One has to admit it. What is susceptible of getting worse, will likely do it.

The CDS of BP rose on Wednesday from 260 to c400, which implies a 20% probability of default in a company that generates a $40bn EBITDA. BP, Anadarko, Transocean have lost c49% of market cap. Those, like me, who thought the first 20% as overdone, were wrong, and it’s worth mentioning why.

1. The spill is larger and taking longer to solve than initially estimated by top geologists and analysts from the industry, or Energy and Capital to Wood Mac. The press is now happy to take the largest figures for liabilities out there, clean-up costs and other risks, up to $35bn. Even if the figure looks too high based on all previous precedents (Exxon paid only $500m in damages from the Exxon Valdez), it is an undoubted risk that no one can clearly identify. And BP, let’s face it, is not Exxon in terms of agressiveness and PR concerns.

2. On the other hand, the decision to install a 24h webcam in the BOP was, in my view, a strategic mistake. Analysts, media and investors are watching this reality show every minute and it doesn’t calm nerves, while making people provide new theories of the magnitude of the spill.

3. Reputational damage on a company that has been branded as a key investment in sustainability funds, sold itself as the “greener” alternative to Shell, and which traded with a “Management Premium” to peers. The capitulation trade of most of these investors has just started, having bought agressively the stock on dips ahead of the failed Top Kill, Junk Fill and clampings.

The two areas that concerned investors the most were the maximum clean-up cost and liability that the company will pay and the security of the dividend. Tony Hayward, BP’s CEO, is not as drastic as Lee Raymond, ex-Exxon CEO, and in BP’s conference call last Friday he was vague and diplomatic. BP trades at a 10% dividend yield 2010, but the market clearly discounts this will be cut either because of political pressure (BP is, and has been always very conscious of this), or because of accounting prudence (if they pay the dividend + a provision for damages of $10bn they will exceed their 28% net debt to equity target)

Technically BP is doing what it can, recovering 15k barrels a day, but the reputational damage on the “green big oil company” is making the stock trade below Book Value and $3/barrel for its resources even if we asume zero value for its US business and a $35bn liability. All of it doesn’t make the stock a buying opportunity, and that’s where analysis has been a mistake. It is impossible to assess now which equity multiples are valid because the uncertainties are enormous. It is also fundamentally challenging to short a stock that trades below 5xPE unless we consider bankrupcy… But even in the case of mass liabilities, BP’s peers will be eagerly awaiting to take over the assets (TNK in Russia, Azerbaijan, Irak, even Amoco are highly desirable assets). Does it make ita takeover candidate now? No. Big Oil is similar to a cartel, and they will help and wait before even hinting at corporate action.

The spill will likely last til August, and BP will pay for all claims in ten-fifteen years time, after strong litigation and numerous lawsuits, but the economic implications will be difficult to assess short term. In the meantime, catching a falling knife no matter what fundamental calculations are made is a very risky job. And too many long term investors and pension funds have been at it recently.

(Article published in Cotizalia in Spanish on Thursday 25th March 2010)

These few weeks have been very relevant to the oil sector. On the one hand we have seen the acquisition by BP of Devon’s assets in Azerbaijan and Brazil at a price 15% higher than initially indicated by Devon. India is looking to establish a sovereign fund of no less than $245 billion to buy oil and gas assets and compete with China. Gulfsands Petroleum and Statoil’s assets in Brazil are also in focus. And finally, China’s CNOOC has acquired 50% of Bridas Corporation in Argentina for $3.1 billion, which implies that if we apply that assessment to Repsol’s assets in the same country, the valuation of YPF would be $15 billion, 25% higher than the average estimated by the market consensus.

Two weeks ago we talked about services. Today we will focus on one of the most volatile and exciting subsector in oil & gas. Independent explorers.

These companies are attractive for two reasons. First, there are very few independent companies with attractive natural resources, which makes them almost inevitable “targets” for predators. Second, their exposure to high-potential exploration assets causes the values to move upwards and downwards faster than other sectors. These are also companies where there is only one objective: to find and monetize reserves. No plan for 50 years, no political strategy, no obligations towards the media. Pure economic value. The sector has generated an average appreciation of 19% in 2010 and 72% in the past three years, including the stock market debacle. And between 2007 and 2010 independent companies worth $75 billion have been acquired, according to Wood MacKenzie.

For the uninitiated, let me briefly explain how they are valued.

Independent explorers buy assets with an attractive potential for exploration, drill them and, once they are assured that the wells are commercially viable, either they develop the portfolio or farm-out to Big Oil. Normally they keep a series of wells that will ensure production, access to financing and cash and use the financial resources to explore more and sell again. The key factor to value for an investor is the history of exploration successes. It is not the same trust Tullow Oil, for example, with 77% of exploration success track-record, and Soco, with 60%, or Lundin or Premier Oil, with a much lower track-record.

