London, 28 June 2010

Somewhere deep inside BP or one of its advisors there is probably a lawyer examining the mechanics of filing for bankruptcy protection in the United States in the event the company needs to safeguard its core operations from open-ended liabilities arising from Macondo.

Somewhere else, there is probably a corporate finance professional discussing an equity issue that would heavily dilute existing shareholders but bring in an infusion of new capital from a strategic partner such as a sovereign wealth fund to help shore up the company's position.

In a crisis, corporations have a duty to examine every possible option to protect the interests of shareholders, creditors and counterparties -- even options that dare not be named openly.

Nor is there any real duty to disclose. Regulators have long accepted crisis-engulfed firms are not required to disclose plans that would hasten their own end by sparking a self-fulfilling crisis of confidence.

Company spokesman Robert Wine on Friday reiterated BP's financial strength and assured investors "We have considerable firepower to deal with any costs as they accrue". He denied rumours that BP was seeking bankruptcy protection.

But fears about a possible Chapter 11 filing in the United States, or a strongly dilutive issue of new equity, continue to pressure the share price, despite the company's agreement with the White House on a $20 billion claims fund and its apparent progress towards capturing more of the oil from the leaking well.

Bankruptsy Not An Option

The attraction of a corporate reorganisation under Chapter 11 of the United States Bankruptcy Code is that it would insulate future operations from the crushing weight and uncertainty associated with past debts and litigation. It would draw a line under the spill. But in practice it is probably neither necessary nor really possible for BP. Not necessary because the company's operations continue to throw off enough cash to meet the enormous claims the company currently faces, and will likely face in future, for clean up, compensation and any penalties. Not possible because putting the whole company into bankruptcy would put it in breach of a huge range of contracts around the world.

The resulting litigation would pose a far greater threat than any number of lawsuits arising from Macondo. Russia has already demanded guarantees BP's TNK joint venture will not be affected, and that the company can honour all its obligations. In this particular case, the implications of bankruptcy would be worse than the claims it sought to contain.

BP could try to limit a bankruptcy claim to its operations and subsidiaries in the United States. But even if that was legally possible -- by no means certain -- it would be explosive politically. The image of the company putting its North American operations into Chapter 11 to avoid claims in the United States, while continuing to meet obligations overseas in full, would enrage an already hostile U.S. public and lawmakers. It would essentially end the company's future in North America.

So bankruptcy remains a remote contingency. The market may be over-reacting to a very distant threat. But a heavily dilutive capital raising, and other reorganisation that would impact long-term shareholder value even further, seem probable, even likely.

Investors Finally Wake Up

From the start, many shareholders and analysts, especially in the United Kingdom, where BP is based, seem to have under-estimated the scale of the disaster that has befallen the company, and the impact Macondo will have on both the company's finances and its long-term future in North America and around the rest of the world.

Underlying this is the assumption the company will make hefty but not life-threatening compensation payments, and reluctantly skip dividends for a few quarters, before starting to throw off record amounts of cash again. The share price will sooner or later recover to pre-Macondo levels as the firm puts the accident behind it. Macondo is a grave and regrettable accident but will not make fundamental changes to the firm. Arguably that vastly underestimates the company's problems.

Even if BP staunches the flow from Macondo, claims litigation, as well as regulatory enquiries into what precisely went wrong, and the need to rehabilitate the company in the United States, will distract senior management for several years.

Even assuming the company can limit compensation to the $20 billion so far pledged, which is by no means certain, and perhaps a few billion more in fines and regulatory costs, that would still amount to more than a year's worth of capital expenditure on exploration and production (E&P), according to the company's financial statements.

While BP is hobbled by compensation payments and its management is distracted, rivals such as Exxon and Shell will be better placed to strengthen their own position, not just in North America but around the rest of the world. It seems likely Macondo has resulted in a permanent, structural destruction of shareholder value, which will not be easily reversed.

BP needs to find substantial amounts of cash. It will either have to come from shareholders (through a rights issue, dilution, or medium-term reductions in dividend payouts); raising new loans from banks and the markets; trimming capital expenditure plans; or spinning off "non-core" assets.

Loans will be expensive. E&P cuts would impose their own long-term costs. Spinning off "peripheral" assets raises questions since they were presumably not deemed non-core before Macondo blew. However the cash-raising is achieved, it is going to hurt shareholders significantly.

Surviving But Diminished

BP will almost certainly muddle through and avoid bankruptcy. But the company will emerge smaller and significantly less cash-rich. The continued downward drift in BP's share price and market capitalisation suggests investors are beginning to realise Macondo has shrunk the company permanently.

There is no doubt plenty of upside in the share price given how beaten up the company has been in recent weeks. But the risks remain exceptionally high, while the reward (in terms of share-price headroom) may be smaller than some investors originally hoped.

Macondo has wiped $100 billion off the company's market capitalisation since the disaster began on April 20 That almost certainly overstates the direct costs of compensation and clean-up by a significant margin (assuming the relief wells bring an early end to the spill). But when indirect and long-term costs are included, it may not be such a huge over-estimate.

There may still be strong upside potential in the shares, but the repeated failure to rally yet suggests the risk-reward ratio is not yet that attractive.

Ends --

By John Kemp, Reuters - for Commodities Now