BP Spinoff Case Overstated

NEW YORK ( TheStreet) -- A spinoff by BP ( BP) of its refining and marketing business is the type of financial engineering trick that will assuage frustrated shareholders and fatten the coffers of investment bankers, but makes less sense from a strategic standpoint for the oil company.

JPMorgan may have added to the support for a BP refinery spinoff on Monday, pegging the spinoff value to BP shares at $100 billion, but the investment bank's not the first to raise the subject since ConocoPhillips ( COP) announced its plans to spin off its refining operations. JPMorgan chose a good time, too, to push the BP spinoff plan. BP is set to kick off big oil earnings season on Tuesday morning, and the ConocoPhillips spinoff plans were just revealed this month, meaning that second-quarter conference calls will be Wall Street's first chance to press "Big Oil" companies on spinoff plans. That's not a chance Wall Street will pass up.

"Everyone will get asked about it. ConocoPhillips brought it into the forefront again, and anytime somebody does a transaction the Street wants everyone to do it to get their money," said Argus Research analyst Phil Weiss.

Weiss is not alone in hesitating to endorse a spinoff that amounts to little more than financial engineering. Raymond James makes the case that a comparison between BP and ConocoPhillips is misplaced when it comes to valuing the refining operations. As a ratio of proven reserves to refining capacity, BP has the second-largest mismatch in the industry, behind Petrobras ( PBR). BP's ratio of proven reserves to refining capacity at the end of 2010 was 5.7, compared to Petrobras at 6.4. By contrast, ConocoPhillips had a much higher percentage of refining relative to proven reserves among oil majors, at 3.4. Further, BP's refining operations seem even less significant when compared to the refining of a company that has completed a similar spinoff like Marathon Oil ( MRO). At Marathon, the ratio of proven reserves to refining capacity was only 1.4, according to Raymond James.

Stacy Hudson, analyst at Raymond James, doesn't see a BP refinery operations spinoff happening for this reason.

"What we've boiled it down to is a look at the companies that have divested refining, and in these cases refining was a much bigger part of the business," Hudson said. In fact, Raymond James data implies that Exxon Mobil ( XOM ) and Royal Dutch Shell ( RDS.A) should consider a spinoff before BP, with ratios of proven reserves to refining capacity at 4. Chevron's ( CVX) ratio is 4.9.

Argus Research's Weiss added that it's logical to make the case that BP's refining and marketing business is large enough to be viable and attractive as a stand-alone stock play, but the financial bang that BP could see in a spinoff might not be as exciting as investors hope. On a revenue basis, refining was four times exploration and production for BP in the first quarter, however, on an earnings basis, E&P was four times greater than refining. In the fourth quarter 2010, E&P earnings were eight times refining and marketing earnings.

"E&P is the profit driver, and if a unit represents a smaller portion of the market value, then the value accretion from a spinoff would be less," Weiss said.

The Argus Research analyst said a better spinoff case for BP can be made to break up the company geographically, such as an "Emerging BP" company. Yet even this would be one more form of financial engineering, Weiss said, because from a deepwater drilling standpoint West Africa, Brazil and the Gulf of Mexico are more alike in profile than different. Even so, an "Emerging BP" or "BP Americas" would deal more directly on the E&P side of the equation, where the value is in BP shares.

In the case of BP, the spinoff issue may be as much a function of the stock lagging peers as making strategic sense for BP. With the Macondo overhang still holding back BP, Wall Street can make the case that the quick payback is worth it, and investors who have watched BP shares get stuck in the mid-$40s will go along for the ride. The market has shown that it rewards companies for financial engineering, said Raymond James' Hudson.

"It's just financial engineering, but it's a reasonable topic to bring up," Weiss said. Between the failure of BP to close the deal with Rosneft to jointly explore the Arctic, the lack of clarity on when BP gets back to work in the Gulf of Mexico, and two specific refinery sales that BP has yet to close -- Carson City and Texas City -- there are few catalysts for BP shares short of financial engineering, and investors may be getting frustrated.

"People are upset because of Rosneft," Weiss said.

The U.S. government also announced last Friday that it would delay the release of the U.S. Coast Guard report on the BP oil spill, which was scheduled to be released this week. BP watchers had hoped the release of the report would be one more sign that the gross negligence argument against BP was weak, and that the report would spread the blame across multiple companies, giving BP shares a legal lift.

In general, the big oil companies have a hard time unlocking value in their shares, even with strong cash flow and with investors not rewarding them for discoveries that may pay off in future years. The fluctuations in the price of oil hold sway over their market value in the near-term, and one-off discoveries are not enough to move the needle for these companies. BP is a magnified version of this dilemma for all the big oil companies because of the Gulf of Mexico spill overhang and Rosneft deal failure.

This doesn't mean that a refining and marketing spinoff makes strategic sense for the company, but it means BP better have an answer prepared on why it doesn't make sense before its earnings call on Tuesday. One potential answer would be to announce the successful sale of either Carson City or Texas City. That might call off the spinoff dogs, at least for the time being.

BP announced on Monday that is has been awarded two deepwater exploration and production blocks by the Government of the Republic of Trinidad and Tobago. BP's Trinidad operations already account for more than half of Trinidad and Tobago's natural gas output and 12%of BP's global oil and gas production. The awards will double the acreage held by BP controlled companies in Trinidad and Tobago.

BP shares were up 1.5% on heavy volume at mi8d-day, even as the energy sector was close to flat in trading.

-- Written by Eric Rosenbaum from New York.


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