BP Gulf Oil Disaster - a lesson in diversification

The BP oil disaster has had an unparalleled effect on the environment. Between 35,000 and 60,000 barrels of oil seeped into the Gulf of Mexico each day from 20 April until the leak was capped in mid-July, an amount equivalent to the 1989 Alaskan Exxon Valdez spill every four days.  However, this dramatic environmental catastrophe also holds an important lesson in diversification for investors.

The financial impact of the disaster

With the estimated fines under US law accruing at the rate of over US$250 million per day, concerns are mounting that the UK’s largest listed company, and the biggest producer of oil and gas in the US, may become insolvent.

The financial effect on pension holders and BP shareholders is unprecedented. Theoretically, almost every pension investor could have indirect exposure to BP. Commonly, pension funds have about 8% of their UK equity holdings in BP, as until the disaster occurred, BP represented about 8% of the FTSE 100 index of leading shares.

In addition, BP’s historically strong dividend has long proved to be an attractive aspect for investors. Prior to the disaster, for every £7 of dividend income paid out by the companies in the FTSE 100 index of leading shares, BP paid out £1.

Now, with the costly legal action looming by those affected by the BP spill, there is a reasonable prospect that the BP dividend could be reduced or stopped.

Since the oil spill occurred, BP’s share price has fallen by over 35% and tens of billions of pounds has been wiped from BP’s market value.

The lesson for all investors

It’s easy for investors to become complacent and think that simply because a company is so prominent, it is unimpeachable. The fact remains that even the largest companies are vulnerable to events that may cause significant financial harm, which reaffirms the importance of diversification when investing.

How diversification works

Diversification is commonly known by the old adage of ‘not having all your eggs in the one basket’. From an investment perspective, however, diversification is an important risk management technique.

Successful diversification strategies involve spreading an investment portfolio across different asset classes, industry sectors, fund management styles and geographic locations.

Aside from some investments having more (or less) risk than others, adequate diversification is also important because not all investments will perform well at the same time. By having a sound mix of quality investments, it also results in a smoothing of investment returns over time, which is good news for the majority of investors who prefer a reasonably stable income stream.

How much diversification do I need?

This depends on a few factors, such as your personal circumstances and financial goals, your appetite for risk, and your desired investment timeframe. Portfolio size has a key part to play too.

Speak to us today if you’d like to know more about the importance of diversification in your portfolio.

Sources :

www.timesonline.co.uk Mark Atherton,BP – Is your pension safe? The Times, 11 June 2010 (accessed24 July 2010)  

www.businessweek.com Dunstan McNichol, BP oil spill costs US state pensions $1.4 billion, Bloomberg 28 June 2010 (accessed 24 July 2010)