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Capital Perspectives

July 2010

The Legacy of Macondo Whats in a name? For Transocean and BP, many think a jinx. Transoceans Deepwater Horizon rig, a troublesome project since inception1, now rests beneath the Gulf of Mexico, the result of an accident that killed 11 workers and caused an environmental disaster. Ironically named after a town blown away by a storm in Gabriel Garcia Marquezs One Hundred Years of Solitude, the effect of the Macondo spill will be far reaching in ways that are not immediately apparent. The disaster will change the risk profile of the oil industry, increase insurance pricing dramatically, and may have downstream effects on oil and credit markets as well. In eliminating the $75 million limit for damages from an oil spill, the regulatory pendulum has swung so far that it has imposed almost unlimited liability on exploration companies by widening the scope of damages to be considered with threatened criminal prosecution of company officers. BP has a minimum out-of-pocket cost in the tens of billions of dollars with a multi-year tail of litigation and expenses. Importantly, there is uncertainty about what else BP might pay for these cleanup costs and for future legal exposure from a variety of claimants. Only three companies in the world could consider self-insuring their well drilling: BP, Exxon Mobil and Royal Dutch Shell. For others, its a case of how much insurance costs, if available at any cost. According to Moody's Investors Service, the chairman of India's biggest explorer, Oil & Natural Gas Corp., said that offshore insurance renewal rates increased three-fold after the disaster, Lloyd's of London Chief Executive Richard Ward told Bloomberg Television that the BP oil spill would ''significantly'' push up the price of insurance on offshore-drilling. Insurance rates for deepwater drilling in the Gulf have yet to be set for the coming years, but it is also hard to imagine many underwriters staying in this market, and certainly those who do, will price protection dearly. (An opportunity for well capitalized specialty lines insurers?). Anadarko Petroleum (APC) has a 25% financial interest in the Macondo Prospect. Even with a Value Line A2 rated financial strength before the disaster, and no role in operating the well, Anadarko nevertheless has seen over half its market value disappear while its debt has been downgraded to junk debt status by Moodys.
1 2 Value Line Research

Anadarkos credit default swaps, a key measure of anticipated solvency, started trading on an upfront basis in June, at a price of 600-800 basis points. As the Wall Street Journal put it Traders typically start asking for payment in advance instead of at intervals if the cost of coverage exceeds 5% of the amount insured. The practice means they believe there is a high risk of a quick default. 3 This means that drilling a single oil well can now bankrupt almost any Oil & Gas Exploration & Production company, maybe even the majors. Deep-water exploration in the Gulf of Mexico is now literally a bet-the-company decision every time a well is drilled. In fact, the following just appeared in the Wall Street Journal (as I was making my final edits to this note).
Smaller Oil Firms Might Exit Gulf, Browner Says: The White House's top energy adviser acknowledged that smaller oil firms might no longer be able to drill in the Gulf of Mexico as a result of legislation moving through Congress that would eliminate the cap on their liability for oil spills. "Maybe this is a sector where you really need large companies who can bring to bear the expertise and who have the wherewithal to cover the expense if something goes wrong," Carol Browner, special adviser to President Barack Obama on energy and climate change, said in an interview. Eliminating the $75 million cap on liability for oil spills "will mean that you only have large companies in this sector," she said.4

Deepwater production accounts for 70% of Gulf of Mexico oil production, and 18% of total United States oil production. 5 It is reasonable to assume that fewer wells will be drilled as smaller E&P companies exit the Gulf, resulting in less oil production coming from this resource rich area. A resulting increase in oil prices, while perhaps not quantifiable in the near term, will nevertheless be felt nationwide. Of course less drilling also results in fewer rig workers needed and jobs will disappear in an already financially strapped area of the country, hurting everyone else in the oil production food chain from transport services to restaurants. This thesis is not uncommon, so the investment opportunity may actually be found going long oversold businesses. Finally, it is interesting to note that BP is an important part of credit and derivative markets. A widely circulated article posits:
the world is highly reliant on BPs provision of long-term credit to many core industries. Who makes good on all the outstanding paper that so many smaller oil, gas and electricity companies, airlines, shipping companies, local bus, railway and transportation networks that rely on Bops creditworthiness and performancethe long-term OTC derivatives in the oil, refined products, and natural-gas markets that get nullified could be catastrophic. These will kick back into the banking system. BP is the primary player on the long end of the energy curve.6

Wall Street Journal JUNE 21, 2010, UPDATE: Anadarko Debt-Insurance Cost Rises On Downgrade, BP Fight WSJ July 3, * JULY 3, 2010 5 US Minerals Management Service, May 2009, Deepwater Gulf of Mexico 2009: Interim Report of 2008 highlights, OCS Report MMS-2009- 016, PDF file, p.51, downloaded 3 July 2009. 6, Could a Bankrupt BP Be Worse for Financial World Than Lehman Brothers?
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While I believe the likelihood of BPs credit affecting associated derivative and credit markets less than the author above hypothecates, the effects on the Gulf area will be significant. For example the spill is affecting about $9 billion in commercial mortgage- backed-securities deals, according to a recent report from Realpoint7. Throughout this analysis, the fundamental point remains that investors in a business must do their homework to understand the company they are purchasing. The Macondo spill has created dramatic changes to the oil industry company valuations. The same uncertainty that makes many avoid this sector might also provide opportunity for astute investors willing to buy businesses that will recover in the coming years. The investor who engages in thoughtful and thorough research will find the most successful investment opportunities.

Author Steven Stoller is the General Partner of Stoller Capital, a Georgia based investment advisor that manages a private investment partnership and separate accounts for select investors, retirement plans and institutions.
This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for educational purposes only and is not a recommendation or offer of any particular security, strategy or investment product or a recommendation to buy or sell any security. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Lets just say it, if you buy stocks or make investment decisions after reading a single article even this one, you need to change the way you invest When you buy or sell, there is someone who has done their homework, taking the other side of the trade with the exact opposite view from you. . As the saying goes, when you sit down to play poker and dont know who the mark is within a few hands, get up, its you!

Institutional Investor Magazine, July/August 2010.