20 February 2012 at 15:38 GMT
BP’s huge spill in the Gulf of Mexico in 2010 is off the front pages now, and of the USD 41bn liability that BP created with the spill, only USD 11bn remains to be fulfilled. As I mentioned in this previous BP theme, about USD 30bn of the liability has already been paid off, some of it by BP and some by other operators of the well.
However, penalties and fines from the US government are still an unknown factor. A few reports have surfaced that hinted at a potential settlement of penalties and fines of around USD 20-25bn.
How would this affect BP’s cashflows? If we strictly assume that the value of a company is the sum of its discounted future cashflows, than we could easily come up with a value for the potential effects of the fines.
Given that the that market capitalization of BP is approximately USD 150, a 20 bn penalty would equal 14% of company’s market capitalization. We are assuming that the market has not yet accounted for the incoming penalties (which is silly but it gives us a base case scenario to work with.)
For any reasonable trader, the potential hit of a greater-than-expected liability is a risk. A trader could easily create a protective put position at the current strike price, to protect his position. As it now stands, a put expiring in July at a strike price of 47 (ADR price) has a price of 3.25. Therefore the cost of protecting a potential BP position comes at a potential upside cost of 7%, or 4% on the stock investment.
If you believe that BP will settle with the government in the next few months, but fear the repercussions of a greater-than-expected liability, than a protective put might be a good way to manage your risk. The downside of this strategy is, of course, that any potential gains are hampered by the cost of the option.