man reprieved in a conference call with analysts Wednesday night.
BP will have no clarity on its ultimate liabilities from the Gulf of Mexico oil spill for a long time and will maintain a conservative approach to its financial position, Grote said. BP’s board is focused on what is right for the company in the long term and will cut its organic capital expenditure by at least $4 billion in the next two years, sell $10 billion of assets and withhold its dividend until at least early 2011, he added.
This is very conservative from a company expected to generate more than $30 billion in free cash flow annually.
So why the caution?
After Wednesday’s deal, the great unknown for BP is the size of civil or criminal penalties it could face from U.S. authorities.
The basic civil penalty for oil spills is a maximum of $1,100 per barrel. If the current top-end leak estimate of 60,000 barrels a day is correct, these fines could be accumulating at a rate of $49.5 million a day (BP is capturing around 15,000 barrels of oil a day). If BP were found to be negligent in the lead up to the spill, the maximum penalty would rise to $4,300 a barrel, taking the rate of accumulation to $193.5 million a day.
Criminal charges, which the Attorney General is currently investigating, could yield unlimited fines.
The damning assessment of a congressional panel this week that “BP made decisions that increased the risk of a blowout to save the company time or expense,” [read our coverage here] raised the likelihood that the company will face stiff penalties, possibly running into the tens of billions of dollars.
It may be with one eye on this frightening prospect that BP capitulated to Obama’s demands Wednesday and continues to put cash aside for a rainy day.
