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How much damage does the market think the oil spill has done?

At this point it's really hard to tell how much the sinking of Deepwater Horizon and the ensuing oil spill will cost BP. There are a number of factors still in play, such as "when will the spill be capped?" or "how much of the oil will hit shore?" If the leak continues to spew oil unabated for three months, the damage and corresponding cost to BP could be huge. If the winds shift, minimizing the amount of oil that hits shore, then the costs to BP won't be that bad. Until there is some resolution of these and other questions, there is a large amount of uncertainty regarding how this will affect BP's profitability.

What we can assess with much more confidence is the market's expectation of the costs. Stock prices give us a yardstick for the markets perception of a company's long run profitability. When an event, such as this oil spill, impacts a company it will also impact its long run profitability. The divergence of the stock price from what we would have expected had the event never happened is a measure of the net present value of the cost incurred by the oil spill. Event study analysis gives us a framework to answer just this question.

BP prices since Jan. 1st have been plotted below in Figures 1 and 2. The black line gives the real prices and the red line shows the model estimate of what would have happened if the spill had not occurred. Table 1 lists the prices and returns over the event window for both the real time series and the estimate. Event studies use other factors in the market to estimate what BP's stock price would have been. A list of these factors can be found on Table 4. The event window spans 7 trading days April 26th - May 4th and is centered on April 29th. A 10-day event window buffer was used to separate the estimated model from the event window. The 250 trading days prior to the event window and buffer were used to estimate the model.

The t-statistic of the cumulative abnormal returns over the event window is -6.33 indicating that the event clearly had an impact that drove BP's share price outside its normal range of variation. The adjusted closing price of BP on May 4, 2010 was $51.20 whereas had the oil spill not happened I've estimated the price would have been $58.11. This amounts to a net loss of $6.91 per share. BP has 3.13 billion shares outstanding amounting to a net loss in $21.62 billion. This loss reflects the market's expectation of the net present value of the loss in profitability of BP as a result of the oil spill, otherwise interpreted as the cost to BP of the oil spill. This cost may come from a number of sources besides simply cleanup. For example, the loss in customers, punitive damages, or possible loss of BP's ability to profit from this or other potential offshore projects may be other ways the oil spill will hurt BP. This high cost estimate is most consistent with the scenario where BP doesn't cap the major leakage of oil for a substantial amount of time. Clearly, not only for the sake of the environment but also for the sake of BP's bottom line, they are going to want to cap this oil spill and clean it up quickly.

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Note: All the data have been obtained from http://finance.yahoo.com