U.S. Government's Intent To Pursue Charges Could Sink BP

| About: BP p.l.c. (BP)

The shares of BP fell almost 3% after it was revealed that the U.S. government intends to pursue charges of "gross negligence and willful misconduct" in relation to the Deepwater Horizon oil spill in the Gulf of Mexico in April 2010. The shares are already trading more than 30% below the pre-spill price and this development could put more downward pressure on the stock. It seems that these charges are backed up by findings that BP and the Deepwater platform Transocean Limited (NYSE:RIG) incorrectly interpreted the results of an important pressure test. The company believes that it is innocent and will present testimony to support this at the trial in January 2013.

If the company is found guilty, it may have to pay penalties of up to $21 billion under the Clean Water Act based on the US government's estimate that the leakage during the spill was 4.9 million barrels. Even if the company's estimate of 2.7 million barrels is accepted, it is liable to pay $12 billion if found guilty under the Act. The company has made provisions for $38 billion for liability relating to the spill but only $3.5 billion relating to the Clear Water Act. An out-of-court settlement remains a possibility but the US government expects $25 billion while BP has said that it is willing to pay $15 billion as compensation for all claims. Unfortunately for the company, the problem has been compounded after waves caused by Hurricane Isaac uncovered tar balls deposited on Gulf of Mexico beaches. It still remains to be established whether these tar balls came from the spill or not.

As if this were not enough, the company has reported very disappointing results for the second quarter of 2012. The replacement cost profit, adjusted for non-operating items as well as fair value accounting, was $3.7 billion compared to $5.7 billion for the same quarter in the previous year and $4.8 billion for the preceding quarter. The results were negatively affected by weaker oil and US gas prices combined with reductions in production due to planned maintenance especially in the Gulf of Mexico and reduced income from the Russian joint-venture TNK-BP. Income from the Russian joint-venture was $700 million less than the first quarter because the Russian oil export duty was based on earlier higher oil prices. This is expected to be partially reversed in the third quarter. Operating cash flow after accounting for $1.7 billion of Gulf of Mexico expenses post-tax was $4.4 billion compared to $3.4 billion in the first quarter. BP expects to increase this cash flow by 50% over 2011 by 2014 based on an oil price of $100 a barrel. The company has paid a total of $8.8 billion in claims from the oil spill and the cash balance in the Trust account as at June 30, 2012 was $10.1 billion.

BP remains one of the largest oil companies in the world along with Exxon Mobil (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A), and Chevron (NYSE:CVX) and has generally been successful in its exploration and development initiatives. The company expects to meet its operating targets with new projects and is meanwhile continuing its $38 billion divestment efforts. Divestments have already reached $23 billion as the company gathers cash for its oil spill liabilities. It has concluded farm out agreements with Petrobras Brazil (NYSE:PBR), extended its offshore interests in Namibia and acquired three new offshore blocks in Uruguay. It has achieved access to the Utica formation which is rich in liquids and expects to start up six new projects in Angola. The Whitewater refinery is progressing well and expects to commence production in the second half of next year.

The problems in the Russian joint-venture TNK-BP continue with sharp differences between the partners. BP wishes to divest its 50% share and should ordinarily have had no problems. The Russian partners Alpha, Access, Renova (the Russian oil partnership AAR) have suggested that they would offer $7 billion for the BP stake which they themselves agree is worth $20 billion. The discount of $13 billion is compensation for the partnership because of BP's failed effort to strike a separate deal with state-owned Rosneft (OTC:RNFTF). AAR has also suggested that they would consider exchanging their TNK-BP stake for a direct stake in BP which would leave BP free to pursue deals with Rosneft or Gazprom (OTCQX:GZPFY). I have no doubt that some kind of a solution will be worked out because the joint-venture as so lucrative for everybody concerned.

The problem for investors is the uncertainty over the final costs of the oil spill and it is in BP's interest to settle with the US government in order to crystallize their liabilities. BP is a large and profitable company but the uncertainty is depressing the price and turning off investors. A positive resolution of the TNK-BP problem should also go a long way in moving the stock price up. Meanwhile the company continues its assets sale programme to boost its cash position and has recently announced the sale of its retail network and Carson Refinery to Tesoro (NYSE:TSO) for $1.175 billion in addition to inventory worth $1.3 billion. In addition, other assets have been identified including non-core holdings in the Gulf of Mexico and a 100% share in a refinery in Texas City.

In other circumstances, I would have recommended a buy at the current stock price, but the tough stance taken by the Department of Justice indicates that there is some hard bargaining ahead before a settlement can be reached. Moreover, it is difficult to forecast the future of the Russian joint-venture. Until there is a more positive outlook for both, I would recommend that you hold on to your existing investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.