Many years ago, and on a regular basis ever since then, we reviewed BP and decided to rate the stock a “buy” and purchase it for many of our clients. We bought Transocean stock for many clients as well. When it became clear that the Gulf oil spill was a devastating disaster, we decided to sell BP and keep Transocean. The reason for this apparent contradiction is that as it stands now, BP, who operated the oil rig, is responsible for the spill and will be financially liable for the majority of the clean-up. Currently Transocean, who owns the rig and leased it to BP, has limited liability for the clean-up. In light of this, and a significant back-log of revenue for their 140+ rigs, we see Transocean as over-sold and have decided not to sell the security at its current depressed price.
What is the Cost?
Financial analysis involves valuing a company based on estimated variables. One way we value a company is to discount future dividends using estimated growth rates. We also take the consensus earnings growth rate and estimate how that translates into a future stock price. We look at many other factors, such as the market value of the company’s debt and equity, or the present value of future earnings.
All of these factors are estimates and variable but they are known. By known, I mean they are conceivable factors. We could not have conceived of an oil spill this large, that would happen at this time, and that would be attributable to BP with any reasonable certainty. And because the estimated probability of something like that would have been so small, it would not have affected any analyst’s valuation metrics. This makes the case for portfolio diversification. In order to protect against company-specific and industry-specific risks, we put 40-50 company stocks in a portfolio, at about a 2% weighting.
Our sell/hold decision on BP/Transocean was based on the spill’s potential impact on the companies’ earnings, and thus the value of the companies. But what if we had made our decision based on the true economic impact of the spill? What if we could quantify the entire economic impact of the spill and attribute that to the companies’ earnings and value? Once we considered the injury to the livelihood of the shrimp fishers, the effect on the Gulf States’ tourism, and the government expense to clean the wetlands and beaches, would there be any earnings left at all? But this is not the charge of our Investment Policy Committee and of course, the impact could never truly be quantified.
What is the Solution?
Some of our clients have requested that we make investments for them in clean energy stocks. It seems like a simple proposition – these emerging technologies are on the cutting edge and will surely be profitable. However, that is often not the case. New industries and technologies face high costs, high barriers to entry, tough competition, and the simple risk that their technology may not be the technology that prevails in the end (think Betamax versus the VCR). For these reasons emerging industries are considerably more difficult to evaluate than established industries, and thus we have opted to buy an index of clean energy companies for those clients who have requested it, rather than invest in a single company.
There is considerable technological ability, capital, expertise and intelligence among those developing technology in the oil industry. They have developed a way to locate the presence of pockets of oil that reside miles under water and thousands of feet further underground, get major machinery down to that spot and drill down to access this reservoir, then pump the oil back up through miles of water and into vessels above the surface. With this type of might and capability, theses companies could put substantially more focus on developing alternate energy technologies. The economics of that development may show it as not yet profitable enough at first glance. But if we calculated the real costs and risks of energy production, perhaps they would see the benefit. I hope that out of this terrible environmental disaster we see an improvement in the collective understanding of the importance of clean energy.
Harli L. Palme, CFP®