 As
horrific as the gulf environmental catastrophe is, an even more intractable
and cataclysmic disaster may be looming. The yet unknowable costs associated
with clean-up, litigation and compensation damages due to arguably the
world’s worst environmental tragedy, may be in the process of
triggering a credit event by British Petroleum (BP) that will be equally
devastating to global over-the-counter (OTC) derivatives. The potential
contagion may eventually show that Lehman Bros. and Bear Stearns were simply
early warning signals of the devastation lurking and continuing to grow
unchecked in the $615T OTC Derivatives market.
hat is yet unknowable is what the reality is of BP’s
off-balance sheet obligations and leverage positions. How many Special
Purpose Entities (SPEs) is it operating? Remember, during the Enron debacle
Andrew Fastow, the Enron CFO, asserted in testimony nearly 10 years ago that
GE had 2500 such entities already in existence. BP has even more physical
assets than Enron and GE. Furthermore, 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. They are obviously not
talking, but as I will explain, they are aggressively repositioning trillions
of dollars in global currency, swap, derivative, options, debt and equity
portfolios.
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. At a time when understanding a corporation’s risk
position is critically important, investors are in the dark. When markets are
uncertain, bad things are certain to follow. The new financial
regulations under the Dodd-Frank legislation does absolutely nothing to
address this. This was the central issue in truly understanding and
corralling TBTF risk. It has not been addressed and the markets will likely make
the tax payer pay for this regulatory failure once again.
Massive
BP Risk lay in the $615T OTC Market that only the major international banks
have any visibility to…. and they are not talking!
THE
LEVERAGE ASSOCIATED WITH “AAA” ASSETS
I
could not have stated it any clearer than Jim Sinclair at jsmineset.com:
“People are seriously underestimating how much liquidity in the global
financial world is dependent on a solvent BP. 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.”
From
a historical context, some may not be aware that the infamous House of
Rothschild at the height of their banking power moved into Energy & Oil. Also, John D. Rockefeller quickly realized his globally expanding Standard Oil was more a bank,
consolidating his financial empire under a banking structure which resulted
in the Chase Manhattan Bank (the basis of Citigroup). As long as an energy
giant can manage its cash flows throughout the volatility of price
fluctuations, it becomes a money and credit generating machine. It can borrow
with AAA yields anywhere on the curve and lend to less credit worthy entities
at attractive spreads. These lending differentials help fuel the $430T
Interest Rate Swap OTC market. BP has been able to spin off $20B of
earnings for the last 5 years and $15B in cash last year. All
of this suddenly comes to an end if its credit rating is significantly
impaired. But what could possibly cause this to happen? It would take a black
swan event. An outlier. A fat tail.
Sound
familiar? Heard this discussion before?
The
Gulf Oil Disaster may be the fat tail to end all fat tails and shows the
exposure behind the entire risk models of the vast majority of derivatives
algorithm models. To suggest that BP would need to take impairments north of
$20B would have seemed out of the realm of possibilities less than 90 days
ago. Now, if it is contained to only $20B, it would be considered a blessing.
Fitch dropped BP’s credit rating an unprecedented 6
notches on June
15th from AA to BBB which followed June 3rd's AA+ to AA cut.
This is what happens when a fat tail occurs and it has only just begun.
CONTAGION
HAS BEGUN
Though
few are talking openly, it doesn’t mean large amounts of money
aren’t aggressively repositioning. This repositioning is
effectively de-leveraging and is consequentially a liquidity drain. This
comes as US M3 has gone negative and M2, M1 are rapidly declining. BP
is going to face a massive liquidity crunch which has all the earmarks of
triggering an already tenuous and worsening international liquidity
situation.
I
found the charts (right) published by
Credit Derivatives Research to
be very telling of the abrupt shift that has occurred. Their charts show that
the April 21st Macondo well explosion has triggered a significant
inflection in the risk, counterparty and high yield areas. A comparison with
Government and High Grade Debt has a different profile (see end of this
report for the charts) which reflects the European banking concerns
associated with the southern European economies (PIIGS). It is important to
differentiate these as separate drivers. Both come as the percentage of
corporate bonds considered in distress is at the highest in six months - a
sign investors expect the economy to slow and defaults to rise. This spells
deleveraging.
