BP Oil Spill and Black Swans: A “Cheap” Stock With Unknown Risk is Not Really Cheap

“Hold Your Nose and buy BP”

– Adam Sharp (May 4^th)

(BP Price on May 4^th: $51.20) (BP Price on June 9^th: $29.20)

“The risk is significantly higher for BP than for [other oil companies]; I’d rather play it relatively safe.”

– Elliott Gue, The Energy Strategist (May 5^th)

I really did not want to write about BP (NYSE: BP), formerly known as British Petroleum. Ever since the Deepwater Horizon rig exploded on April 20^th causing the worst oil spill in U.S. history, the story has been covered non-stop. I am sick of hearing about it every day. It’s the same feeling I had during the endless news stories about swine flu vaccine shortages, Paris Hilton’s jail stay, Tiger Woods’ infidelity, and the John & Kate Gosselin divorce saga. Enough already!

BP’s Stock Price Collapses

Yet, here I am writing about it because on Thursday (June 9^th) BP’s stock price collapsed 16%; it was a total freefall all day. A lot of shareholders got hurt. That got me thinking: why did they allow themselves to be hurt? The oil spill had been front-page news for a month and a half, more than enough time for anyone to sell their shares, and yet . . . many continued to own the stock.  In fact, many had bought more BP shares in the days leading up to the price collapse on June 9^th. What does this behavior say about human nature?

The Big Loss Destroys Wealth

I see investors’ reaction to the oil spill as a metaphor for greed and unnecessary risk taking.  As I wrote in The Great Investment Truth, the primary obstacle to generating great wealth is suffering “the big loss.” Losses are more damaging than gains are beneficial. Small losses can easily be recouped, whereas recovering from big losses is virtually impossible. This is basic arithmetic and yet I am astounded time after time at the ridiculous risks people – even so-called financial advisors – are willing to take in order to score an above-average gain.

Recommending BP: A Cautionary Tale

Take, for example, this Adam Sharp guy I quote above. Nothing personal because I don’t know him, but his recommendation to buy BP on May 4^th was outrageous. He based his buy rating on the fact that (1) BP had fallen 18%, (2)  its dividend yield was up to a relatively high 6.6%, and (3) the “worst case” scenario put BP’s liability from the spill at $6 billion, which is only three months worth of BP earnings. My responses to his reasoning are as follows:

1. A stock sometimes falls 18% for a reason and can fall another 82%.
2. A high dividend yield is often an indication of danger and fundamental problems. As Utility Forecaster advisor Roger Conrad said in an article entitled High Yield Traps:

A sweet yield can bring sour consequences. The key is to know what you’re holding before taking that first bite. It’s more important than ever to scrutinize your stocks and bonds as businesses, and to unload those that are coming apart or which are vulnerable to a downturn.

3. There is no way to “know what you’re holding,” or what a worst-case scenario would be, when dealing with the uncertainty of the largest oil spill in U.S. history. 

About a month later, Mr. Sharp saw the error of his overconfident previous “analysis” and completely reversed himself, now arguing that the worst case scenario for BP is a $200 billion liability and the company has a significant chance of going bankrupt.

Wall Street Has Gone Mad

The disturbing thing is that Sharp was far from alone in recommending a buy on BP back on May 5^th. Barron’s Magazine thought BP had “bottomed.” The Wall Street Journal thought it was “cheap” despite noting that there was an “unknown risk regarding the financial costs of this crisis.” And my favorite statement came from a blogger named Mark Riddix who recommended BP because “sometimes disasters like these create investment opportunities.” Sometimes yes, but what about the other times? Is it just me or does this type of statement sound like pure gambling? Investing is supposed to be different from gambling, based on a cool calculation of known risks, not unknown, unquantifiable ones.  As one writer recently put it in an article entitled BP Stock Buy Ratings Prove Wall Street is Insane:

If BP stock had even a 17% chance – a little over one in six – of getting cut in half or worse, I would not consider it an investment “buy” under any conceivable circumstance. That’s like playing Russian roulette with someone’s nest egg, is it not? Put the stock to your head, hope the bullet chamber is empty, and pray.

