The BP Saga is nearly over

The US government yesterday now allows drilling applications to take place in the Gulf of Mexico. There will be increased scrutiny with respect to contingency plans that will make the already expensive process even more so, but there will eventually be drilling back in the Gulf.

This nearly closes the saga on the BP oil spill – although you hardly hear of any further environmental consequences. The only story left will be a decade of litigation in court to determine who pays for the damages.

Be careful of people touting their horns – what I’m about to write will be a high magnitude of chest-beating.

Earlier, I gave a fairly accurate forecast of the financial consequences. I made a projection on June 16, after BP had cut its dividend, that if you were playing BP, one should purchase BP shares between $25 to $30/share. BP subsequently made it to $26.75/share, which would have resulted in a 65% fill. On July 15, stated that one should exit BP at $45 to $50/share (this is after it spiked up to $39/share), and July 27, I fine-tuned the price model to $42-47/share. I stated that BP should be around that price range by the end of the year.

Currently, BP is trading at $41.50/share, so it is within striking range of this price range where an investor should offload the shares. Indeed, the price risk from the oil spill has been mitigated to a degree from the stock, so investors in BP at this moment should be evaluating the company not with political risk in mind, but operational risk of the various businesses it controls around the world, and of course, the price of oil.

BP still looks undervalued strictly from an earnings and “price of oil” perspective – they have a huge amount of reserves and production going on, and will likely continue to make money in the foreseeable future. Analysts expect the company to earn about $6.51/share in 2011, which gives it a 6.4x P/E ratio, or about 15.7% yield from current earnings. By comparison, Exxon has a 9.7x P/E ratio on 2011 earnings. Even though it is an operational basket case, BP still looks dramatically undervalued.

Always keep in mind that analyst projects tell you what the market is pricing in – so in order to make money from the present, you have to believe the company will make more money than what the analysts are predicting. In theory, the analyst estimates are baked into the current stock price.

One prediction that has not come to fruition yet has been a June 16 prediction that the drillers will fare better than BP – right now, BP is leading the two drillers I selected by about one percent. When re-evaluating the drillers, I think BP is now the better deal.

There is a reason why I do not like large capitalization companies – many other eyeballs have spent time looking at the companies far longer than you have, which makes your potential advantage in properly valuing such companies to be less probable.

BP – When to exit?

Earlier, specifically on June 16, I stated the following about BP:

For people that insist on getting into BP, the next couple weeks should be a good time. The exact timing in terms of price is an unknown variable, but I would estimate layering in 25-30 dollars a share (e.g. if it goes down to 28, you will get a 40% allocation).

Indeed, the common shares fell to a low of 26.75, which means that using the “25-30 dollars a share” algorithm would have resulted in a 62.5% position (e.g. if your typical position is 5% of your portfolio then you would have ended up with 62.5% of 5%, which would be 3.125%). The average price would have been $28.375/share, not factoring in commissions.

Now that BP has risen and the big headline (“they’ve solved the oil leak”) has come out in the news, it brings up questions of what the ideal price to liquidate will be.

I see a two-phased trading approach should work well. The first phase should involve an immediate bump up due to the “news” coming out. This has mostly occurred, as you can see by this one-day chart:

After attracting the initial wave of profit-takers, I anticipate a second wave of demand coming for BP shares which should bring the stock to the $45-50 range. This is the target I would set for my sell order. The simple justification is that I estimate this whole debacle should cost BP about $40 billion dollars, or about $13/share. Before this all began, BP was valued at around $60/share, so simple math would assume an approximate $45-50 valuation, hence the sell point at this price. Assuming the exit is achieved, you would be looking at around a 67% gain on the transaction, which I would estimate between now and the end of the year.

This is a very elementary valuation exercise; naturally to properly model the situation you have to take into assumption the strategic effects of the oil spill (i.e. reduced offshore drilling in the Gulf of Mexico) but also have to strongly factor political considerations.

I have not and will likely not trade common equity in BP, but I have sold puts on Transocean and they have moved out of the money at present from my initial transactions. They will likely expire in August.

This was probably one of the better trading opportunities I have seen in 2010.

Prediction: BP vs. Drillers

I have now been asked by many different people about the valuation of BP.

My response to them is the same as before: “I would not bother thinking about this [buying shares] until BP has cut their dividend.”

However, I will offer up a prediction:

Over the course of the next 2 years, $10,000 invested in BP (NYSE: BP) at the closing price of June 16, 2010 will under-perform $10,000 evenly invested in Transocean (NYSE: RIG) and Noble (NYSE: NE). Assume dividends are not reinvested and remains as zero-yield cash.

The analysis of BP has converted from a financial/resource calculation to purely a political risk calculation. The current US administration is very adverse towards their non-donor constituents and while BP has donated scalds of money to the Democratic party in 2008, it is very likely they will still be made into a scapegoat for the Gulf of Mexico oil spill.

I am very interested in the drillers, and I am waiting for one more “shoe” to drop before likely placing some bids. Implied volatility on Transocean would suggest that selling near-the-money put options is a viable strategy for entry, but I am waiting for a price drop before executing on that. This also goes outside of my “don’t invest in companies outside an English-speaking jurisdiction” rule, but there are times to make exceptions and it seems to be close to one.

I also notice that Canadian oil sands companies are getting quite a bid – I am guessing capital is flowing into the politically safe Alberta oil sands. Suncor and Cenovus are the big players here, although there are a couple interesting bitumen plays that have a smaller capitalization worth looking into.

All of these oil investments assumes an implicit risk that the price of oil will at least be stable or preferably increase.