WHAT
WE KNOW ABOUT BP DERIVATIVES:
1 -
CSO (Credit Synthetic Obligations)
A
study by Moody’s outlines that a BP
bankruptcy would impair 117 Collateralized Synthetic Obligations (CSOs),
which would lead to pervasive losses by a broad range of holders. The 117
effected is a startling 18% of the total CSOs outstanding, which is an
indication of the scope and impact of BP financing globally. For those that
remember the 2008 financial debacle, you will recall its epicenter was the
collapse of Collateralized Debt Obligations (CDO) associated with
mortgages and Credit Default Swaps (CDS) of financial companies impacted. CSOs
are even more leveraged and toxic.
The
exhibit above lists CSOs (excluding CSOs backed by CSOs) with over 3% exposure
to
the five companies involved in the Gulf of Mexico incident.
To
quote Moody’s:
In
the event of BP’s restructuring or bankruptcy, CSO transactions
referencing BP or its affected subsidiaries may experience what is called a
“credit event.” If the credit event occurs, the CSO transactions
will have to meet their payment obligations to the protection buyers, which
will result in the loss of subordination to the rated CSO tranches. In cases
where the subordination is no longer available, CSO investors will incur the
loss.
….
We
reviewed our entire universe of outstanding CSOs and determined that exposure
to BP and its rated subsidiaries appears in 117 (excluding CSOs backed by
CSOs) transactions, which represents approximately 18% of global
Moody’s-rated CSOs. Exposure ranged from 0.26% to 2% of the respective
reference portfolios. The transaction with the largest exposure to BP and its
subsidiaries is Arosa Funding Limited – Series 2005-5.
Restructuring
or Bankruptcy of Other Oil Companies Involved in the Spill Also Affects CSOs.
In addition, we assessed Moody’s-rated CSO exposure to the other four
companies and their subsidiaries that were involved in the Gulf of Mexico
incident, which are Halliburton, Anadarko Petroleum, Transocean Inc., and
Cameron International. Halliburton appears in 43 CSOs, Anadarko Petroleum
appears in 28 CSOs, Transocean Inc. appears in 79 CSOs, and Cameron
International appears in 6 CSOs. We recently changed the credit outlooks for
Transocean and Anadarko Petroleum, as well as their rated subsidiaries, to
negative from stable because of uncertainties related to the companies’
involvement in the Gulf of Mexico incident and potential financial
liabilities associated with it. The CSOs referencing one or more of these
issuers would face credit event consequences in a scenario where any of them
restructures or enters bankruptcy.
We
need to recall that Transocean was the owner /operator of Deepwater Horizon
with 131 of the actual 137 employed by Transocean (RIG) and that Anadarko
(APC) was BP’s 25% partnership holder in the well. Cameron
International (CAM) was the builder of the faulty blowout preventer and
Halliburton (HAL) the contractor for the well cementing operation in sealing
the 13,350 foot Macondo drill site. These players will no doubt be heavily
involved in the litigation and compensation settlements, but additionally
will have collateral damage on other oil industry participants as they are
forced to raise cash for litigation and claims.
2 -
CDS (Credit Default Swaps)
On
June 25th BP’s Credit Default Swaps shot up 44 to 580 on the
5 years CDS. This meant it costs $580,000 per year to ensure $10 million in
BP bonds over a 5 year contract period. Anything approaching 300 is
considered serious risk. For counterparties willing to pay this amount means
their dynamic hedging models are working over time and a near panic scramble
is taking place.
On
June 16th Zero Hedge Reported:
The
BP Curve has really flipped (out). The 1 year point on the curve is now over
1,000 bps, a 400 bps move in one day. The point is also offerless (bidless in
traditional cash jargon). Granted the DV01 so close to 0 is rather low, but
this kind of ridiculous curve inversion is simply wreaking havoc on
correlation desks. The 6 month point is now 0.5 pts upfront. Pretty soon BP
will need to apply for the same ECB bailout that rescued all those banks who
were risking a wipe out when Greek spreads were trading at comparable levels.