Deepwater Horizon and Black Swans

Why did all of these reasonably smart people recommend buying BP right before it plunged? Nassim Nicholas Taleb, author of The Black Swan, provides an answer.  He writes that most people suffer from arrogance:

Before the discovery of Australia, people in the Old World were convinced that all swans were white, an unassailable belief as it seemed completely confirmed by empirical evidence. The sighting of the first black swan illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single (and, I am told, quite ugly) black bird.

We overestimate what we know, and underestimate uncertainty, by compressing the range of possible uncertain states. 

Similarly, Harvard economist Robert Stavins states that:

Low-probability, high-cost events are precisely the kinds of events that are hard for us as humans to get our hands around and react to rationally. When an event is difficult to imagine, we tend to underestimate its likelihood. This is the proverbial black swan. Most of the people running Deepwater Horizon probably never had a rig explode on them. So they assumed it would not happen, at least not to them.

Taleb says that the number of black swans increase as the world becomes more complex. This makes sense, since the more moving parts something has, the more difficult it is to anticipate how all of those parts will interact with each other. Just look at the past ten or so years. I can count at least four black swans since 1998: (1) the collapse of Long-Term Capital Management as described in When Genius Failed, (2) the collapse of the World Trade Center in the 9-11 terror attacks, (3) the collapse of housing prices which precipitated the financial crisis of 2008, and (4) the collapse of the Deepwater Horizon oil rig. None of these things were supposed to happen under any circumstances – yet they did.

Is the BP Oil Spill a Black Swan?

What remains to be seen is whether the BP oil spill will be yet another black swan that causes environmental and economic devastation the likes of which has never been seen before. I’m not saying it will happen. In fact, if I did say such a thing it would mean that it wasn’t a true black swan. But an appreciation that the oil spill damage could be so severe that it bankrupts BP should lead any responsible financial advisor to avoid recommending BP stock at this moment.

One of the main reasons I respect KCI investment experts like Roger Conrad and Elliott Gue so much is that they are humble and don’t underestimate uncertainty. They know what they don’t know and recognize that black swan events can occur. Consequently, Roger’s Utility Forecaster investment service rarely recommends the highest-yielding stocks because of the risk that their dividends may get cut. Similarly, in the quotation I reference at the beginning of this article, Elliott Gue refused to recommend BP on May 5^th in his Energy Strategist advisory because of the unknown risk surrounding the stock.

Petrobras vs. BP

What did Mr. Gue speak favorably about on May 5^th? Petrobras (NYSE: PBR), the Brazilian deepwater driller that had no connection to the Deepwater Horizon explosion. It’s better to buy stocks that have declined in price in sympathy with a disaster but have no exposure to the actual risk associated with the disaster. Below is a chart comparing the performance of Petrobras and BP since May 5^th:

Source: Bloomberg

BP’s Irresponsible Risk-Taking

A couple of weeks ago 60 Minutes did a story on the oil rig explosion and interviewed Mike Williams, one of the surviving crew members, as well as along with UC-Berkeley engineering professor Bob Bea. Williams explained how two days prior to the explosion everybody on board knew that the rig’s blow-out preventer (BOP) was damaged. Yet BP decided to continue to remove drilling fluid and attempt to plug the well despite this knowledge. The drilling fluid or “mud” exerted downward pressure on the well spout and kept the outflow of gas under control. The rig was costing BP a million dollars a day and the company didn’t want to spend time fixing the BOP.

In other words, in order to save a few million dollars, BP was willing to take the risk that the damaged BOP was providing faulty readings that underestimated the pressure in the well. The result is that BP is now liable for tens if not hundreds of billions in liabilities. BP has suffered “the big loss” that could have been prevented with risk control. Millions wise and billions foolish.

None of this would have happened if just one BP executive had taken Professor Bea’s course at Berkeley. Bea always told his students: “Stop, think, don’t do something stupid.”

Investors would be wise to heed the same advice.