Is BP the Next Lehman Brothers?

Mark Twain famously said history doesn’t always repeat but it sometimes rhymes and Wednesday was rhythmic in a not-so-hot way.

Part of my early morning ritual is to check credit spreads. Yesterday, when I peeked at the overnight action, BP (BP) jumped out and screamed for attention. The spreads, which are a layman’s way of measuring default risk, were “blowing out” and this morning we’re seeing the exact same thing.

I drew attention to this dynamic on the Minyanville Buzz & Banter, wondering who has the counter-party risk to BP. In a finance-based, derivative-laced global economy, a pelican flapping his oil-soaked wings in the Gulf could have profound implications on the other side of our interconnected world.

Professor Mike Paulenoff, writing in real-time on the Buzz, offered “BP and Transocean (RIG) have created a bit of a Lehman feel to the markets. BP has now plunged to levels not seen since 1996; whether or not BP is heading into bankruptcy is immaterial, because Mr. Market certainly thinks so.”

Professor Steve Smith shared the following thoughts:
 

The trading in BP (BP) and Transocean (RIG) is starting to feel like that in the final days (subscription required) of Bear Stearns (JPM) and Lehman Brothers. And the trading in their options is also mimicking what occurred when there was the realization that these may longer be going concerns; namely panic.

As little as a few days ago, the trading in BP options was somewhat two-sided as people tried to take advantage of the climb in IV (implied volatility) and leverage to try to pick away from the long side on the notion that these were becoming value plays. That seems to have given way today. There's been an explosion way out-of the-money put volume and IV had jumped another 45% to the 95 level. Strikes as low as $7.50 are seeing a very active buying. This is occurring not only in longer-dated options but also in the June series, which expire in just two weeks. The June $7.50, $10, $12.50, and $15 puts have traded over 35,000 contracts; prior open interest in those four strikes was just five contracts total prior to today. The July $12.50 put has traded over 12,000 contracts against prior OI of just 350 contracts.

A similar pattern had developed in Bear Stearns and Lehman initially as some high-profile put sales (ie, investor Joe Louis sold a slug of Bear Stearns puts with a $30 strike in the weeks prior to the complete collapse) only to see a dramatic shift of some well-timed well OTM purchases by some nameless hedge funds.

BP has assets and, at least for the moment, a better balance sheet, so it shouldn't go to zero as quickly. But the option activity suggests that traders believe that a bankruptcy is a distinct possibility.

A Forward-Looking Lens

Minyanville has a reputation for being early; we like to say we offer the financial news you need to know before you know you need it. There are two commonly used views in financial media and suffice to say we’re a buyer of foresight and a seller of hindsight.

Professor Jeff Macke has been particularly acute in his analysis of the BP oil spill. On April 30th, he shared The Ugly Truth about BP and Its CEO. A few days later, he opined the BP Situation Can’t Be Salvaged. As the public relations machine kicked into overdrive, he insisted Progress is Debatable in BP Oil Spill. More recently, he mused that Value Play or Not, BP is an Evil Investment.

Given the current state of social mood, few folks will shed a tear if this company was fitted for a toe-tag. I’m reminded, however, of how angry people were at Wall Street heading into that fateful autumn in 2008. What they didn’t realize, as is often the case until after-the-fact, were the unintended consequences involved in letting them die. We suggested at the time, “be careful for what you wish,” and that may again prove true.

I’m all about attendant culpability and measured punishment. In a perfect world, the free-market system would exact that pound of flesh for us. Given the intricacies of our global market machination, not to mention a litany of cumulative imbalances. there are no easy answers, only the lesser of multiple evils.

Away from the potential derivative contagion, we must remain conscience of the impact to (and reaction of) large shareholders of the stock. According to Bloomberg, the top ten holders on March 31st (which has likely shifted during the distribution following the spill) were:
 

1. State Street Bank (STT): 43,453, 340
2. Wellington Management: 34,841,626
3. Barrow Hanley: 16,700,000
4. Bank of America (BAC): 13,905,449
5. State Farm: 13,052,048
6. T. Rowe Price (TROW): 12,442,139
7. Morgan Stanley (MS): 10,234,612
8. Fidelity Management: 7,812,100
9. Tradewinds Global: 7,436, 248
10. Gates Foundation: 7,133,000

The eleventh-largest holder as of March 31st? Goldman Sachs (GS), with 6,695,882 shares. You can almost see a populist smile forming on the lips of disgruntled Americans as societal acrimony spreads and patience thins. See both sides, and understand the implications and complications of the situation we’re currently navigating.

Given the weakness we’ve seen, the fragility of the system and next week’s options expiration, we would be wise to respect the unexpected and brace ourselves for two-sided volatility, particularly given the penchant for policymakers to pull rabbits from their hats into expiration.

They call it a process of price discovery for a reason. Be patient and remain disciplined, as we’re likely in the eye of the storm.

R.P.