The question now becomes: who sold the bulk of the BP protection? BofA's
announcement yesterday (06-15-10) that it is limiting counterparty risk
exposure with BP to all contracts over 1 year could be a rather material clue
as to the identity of at least one such entity.
3 -
BOND INVERSION
With
Credit Default Swap concerns we would expect this to be reflected in
BP’s Yield Curve Spread. What is interesting here is that the curve is
inverted as is BP’s CDS curve (shown above). Usually short term yields
are less than longer term yields because of inherent risk over a longer
period of time. For instance, one heavily traded bond, which matures in March
2012, traded with 9.48% yield recently. Meanwhile, further down the curve a
bond that matures in March 2019 is trading at a yield of 7.74%, less than the
shorter-term bond. This suggests that the market is pricing in a credit
event. A credit event would have a profound impact on OTC contracts, which we
have no visibility to.
What
we do know however is that BP has between $2 and $2.5 Billion in one year
commercial paper to rollover that is required for trading operations and
working capital. This is going to make it both more expensive and
harder to secure and will be a liquidity drain for BP.
4
– LIQUIDTY REQUIREMENTS
To
the above Commercial paper roll-over ($2-$2.5B in one year), ongoing new and
rollover debt issuance, we need to add the $20B it has agreed with the White
House to put in place, though we know of no detailed agreement actually being
signed.
5 -
SHORT INTEREST
The
Financial Times Alphaville via Data Explorers reported the short interest through
June 4th. As you can see from the graph below by stripping out the
spike related to the last dividend payment, the underlying level of stock
outstanding on loan (SOOL) has barely budged since the spill. So, short
sellers can’t be blamed for the plunge; the selling must be coming from
somewhere else, such as long-only funds. Rumors circulated 06/10/10 that
Norges Bank was looking to offload 330m shares. Brokers said the total
Transatlantic volume of stock traded in BP 06-09-10 had a value of $8bn. To
put that figure into some perspective, the total volume traded on the entire
EuroStoxx index on the same day amounted to $15bn. Moreover, since the
Deepwater Horizon rig exploded on April 21st, 70 per cent of BP’s
market cap has turned over, most of it in the US. Trading volumes in BP
American Depository Receipts (ADRs) are usually 10 per cent lower than the
ordinary shares in London. Since the spill, that position has been reversed
and the ADRs have traded 3.5 times the ordinaries, all of which suggests
BP’s largest US investor base have been dumping stock.
How
long before equity shorting begins? It must be noted here that this is BP
equity. Shorting activity of BP debt is all together another matter
especially concerning dynamic hedging, with again much less visibility.
6 -
OPTIONS ACTIVITY
Wall Street Pit on
06/10/10 wrote that “Options volume on
beleaguered oil company, BP PLC, is fast approaching 750,000 contracts,
fueling a more than 79.7% upward shift in the stock’s overall reading
of options implied volatility to a 5-year high of 120.96%. Options activity
on the stock can easily be described as frenzied as volume continues to grow
in both call and put options across multiple expiries.”
COST
OF CAPITAL IS SKYROCKETING FOR BP WHICH AS FUNDAMENTALLY AN ENERGY FINANCING
CORPORATION CAN BE TERMINAL!
SIZE & SCOPE OF
LITIGATION
Are
the final gulf oil spill costs going to be $20B or $60B? Does anyone know? I
personally believe it is closer to the latter than the former. If we just use
the reported oil spillage numbers for comparison we might get a better
understanding of the complete failure to grasp the scope of the
disaster. According to the Financial Times, the oil spillage was reported as follows:
SPILLAGE
COST INCREASE
(bls./day) TO
DATE
April
20 1000
May 4 5000
May 7 5000 350M
May
14 5000 625M
May
28
15,500 950M
June
3
19,000 990M
June
8
15,500
1,250M
June
10 15,500
1,430M
June
17
15,500
1,600M
June
23
25,800
2,600M Spillage
increased by 25 X in 60 days
As
time passes the numbers are rising exponentially. Engineers are warning that the capture will
be complicated and scientists monitoring the situation are predicting the
spill will prove larger than the current estimates are reflecting. An expert
in the field, Matt Simmons of Simmons International has stated that the flows are over
100,000 barrels per day. Most independent experts agree.
