BP’s black hole

Hedge funds should stay away from not only the stock but also the debt

When it became evident that BP’s oil spill in the Gulf of Mexico that began on Earth Day (!) was a monumental environmental catastrophe, the potentially devastating liabilities for the British company led many hedge funds to do two things. First, of course, they shorted BP every which way from Sunday. Then they began to imagine a bankruptcy scenario that would segregate the liabilities from the rest of the company and allow them to buy BP’s stock.

I’m not in the business of market prognostications, but in this case, I’d like to suggest hedge funds stay away from not only the stock but also the debt (unless they continue to short it). BP now has a market cap of about $90 billion, net fixed assets of $120 billion, and estimated net debt of $25 billion for 2010. Under pressure from President Barack Obama, BP agreed to create a $20 billion fund to pay for Gulf claims. To come up with the cash, not only is the company going to have to sell some assets; it’s also going to be doing more borrowing. Right now, it’s working with its bankers on a bond sale.

It’s becoming obvious that $20 billion is not going to be the end of it for BP; victim claims alone could exceed $60 billion by some estimates. Moreover, the escrow fund won’t be used to pay the damages and fines the company will have to pay to the U.S. government, which could amount to tens of billions of dollars.

Obama made a grave error in promising Americans that 90% of the oil will be contained by the end of July, even if that’s what BP is saying. BP has zero credibility at this point, and oilmen such as T. Boone Pickens and scientists say stopping the leak could take until the end of September or even the end of 2010.

The longer the oil continues to gush, the more expensive it becomes. And when it comes time to pay for fixing this mess, a good bank/bad bank type of solution isn’t likely to work for BP any more than it did for Lehman Brothers. The entire entity of BP could easily go bankrupt. If the U.S. government insists on keeping BP alive, as is its position now, the United States could be forced to come in as the debtor-in-possession financier.

If such a political solution is required, there is a strong possibility that the claims of the Gulf Coast—of its people, its animals—will become senior to everyone else, leaving investors to pick up the crumbs. It’s the kind of political reality that trumps bankruptcy law, as investors learned in the case of Chrysler. Remember how hedge funds were vilified then? Imagine if they are seen as being on the wrong side of the BP mess.

Instead of wasting energy on trying to figure out how to play BP, why don’t hedge funds start working with government to invest in clean-energy sources, like solar and wind? Some funds—D.E. Shaw comes to mind—are already in alternatives.

Hedge fund managers are typically ahead of the curve, often suffering financial reversals until the rest of the world finally catches on. Why not put those talents to use saving the planet and weaning us off oil?