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The Economics of BP: Credit Crisis

July 5, 2010

British Petroleum (BP) has a PR problem. But, I do not want to jump on the bandwagon to crucify them. In terms of crisis management, I’d hate to be a Monday morning quarterback on a deal this big and hairy, so I won’t. For years, it was among the world’s most admired companies, until of course, the Gulf disaster. Managing the Gulf of Mexico’s deep water oil fields is every bit as complicated as it sounds. A vast network of pipelines and facilities crisscross the region. Worldwide fluctuations in supply and demand affect business decisions. And as anyone who’s worked at sea knows, the most dramatic variable of all is Mother Nature.

From an environmental standpoint, the word disaster falls short. The effects on the gulf coast’s business and ecology will be felt for years, if not decades. The economic cost alone can potentially bring down a world economy already teetering on the brink of collapse. Oil prices will be disrupted for decades. And, consider this: if BP went out of business tomorrow, many UK pension schemes would run out of money, and our trade deficit would be drastically affected. The global economic consequences of BP are tremendous.

Which leads me to the economics of the BP disaster. Follow along…

For starters, fears of an economic relapse across the world have begun to stalk markets again after pending homes sales in the US crashed by a third. The US and global credit system is once again flashing warnings of extreme fragility, with the yield on 10-year US Treasuries plummeting back to crisis-levels of 2.89%.

In general, the amount of credit needed where banks can lend more is hampered by the deposits available in the credit creation market. The credit creation model, which comes from banks traditionally accounted for 50% of loans. Finance Co’s and securitization firms were the other 50% – which is motoring near idle. All this effects trade flows and capital flows and new investment when half the engine of new credit creation is gone. With both engines evaporated, the combined crisis of consumer consumption coupled with limited credit creation in a credit-driven US economy has created market-sector-wide chaos in our economy. You might be able to spend your way out of a typical business cycle recession…

but, the thing is…

This is not a business-cycle caused recession.

This is a bursting credit-bubble recession.

And now another shoe may drop. Unknown to many is :

As horrific as the gulf environmental catastrophe is, arguably the world’s worst environmental tragedy, British Petroleum (BP) may be in the process of triggering a credit crisis event. A likely scenario is that the US operations of BP will voluntarily attempt Chapter 11 bankruptcy proceedings. This is the worst possible scenario for claimants and the economy. The problem is that this triggers a credit event which has daunting repercussions to the highly leveraged global financial markets. BP is aggressively repositioning trillions of dollars in global currency, swaps, derivative, options, debt and equity portfolios. BP bonds and credit-default swaps have been trading as junk — as though the energy company has lost its investment-grade rating.

As the Market Oracle explains:  A BP Collapse could potentially be more devastating than Lehman. Yet, no one knows the true size of BP’s OTC derivative contracts such as Interest Rate Swaps and Currency Swaps. Only the major international banks have visibility to what the collateral obligations associated with these instruments are, their credit trigger events and who the counter parties are.

“In a finance-based, derivative-laced global economy, a pelican flapping his oil-soaked wings in the Gulf could have profound implications on the other side of our interconnected world,” writes Minyanville CEO and founder Todd Harrison in a recent column. The credit default swap market is where financial players buy and sell insurance against credit risk. When times are good, insurance is cheap. When the credit markets go nuts, the cost goes up … and right now, it’s surging.

China could swoop on $9 Billion of BP’s assets in South America, as the oil giant looks to raise money to pay for its giant Gulf of Mexico oil spill. The Gov told BP they need to cough up $20 billion dollars to put in a recovery fund. BP is understood to be in talks with the state-owned China National Offshore Oil Corporation (CNOOC) about selling its 60% stake in Pan America, among others. BP is looking to sell $10 Billion of non-core exploration and production assets. Bankers and analysts expect up to 20 of Europe’s banks to be forced into cash calls as a result of this month’s stress tests.

Once again, as we saw with Lehman Bros and Bear Stearns we have no visibility to the murky world of off balance sheet, off shore and unregulated OTC contracts, where BP’s financial risk is presently being determined. BP extends credit – through trading and finance. They extend the amounts, quality and duration of credit a bank could only dream of. You should think about the financial muscle behind a company with 100+ years of proven oil and gas reserves. Think about that in comparison to a bank with few tangible assets. Then think about what happens if BP goes under.