 Assuming
$4,000/barrel damages costs, 100,000 barrels per day flow rates, a 90 day
flow duration (minimal), we arrive at clean-up, litigation and damage
compensation of approximately $32B. This is nearly twice the US escrow
account agreement and within our expectations of between $20 and 60B. There
are a range of issues regarding further leaks, shifting seafloor, methane
levels, hurricanes, disbursement effects and many more that are surfacing
daily that will have significant negative impact on current analysis and
assumptions.
An
element of future litigation that is very concerning is the amount of
punitive damages that may be awarded. After the White House sent
Attorney General Eric Holder to New Orleans to threaten BP with criminal prosecution, BP
responded that it believes a case of negligence can’t be proven.
However, the Deepwater Horizon travesty comes at a particularly bad time for
BP. According to Caroline Baum at Bloomberg:
“BP is already the most reviled company in America. Two of its
refineries accounted for 97 percent of the violations (a total of 862, of
which 760 were “egregious willful”) in the refining industry over
the last three years, according to the Center for Public Integrity. It holds the record for the largest fine ($87 million) ever levied by the Occupational Safety and Health
Administration.” Additionally, the US Chemical Safety & Hazard
Investigation Board has immediately jumped into the oil spill investigation
as they did previously at the 2005 fire and explosion of BP’s Texas
City refinery that killed 15 and injured many others.
After
Moody’s cut Anadarko’s rating to junk late on June 18th, the US
oil company (a 25 per cent non-operating investor in the Macondo well) broke
its eight-week silence with this broadside from CEO Jim Hackett:
“The
mounting evidence clearly demonstrates that this tragedy was preventable and
the direct result of BP’s reckless decisions and actions. Frankly, we
are shocked by the publicly available information that has been disclosed in
recent investigations and during this week’s testimony that, among
other things, indicates BP operated unsafely and failed to monitor and react
to several critical warning signs during the drilling of the Macondo well.
BP’s behavior and actions likely represent gross negligence or
willful misconduct and thus affect the obligations of the parties under
the operating agreement.”
We
can safely surmise that the stab in the dark by the White House of $20B is
about as accurate as its forecasts of GDP growth, unemployment improvement
and the Recovery and Reinvestment Act of 2009. Slim to none. A more realistic
number is likely substantially larger and will likely surface soon. However,
anything larger than $20B is likely to be the immediate nail in the coffin
for BP as evidenced by how quickly the newly elected British Prime Minister
was dispatched to the White House to stop the mounting implosion of both BP
and the seriously impacted British Pension system.
BP
RESPONSE
BP
has stated it has immediate cash
available of $15B and will raise additional cash via:
1- Asset Sales
2- Capital Expenditure
Cuts
3- Dividend Cut for the
Next 3 Quarters
LEHMAN
BROS / BEAR STREARNS DEATH SPIRAL
To
again quote Jim Sinclair at jsmineset.com: “BP is the primary player on
the long-end of the energy curve. How exposed are Goldman sub J. Aron, Morgan
Stanley and JPM? Probably hugely. Now credit has been cut to BP.
Counter-parties will not accept their name beyond one year in duration. This
is unheard of. A giant is on the ropes. If he falls, the very earth may shake
as he hits the ground. As we are beginning to see, the Western pension
structure, financial trading and global credit are all inter-twined. BP is
central to this, as a massive supplier of what many believe(d) to be AAA
credit. So while we see banks roll over and die, and sovereign entities begin
to falter… we now have a major oil company on the verge of going under.
Another leg of the global economic "chair" is being viciously
kicked out from under us.”
