When the Deepwater Horizon blew up in April of 2010 and the Macondo well started spilling thousands of barrels of oil a day into the Gulf of Mexico, BP’s management had to deal with massive human, environmental, operational, and financial challenges. The controversy over how well BP handled the disaster will take years to resolve. But BP’s response to the financial aspects of the crisis is beginning to come into focus.
This post is about how BP met the financial challenges that flowed from the Macondo well spill. Although the company may not be a model for safety management or environmental stewardship, BP is a surprisingly good model for liquidity management under stress.
Operating Results Suffer
The financial impact on BP was sudden and severe. Although BP’s revenue was scarcely affected, there was a massive operating loss in the second quarter of 2010; and the company barely broke even in the third quarter.
Spill Costs Soar Then Plummet
Costs for the spill were $32.1 billion in the second quarter, but then fell to $7.7 billion in the third and to only $1.0 billion in the fourth. The expense in the second quarter was a special charge to create a reserve for oil spill costs. Adjusted for spill costs, BP’s operating margins fell only slightly — from 12.9% in the first quarter to 11.8% in the fourth.
Spill Expenses Exceed Spill Spending
The cash outlays for the spill followed a different pattern from the expenses. BP accrued $40.9 billion in spill expenses in 2010 but made only $17.7 billion in cash payments related to the spill.
Rising Liquidity Position
Still, coming up with $17.7 billion in a hurry was a problem for BP, as it would be for any company caught in a costly, fast-growing crisis. Yet BP was able to improve its liquidity in the face of those extraordinary demands on its cash by adding $7.6 billion in new revolving credit commitments and $20.0 billion to its cash reserves.
Sources and Uses of Cash
With so much money pouring into the Gulf oil spill, how was BP able to add so much to its cash reserves? The company cut uses – mainly shareholder payouts (dividends and share repurchases), which fell from $2.5 billion in the first quarter to under $100 million in each of the last three. It also boosted sources – mainly $16.4 billion in asset sales and $10.8 billion in borrowings in the last two quarters. That drove cash flow to $10.2 billion for the year, in spite of outlays for the spill.
How to Handle a Liquidity Crisis
What made BP’s response so effective? Is what BP did a good model for evaluating companies facing liquidity problems? We think so. Companies struggling with liquidity problems need to:
- React quickly
BP recognized the severity of the problem right away. In financial terms, that meant taking a big charge in the same period as the Deepwater Horizon disaster.
- Reduce discretionary spending
BP stopped share repurchases and cut most of the dividend in the second quarter. It had less flexibility with capital spending, which remained at pre-spill levels or more throughout the year.
- Increase cash from operations
In the second quarter, BP was able to generate only slightly less cash flow from operations than in the first, thanks to a $13.5 billion inflow from working capital. Big gains in working capital efficiency are difficult to sustain, and BP’s cash flows from operations went negative in the following two quarters.
- Exploit other internal sources
What BP couldn’t get from operations it generated from asset sales. The company sold gas and oil fields, pipelines, and retail operations to strategic buyers.
- Tap external sources
BP turned to the financial markets for funding. It raised $4.6 billion in bank loans backed by crude oil sales from fields in Angola and Azerbaijan. It raised another $6.2 billion from bond issues in Europe and the United States.
It’s not over for BP: costs and cash outlays are likely to rise. But the worst of the crisis is behind them. Today, Tokyo Electric Power Company is struggling with an even greater problem. The challenges they are facing are likely to dwarf BP’s. It will be interesting to see how well they cope with them, and, financially at least, whether they are as effective as BP.