subject: BP's Stock Price and Market Lessons [print this page] BP's Stock Price and Market Lessons BP's Stock Price and Market Lessons
On April 20, 2010, the Deepwater Horizon drilling rig exploded in the Gulf of Mexico. Concurrently, the price of BP's shares began to implode. On April 20, BP's stock price closed at $60.48. By May 10, it had dropped to $48.75. During this time, the company's market capitalization (calculated by multiplying the stock price by the number of trading shares outstanding) dropped by over $36 billion.
At this point, many financial advisors began recommending that investors purchase BP stock. They believed that the amount of money that it would take to clean up the oil spill would not come close to the $36 billion that BP's aggregate share value had lost. Even Jim Cramer, CNBC's high profile stock guru and host of the show Mad Money, stated that the stock was a buy for this reason. Yet, about a month and a half later, BP's stock now sits at about $29 per share, representing a market capitalization loss of close to $100 billion. The initial investment advice seemed rational, so what went wrong?
The first thing to note is that the stock market does not always behave rationally. As John Maynard Keynes pointed out, the markets can remain irrational longer than you can stay solvent. This is especially true when a company constantly receives negative media attention as BP has. Investors become nervous and often will sell their shares in a company that is consistently in an adverse spotlight.
As well, the market typically dislikes uncertainty. When market analysts recommended investing in BP in early May, they assumed that the flow of oil into the Gulf of Mexico would soon stop. Many pointed to how Exxon's stock performed after the Valdez disaster and uncategorically stated that BP's situation would not be worse than this. However, there was no basis for this faulty assumption. The BP disaster has been worse and it is still uncertain when the flow of oil will cease. In addition, no one knows for certain what BP's total cost in dealing with the ramifications of this disaster will be. Many news agencies are reporting that clean up is costing BP about $100 million per day and that total costs have now surpassed $3 billion. Yet, until the oil flow stops and the damage is surveyed, it will be difficult to know how much money BP will lose as a result.
Does this mean that investing in BP's stock is a poor decision? Not necessarily. Assuming that the stock was fairly priced prior to the disaster, it seems very unlikely that BP will incur costs nearing the $100 billion market capitalization loss. As well, BP generates about $30 billion in operating cash flow annually, which should allow it to cover ongoing clean up costs and make it easier for the company to raise additional funds they need through loans or equity sales. One caveat is that BP may be forced to cut its dividend in order to cover clean up costs. Perhaps this is already priced into the stock, but it is likely that the share price will fall if and when a dividend cut is announced.
One of the lessons of BP's stock slide is the importance of portfolio diversity. Even financially strong companies, such as BP, are subject to what is known as event risk. If BP stock represented a small percentage of your total investments, it should not have had a significant impact on your overall return. Research suggests that most of the gains that you achieve from diversification come from investing in about 30 different securities provided that you hold relatively equal positions in each one. This diversification protects you from almost all firm specific risk. A diversified investor should not have suffered any significant losses from BP's plight.
