The Short Side Fueled Liquidity in BP's Stock During Market Stress

Almost every investor is, by now, aware of the 50 percent decline in value of BP stock since the offshore oil rig accident of April 20. Those who pay close attention to the short side of the stock market – short sales, short interest, and shares borrowed in the securities lending market – have also watched shorting activity rise and fall substantially during the last few months.

Most recently, during the period from June 7 to June 22, when dividend payments were suspended, the number of BP’s shares borrowed, for short sales or settlement failures, more than doubled to 17 million shares of the ADR and 150 million ordinary shares. SunGard’s securities lending market database, from Astec Analytics, also shows that the cost to borrow BP’s ADR shares rose from 5-8 basis points, which is typical for a large and liquid issue like BP, to 25 basis points – noticeably higher. Also during that time, daily short sales of BP stock reported by NYSE, NASDAQ and BATS went from about 40 percent of all trades to about 60 percent. Short interest in the ADR for June 15 was significantly higher than the May 28 report, at 25 million shares, up from 6.5 million, as predicted by the Astec Analytics daily securities lending database. But since that period when dividend payments were under such close scrutiny, share borrowing has mostly subsided, returning to typically lower levels. Short side trading fluctuations have not been isolated to just the past couple weeks, however – they started months before the oil rig explosion.

When BP’s drilling at the Macondo Prospect started in February, investors started to borrow an increasingly large amount of shares of the company’s ADR. At least 15 million shares were borrowed in January, most likely to fill short sell orders. By February the number of shares borrowed exceeded 20 million, in March it passed 25 million, and on April 20 there were more than 33 million shares borrowed in the securities lending market. This is barely 1 percent of BP’s shares, but at the time it was almost 10 times the number of shares traded each day on the New York Stock Exchange.

Several days after the oil rig explosion on April 20, as investors began to digest the magnitude of the event’s consequences, stock trading activity changed significantly. The price of BP’s ADR turned sharply downward towards what would become a 45 percent decline by June 17. Short sellers who had borrowed millions of shares began to cover their trades, and overall trading volume on the NYSE rose from about 5 million shares traded each day to 85 million on April 29 and 156 million on May 3. Short sellers covered trades of about 20 million shares worth of BP stock in the weeks after the oil rig explosion, providing helpful buying pressure and price support while so many other investors were selling.

The BP ordinary share did not show a similarly large increase in shares borrowed before April 20; there was only about one-quarter as much of an increase compared to borrowing of the ADR.

This appears to be another example of how short selling – despite what its critics claim – is not the reason behind a stock’s price decline, and how short covering truly provides essential liquidity during stressful trading periods. Given the circumstances, however, it is a case study that everyone wishes never actually happened.