The Rising Influence of Rising Affluence

[DewDiligence]

Does BP Deserve a ‘Safety Discount’ from Investors?

[I’m skeptical of the model from GS described in this article—see annotations in the fourth paragraph.]

http://online.wsj.com/article/SB20001424052748704113504575264413169581010.html

›MAY 25, 2010
By LIAM DENNING

It is difficult enough forecasting the oil price. But modeling potential disaster is in another league altogether.

Relative to the global integrated oil sector, BP's stock has underperformed by 11.3 percentage points since the Deepwater Horizon explosion April 20, equivalent to an additional $21.3 billion of lost market capitalization. BP's stock languishes at a 12-month forward earnings multiple of 6.5 times, well below peers' eight to 10 times.

Intuitively, an oil company's safety record is linked with profits: Productivity depends on smooth operations. Yet Robin West, chief executive of consultancy PFC Energy, laments that "when CEOs talk about safety at presentations, analysts look at their BlackBerrys."

Apparent indifference may simply reflect an inability to adequately model the risk of events like a well blowout in an inherently hazardous sector. Some try harder than others. Goldman Sachs, for example, has incorporated ratings on oil companies' environmental, social and governance, or ESG, performance into research since 2004. It finds firms scoring highly on issues like employee safety tend to also produce higher returns on investment. [It’s easy to back-fit a model to empirical data by varying the parameters; the question is whether such a model has prognostic value for ascertaining shareholder value. Back-fitted models suffer from the same mathematical deficiency as post-hoc clinical studies, which is why the FDA rarely if ever accepts the data from such studies as the basis for product approval. Color me skeptical of GS' approach.]

Even this approach has its limitations: BP's 2009 sustainability review showed a marked improvement in measures like employee injuries and oil spills. Many would reasonably conclude the company was making progress after recent disasters like the Texas City, Texas, refinery explosion and leaks in Alaska.

Even now, most analysts rate the stock a "buy," recognizing BP will likely pay a heavy price but reckoning the market's reaction is overdone. In the short term, they likely are right. But that is of only limited comfort to BP.

The inherent difficulty of forecasting safety risk may mean investors with an eye on short-term profits are quick to forgive and buy the stock. After all, despite the legacy of earlier mishaps, BP traded at a higher P/E multiple than rivals Royal Dutch Shell and Total through most of 2009. The paradox of a bad history is that some investors will buy on the hopes of improvement.

For others, though, that inherent difficulty makes it more likely that a company that notches up enough problems in a short space of time will be segmented from its peers in broad qualitative terms. This is similar to what can happen to companies that are deemed to be "acquisitive," for example, leading to an arbitrary discount becoming embedded in the stock's multiple.

Unlike a numeric deficiency such as bloated costs or a stretched balance sheet, that kind of reputational cloud can be the hardest to lift, particularly when it comes to attracting buy-and-hold investors. These are the very sort that support a company's valuation over the long-term and that companies like BP, with their extended time horizons, should be keen to court.‹