The independent companies are valued on an estimate of their core assets (“core NAV”) and an estimated percentage of future exploration success on their portfolio of wells. A percentage assigned by the market depending on the geology and seismic interpretation. Then, as they start conducting their exploration program, the market assigns value to the reserves encountered, or subtracts it from the pre-estimated value given to those assets if what they find is a dry hole (non-commercial).

If you are interested in the sector, pay attention to companies with little debt and exposure to areas of strong interest for predators, but also to those with better opportunities to acquire and explore reserves in attractive areas: West Africa, North Sea, Gas in the U.S. and Gulf of Mexico.

In Africa, the war for the control of reserves in Uganda and Ghana has made Tullow Oil one of the most successful stocks of the industry, but we must not forget the possibilities that arise in Nigeria for Afren Oil. Elsewhere, Anadarko, the leader in the Gulf of Mexico, gave one of the biggest successes of 2009 in Sierra Leone.

In gas, the main candidates to develop large reserves in 2010 are some of the few remaining independents in the North Sea, Dana and Premier.

In shale gas in the United States always look for companies with low costs and an intensive exploration program, from Range, Ultra Petroleum, Petrohawk or Quicksilver. Obviously they are exposed to a complex environment of gas prices in the U.S., that falls almost 2% per week, but also the least affected thanks to their low costs and attractive position to make alliances or mergers.

These are stocks that are highly correlated to oil and gas prices, but also very exposed to the credit environment, as they have to maintain a very low level of debt while financing large exploration programs. These are stocks to buy when there is a point of entry, either a capital increase to finance a drilling program or the announcement of a non commercial well of low relevance before an intensive program of exploration. A sector that is not suitable for risk averse investors or fans of dinosaurs with high dividend yield. But exciting as few.

(Article published in Spanish in Cotizalia on 11/03/10)

In the last twelve months the merger and acquisition activity in the oil world has accelerated. $45 billion in acquisitions so far, and this only just begun.

In this environment, I have seen little written in the press on oil services companies. And meanwhile, investors lose money by investing in large integrated oil, which is like watching grass grow. However, it’s in services where the opportunities might be.

Let me be concise. Big Oil’s capex is rising again. $170 billion of investments will be devoted to upstream this year globally. New contracts are being awarded to the more efficient, aggressive and flexible service companies. And if something has been demonstrated in the 2008-2009 period is that, despite the large drop in oil prices, oil service costs did not fall more than 15% over the same period. This is the proof of the power of this sector over its customers. Competition is relatively low barriers to entry and specialization is very high and oil companies (clients) do not jeopardize safety and efficiency to save a little money.

Oil services companies are the key to maximize the performance of the fields and avoid expensive delays and technical problems. And they generate spectacular returns. Groups such as Petrofac, in the UK, and Subsea 7 and Seadrill in Norway charge their customers between $200,000 and $400,000 a day for their rigs(see footnote), generating annual growth of over 10% on their backlog.

Also, it’s worth mentioning the companies that specialize in large complex projects. Among the latter, Halliburton and Schlumberger have proven their ability to carry out giant projects from Saudi Arabia to Nigeria and generate very strong returns. In Spain, a much more modest play is Tecnicas Reunidas, an example of performance and competitiveness.

U.S. companies have woken up and now seek to attack the juiciest segment of the oil market: large contracts to exploit giant fields, both in deep water (Gulf of Mexico, Brazil) and the three that open borders for the coming decades : Alaska, Iraq and West Africa.

We have seen the recent deals between Schlumberger and Smith International, followed by Baker Hughes and BJ Services, and the market is already beginning to speculate about the possibility of a merger between Halliburton with Weatherford. If the latter merger is completed, be prepared to witness the creation of a genuine global leader. Meanwhile in Europe, it is rumored that Seadrill could buy Pride.

For the uninitiated investor, let me recommend that if you’re interested,you should concentrate on the following three characteristics:

– A Company’s ability to maintain or increase their prices to customers and increase its order book. This is a highly specialized industry and the weak fish die quickly.

– Avoid semi-state owned and over-diversified firms that often face execution risks, or are too dependent on one customer.

– Focus on independent and well capitalized companies with expertise in a specific segment that is of interest to predators. From my point of view, these are the deep-sea drilling and seismic companies.

The service sector is an area for investors with risk appetite who want exposure to oil prices, as one of the few sub-sectors that generates double-digit growth and high margins in the oil world. As the world continues to need $170 billion dollar annual investment in oil and gas, and I think we have many years ahead like this, oil service industry leaders will maintain the capacity to increase margins and orders.

Note:

Land Rig: manufacturing cost $10-15 million, then hired for $ 15-20.000/day

Jack up: Cost of production $75-175m, then hired for $ 100-200.000/day

Semi submersibles: Cost between $200-400 million, then hired for $ 200-400.000/day

Drill ship: Cost of construction: $300 – $500 million, then hired for $ 250-500.000/day