This is no bank. With proven reserves and wells in the ground, equity in fields all over the planet, in terms of credit quality and credit provision – nothing can match an oil major. God only knows how many assets around the planet are dependent on credit and finance extended from BP. It is likely to dwarf any banking entity in multiples…. The price tag and resultant knock-on effects of a BP failure could easily be equal to that of a Lehman, if not more. It is surely, at the very least, Enron x10.”

Fitch dropped BP’s credit rating an unprecedented 6 notches on June 15 from AA to BBB which followed June 3rd’s AA+ to AA cut. BP is going to face a massive liquidity crunch which has all the earmarks of triggering an already tenuous and worsening international liquidity situation. BP also has a substantial trading operation that could endanger the rest of the energy markets. “You have to respect the counterparty risk, the dominoes that could eventually topple if BP continues to trade lower,” noted Todd Harrison. Observing the charts, BP’s credit looks “similar to the way Lehman Brothers credit traded” before it collapsed in 2008.

If you check the credit spreads of BP in mid-June, 2010, they are screaming for attention. Spreads, are a layman’s way of measuring default risk. And, BP’s are blowing a gasket – creating a bit of a Lehman feel to the markets. The option activity suggests that traders believe that a bankruptcy is a distinct possibility. We’ve already seen signs of worry in the markets, in mid-June, Bank of America told its traders not to enter into trades with BP past June 2011.

Once sporting a $180 Billion dollar market cap, British Petroleum (NYSE: BP) is now valued under $90 billion just a few months later. Even if bankruptcy is imminent due to the magnifying environmental catastrophe, BP’s failure is still no comparison to the credit crisis collective of AIG, Ambak, Bear Stearns, Citigroup (NYSE: C), Fannie Mae, Freddie Mac (NYSE: FRE), Lehman Brothers, MBIA Inc (NYSE: MBIA), Merrill Lynch (NYSE: BAC), Wachovia (NYSE: WFC), WaMu (NYSE: JPM). These financial cancers caused well over $1 Trillion in market cap losses.

Given the current state of social mood, few folks will shed a tear if BP is fitted for a toe-tag. But similar to piling on the credit crisis collective of Wall Street and Fannie and Freddie, what many didn’t realize, as is often the case until after-the-fact, were the unintended consequences involved in letting them die. The eleventh-largest holder as of March 31st was  Goldman Sachs, with 6,695,882 shares. You can almost see a populist smile forming on the lips of disgruntled Americans. Remember, BP is aggressively repositioning trillions of dollars in global currency, swap, derivative, options, debt and equity portfolios. The next domino to fall may be more than we wished for in a credit based economy that is spiraling out of control – without BP’s help.

As I wrote in “State of the Economy – June ’10” and “State of the Economy – March ’10”… in the days ahead, this is going to get ugly. If you think seeing the pelicans covered in oil makes you want to weep, just wait. BP has been fatally wounded, it just hasn’t fallen down dead yet. Will it be cheaper to close the business and sell, or pay off-the debts incurred? BP may just be the flake of snow that causes an avalanche. Regardless, the consumer will pay for BP’s clean-up in the form of higher oil prices. Stay tuned.

In a perfect world, we will learn that BP has real assets and clear accounts whereas, Lehman’s obfuscated their accounts and were loaded up with toxic subprime. Regardless, the BP name will be forever toxic. Going forward their best bet will be to re-brand to Amoco. They dropped the BP-Amoco tag a few years after the merger. The potential irony? When oil goes back over $150 a barrel we’ll be cursing Big Oil for not having developed new US fields and Obama will join in chastising Big Oil.

Finally… don’t forget this administration should also be held accountable for the piss-poor job they have done managing this mess. Or is this is the perfect distraction to keep everyone focused away from the piss-poor job these people are doing on bringing back the economy? Stick a fork in BP, they’re done. The market sheep just haven’t figured it out yet. When they do, the rush to the exits should be quite a show. Its going to get bumpy again.

My tray table is stored and my seat is in the upright position. Bring on the hurricane season.

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