Costs, the Market, and BP

One of my major beliefs (and the rationale behind much of the philosophy of the Business Detox Project) is that the world would be a much better place if we worked to price “externalities” into our market transactions. The current fiasco that is playing out in the Gulf of Mexico with BP provides a real-life case where we explore what this might look like.Thus far, according to this Economist article from 3rd June, over the 6 weeks that this disaster has played out, the company has lost $62B in market value. Accordingly to the same article:

“Barack Obama, under increasing criticism for his handling of the disaster, has promised to “bring those responsible to justice”. On June 1st his attorney-general, Eric Holder, visited Louisiana and announced that he was exploring both civil and criminal charges against BP and the other firms involved in the drilling. Criminal action could leave BP facing massive fines on top of the costs of the effort to stop the leak, the clean-up operations and claims for damages by companies and individuals that have been affected. So far BP has spent some $1 billion; that said, it made $6.1 billion in the first quarter of 2010. It is profitable enough to absorb $20 billion in spill-related losses while paying a $10 billion dividend, as it did last year. That would reassure anxious investors, but worry rating agencies (on June 3rd Fitch trimmed BP’s ratings) and outrage politicians who want the dividend scrapped.”

According to various sources, BP has spent $1B to date to try to plug the leak (unsuccessfully) and might well spend up to double or triple that to finally get the leak under control. On top of that there will be some significant cost to a clean up (another $1B to $3B?), and then possible fines stemming from any civil or criminal charges that eventually get laid. All told, it would be fairly reasonable to believe that the ultimate cost to BP might well be in the range of $10B or so.

The Economist article states that they could absorb up to $20B in costs while still affording to pay the same $10B dividend as they did last year. Clearly then this spill will not break BP financially, although its reputation will certainly suffer from all this:

“The scale of the stock’s fall makes it possible that the foreseeable losses, huge as they are, have not only been priced in, but even overpriced. Reputational loss, and the possibility of losing further access to the gulf, where BP is a large player, are harder to calculate while the spill and its attendant inquiries continue. When the waters finally clear, though, there could be some interesting sharks swimming in them.”

What does this all tell us? According to the Economist article, BP can absorb up to about $20B in costs and not face any significant financial difficulty, yet the market wipes $62B in value off the company in successive cuts as each major attempt to cap the risk (by stemming the flow of oil) failed. The $42B delta between these two figures represents some combination of (i) over-shoot by the market; (ii) actual reputational loss to BP;  (iii) estimated production/profit loss, and; (iv) market-perceived “price” of this major environmental externality.

Of course, (i) will correct itself somewhat immediately after the well is capped and some of the clean-up costs become more predictable, and (iii) is fairly straightforward to calculate and account for. Items (ii) and (iv) are actually related, and taken together may become a useful proxy for what a “5 star environmental disaster” should be priced at.

It may prove interesting and valuable to revisit this line of thinking and this “pricing exercise” in 6 or 12 months once this chapter of BP’s Deepwater Horizon story is closed.

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