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Financial Times: Satisfying BP investors will be hard (‘merger with another oil major’)

By Ed Crooks and Carola Hoyos
Published: January 18 2007 02:00 | Last updated: January 18 2007 02:00

As James Baker was delivering his politely excoriating verdict on BP’s safety culture and leadership, analysts were judging its qualities as an investment.

Many of their views were positive. Citigroup, UBS and Deutsche Bank were among those making or reiterating “buy” recommendations on the shares. After a period of sustained underperformance, on many yardsticks BP’s shares now look cheap, they believe.

The problem for the company’s cheerleaders is timing. BP’s strategy – getting safety and operations right and steadily increasing production – is unlikely to pay off fast enough to satisfy investors.

One BP shareholder told the Financial Times that Tony Hayward, the new chief executive from the summer, “won’t have the luxury of a year”.

That pressure has inspired a variety of ideas for a dramatic move to transform negative perceptions of BP.

Use of its strong balance sheet to buy back a block of shares or pay a special dividend, a merger with another oil major or even a break-up have all been suggested. For their proponents, these ideas are more appealing than the long, hard slog that lies ahead.

The immediate financial cost of responding to Mr Baker’s recommendations is modest for a company of BP’s size. It is to raise spending on its US refineries from $1.2bn in 2005 to $1.7bn (£863m) a year during 2007-10 to improve their integrity and reliability. An extra dollar on the price of oil would be enough to pay for all that.

However, that may under-state the trauma BP has undergone, not just from the Baker report but from everything that has happened since the Texas City explosion in March 2005. Everything it does is now under scrutiny.

Like other big oil companies, BP sits on much ageing infrastructure. As the oil price has risen and technology has improved, squeezing the last drops of oil out of declining fields has become profitable. Rigs, pipelines and other hardware have been pushed to last for longer than intended when they were built.

Replacing that hardware will take time, during which the dangers of a repeat of problems such as the corrosion discovered in Alaska last year and accidents such as the explosion at Texas City will remain.

Wherever there is a marginal call to be made, managers will feel pushed towards the safer, more expensive option. Mr Hayward made that explicit last year when he questioned BP’s “mantra of more for less”: trying to do 100 per cent of a job with 90 per cent of the resources.

Other problems also overshadow BP. Like every other oil company, its shares are highly dependent on the price of crude, which fell sharply on Tuesday after Saudi Arabia, the dominant member of the Organisation of the Petroleum Exporting Countries, said it saw no need for the oil producers’ group to cut its output any further.

There are persistent fears over the future of TNK-BP, the 50 per cent-owned Russian joint venture which was BP’s greatest success in the first half of the decade.

Most recently, investors have worried about its disappointing production performance. Since 2004, BP’s output has been stuck at about 4m barrels of oil equivalent per day and it has several times fallen short of analysts’ expectations and its own targets.

Eventually, perhaps towards the end of the year, the good news is likely to start to flow. Production will start rising visibly, as new projects in Azerbaijan, Angola and the Gulf of Mexico come on stream and ramp up output. But BP’s recent history is an object lesson in what can go wrong between finding oil in the ground and turning it into money.

Hence renewed calls for a quick fix. BP has been advised either to get bigger, by merging with another “super major” oil company, or smaller, by splitting its downstream business such as refineries from its upstream exploration and production activities.

But both those routes are fraught with difficulty. A mega-merger with Royal Dutch Shell, for example – which was contemplated by BP in 2005 – would run into competition problems in Europe and the US. Disposals might get round that obstruction, at the cost of losing much of the benefit of the merger.

Break-up of the company, as suggested by Cazenove analysts, would be a gamble. Oil companies like to be able to extract the profit from the value chain between the oil well and the petrol pump wherever it can be found. If BP were the only super-major to split itself up, it could expose itself to rough treatment from competitors.

Financial solutions would be easier. Awash with cash thanks to the high oil price, BP has been buying back its shares. In the past two years it has spent more than $27bn on buy-backs, apparently to little effect.

Jonathan Wright of Citigroup argues that, rather than making steady purchases, it should announce a single tender offer for a significant quantity of its shares, or pay a special dividend.

If returning $27bn to investors has been ineffectual, however, there can be no guarantee that returning similar sums in a slightly different way will be any more successful. It seems that on the slow and steady road to recovery, the short cuts are all blocked off.

Copyright The Financial Times Limited 2007

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