Legal issues are some of the great X factors when assessing a company’s investment potential. You can estimate earnings, costs, likely dividend, economic prospects of the markets in which businesses operate, quality of product and of management.
But when it comes to entanglements with the law, well, all bets are off. They cause the one thing every big business gets frightened of: uncertainty. Analysts don’t much like them either, for the same reason. Legal and regulatory problems and the costs they impose don’t easily slot into a spreadsheet. When trying to weigh their financial impact about the best you can do is to wet the top of your finger, hold it up, and see which way the wind is blowing.
Which brings us neatly on to BP, where legal and regulatory issues have been the prime focus ever since one of its rigs blew up in the Gulf of Mexico, leading to a huge oil slick that polluted a good stretch of the coastline of the Southern US.
Last week the BBC reported that the company was pressing David Cameron to lobby the US on its behalf as the costs of its settlement mushroom, largely thanks to the abuse of the system set up to companies affected by the spill. Or not affected, because BP believes many of the claims against its compensation fund are fictitious.
The spectre of the company’s recovery being put in “jeopardy” was raised – even the possibility of it becoming a takeover target.
BP’s accounts, however, tell a different story. It has reaped $38bn from divestments since the spill and the shake-up of its Russian operations, which saw the oil giant taking a 20 per cent stake in Rosneft and selling its troublesome TNK-BP venture. This saw $12bn of net cash pouring into BP’s coffers in the first quarter. As such, its gearing – a measure of debt – fell to just 12 per cent, which is pretty low for a big, profitable company.
BP is retaining $4bn of that but using $8bn to buy back shares. It’s also still paying a healthy dividend with the forecast yield this year standing at 5 per cent.
The company admits there are significant uncertainties still being created by the ongoing reverberations from the Deepwater Horizon spill. But the business is in a very different place to where it was two years ago.
As such, if I were an investor I wouldn’t be too concerned about the report at the moment. I would be more concerned about more recent events, namely the EU’s raid on several oil company offices amid suspicion that they may have conspired to keep oil – and, more to the point, petrol prices – high for more than a decade.
This, potentially, is a real doozy. If the allegations are correct, an average of £2,000 could have been added to the average family’s petrol bill over the last decade.
Then there’s the average company’s bill. The legal implications hardly bear thinking about.
Shell is affected by this one, too.
What is an investor to do? Sit back for the moment. Nothing has, as yet, been proved. Companies say they are co-operating with regulators. It’s early days and, financially, we just don’t know. It is impossible to make any predictions.
There’s that uncertainty again.
Back on 6 March, I said avoid BP, and that looks to have been the correct call. The shares were trading at 491p, and they are quite a bit lower than that now. I said buy Shell at £22.78 and, if you had done that, you’d be about where you were, albeit with a near 5 per cent return on your money from the dividend. Which is better than having it sit in the bank.
As well as having similar yields, both BP and Shell also trade on very similar multiples of about 8.5 times their forecast full-year earnings.
Shell’s worst problems came several years ago when it mis-stated the quality of its reserves and fell foul of regulators. The company’s gearing is actually lower than BP’s, and while analysts have pointed to high levels of capital expenditure this year affecting returns, that’s not something I’d worry from the standpoint of the company’s long-term health.
Both have suffered from a low oil price, more than anything else, which is why they have underperformed the market over the last year or so.
As a general view, Shell still looks cheap, and I’d buy it over BP, simply because of the uncertainties that even BP admits. It is much easier to gauge where you are with the former. However, you are likely to endure a bumpy ride. The EU’s investigation could prove to be explosive. It certainly provides an X factor whose impact cannot be easily predicted.
There aren’t only financial issues to be faced by the industry: the reputational impact could be severe. This column considers business ethics as well as finances when it comes to investment and the ethics of the oil industry are now open to question.
If you want to invest in big oil, Shell would be my pick, and it is cheap.
But if the industry has been engaged in sharp practice, it will demonstrate once and for all the fallacy of ignoring ethical issues when it comes to investment, because investors will pay the price.