The
whole BP travesty is quickly compounded via the OTC Derivatives market and
the risk inherent within it.
1- As it was in Lehman, opacity is once again experienced when
transparency is most critically required.
2- Finance has always been about risk determination but never
before with so much leverage associated with risk assessments and held in
such complex, dependent structured instruments.
3- Investors are still unprotected. The Frank-Dodd Bill is
now nothing more than watered down window dressing before it finally reaches
legislative approval and even before it begins the regulatory supervision
machinations.
4- Investors hate uncertainty and we have nothing but uncertainty
here:
a. Political
b. Legal
c. Financial
d.
Business
CONCLUSIONS
The
most likely scenario is that the US operations of BP will voluntarily attempt
Chapter 11 bankruptcy proceedings. This is the worst possible scenario for
claimants. The problem here is that this triggers a credit event which has
daunting repercussions to the highly leveraged global financial markets. Like
AIG before, the government does not want to tamper with the ramifications and
fall out of a CDS event. Lehman was one too many.
If a
US voluntary bankruptcy is stopped by the US and there is a BP
corporate bankruptcy, then there is a strong possibility that the
British Government will be forced to step in and bailout BP. In the
end, the tax payer will pay as the ongoing game of Regulatory Arbitrage is
played masterfully once again.
Deleveraging
associated with BP may be the event that triggers the $5T Quantitative Easing
spike we have been warning about for some time now. It will be needed to
complete the final process of manufacturing of a Minsky Melt-up to avoid the
looming pension, entitlement and US state financial crisis.
The
ability of the government to achieve this is anything but certain. However,
we need to expect the unexpected and watch out for fat
tails we might trip over.
The
Dodd-Frank Legislation leaves investors & taxpayers once again exposed to
another Lehman
The
Regulatory Arbitrage Game Continues.
SOURCES:
(1) 06-21-10 BP's Bankruptcy Would Impair 117 (18% Of Total) Collateralized
Synthetic Obligations, Lead To Pervasive Losses Zero Hedge
(2) 06-16-10 BP CDS Curve Goes Nuts, 1 Year Passes 1,000 Bps, No Offers In
Market Zero Hedge
(3) 06-25-10 BP Getting Crushed: What Does its ‘Yield Inversion’
Mean? WSJ
(4) 06-28-20 Interactive timeline: BP oil spill disaster Financial Times
(6) 06-25-10 BP reassures on cash pile as shares plunge Financial Times
(7) 06-18-10 Macondo, in historical Hollywood context FT Alphaville
(8) 06-10-10 BP short interest, other facts and stuff (updated) FT Alphaville
(9) 06-24-10 BP Bankruptcy in U.K. Is Obama’s Worst Nightmare Caroline Baum Bloomberg
(10) 06-21-10 BP and Anadarko turn on each other FT Alphaville
(11) 06-20-10 Internal BP Document Confirms Matt Simmons' Worst Case Prediction
Of Spill Rate Of 100,000+ Barrels Per Day Zero
Hedge
Gordon T. Long
Tipping
Points
Mr. Long is a former senior group
executive with IBM & Motorola, a principle in a high tech public start-up
and founder of a private venture capital fund. He is presently involved in
private equity placements internationally along with proprietary trading
involving the development & application of Chaos Theory and Mandelbrot
Generator algorithms.
Gordon T Long is not a
registered advisor and does not give investment advice. His comments are an
expression of opinion only and should not be construed in any manner
whatsoever as recommendations to buy or sell a stock, option, future, bond,
commodity or any other financial instrument at any time. While he believes
his statements to be true, they always depend on the reliability of his own
credible sources. Of course, he recommends that you consult with a qualified
investment advisor, one licensed by appropriate regulatory agencies in your
legal jurisdiction, before making any investment decisions, and barring that,
you are encouraged to confirm the facts on your own before making important
investment commitments.
© Copyright 2010 Gordon T Long. The information herein was
obtained from sources which Mr. Long believes reliable, but he does not
guarantee its accuracy. None of the information, advertisements, website
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