BP hasn’t had a great five years.
In 2010, the Deepwater Horizon disaster led to endless legal battles and billions in compensation.
High oil prices between 2011 and 2014 helped to offset these losses. But they’re gone now. And that’s had a big impact on BP’s bottom line. This week, BP announced that stated profits had fallen by half to $5.9bn in 2015.
Yet CEO Bob Dudley has decided not to cut the dividend, in the expectation of prices recovering. On a yield of 8% or so, that would make BP a steal.
But can he keep his promise?
Is betting on an oil price recovery a sensible strategy?
Bob Dudley, like many in the oil industry, is betting that crude prices will rebound. He’s admitted that BP needs long-term prices to rise to $60 a barrel for his plan to work – near double their current levels. In the meantime, he’s prepared to use a combination of borrowing and cost-cutting to keep paying the dividend.
He might be right about rising prices. US shale producers – one of the main drivers of the current over-supply – are hurting. Credit ratings agency S&P has downgraded many of them. The three biggest shale firms now all have “junk” status. Fadel Gheit of Oppenheimer believes that half the companies in the sector could end up going under.
But this clearout will take time. And even if a clearout does take place, allowing prices to bounce, new shale operators will return to the sector as soon as it becomes viable. That will drive production higher again, and cap prices.
Certainly, it’s hard to see how prices could go above $65 a barrel, which research firm Rystad Energy believes is the “breakeven” level for shale oil. And as technology keeps improving, that breakeven point will only get lower.
BP’s dividend policy also makes it particularly vulnerable to unforeseen shocks. For example, Deepwater Horizon still has the potential to spring nasty financial surprises.
BP finally reached a $20.8bn deal with the US government and the states affected. But civil compensation costs continue to mount. And that’s just the American claims. The oil giant also faces a legal challenge from Mexican groups, which could further increase costs.
Maybe that won’t end up being an issue. And maybe the oil price will bounce back more rapidly than anyone thinks.
But even if there is a rebound in the oil price, BP may be in no state to take advantage. The company is slashing investment. A few days ago it said that it was going to fire 3,000 people in the exploration division. This will hinder efforts to find new oil fields to replace those being exhausted – bad news for the long-term health of the company.
So is prioritising the dividend – especially when the market clearly expects a cut – really the right thing to do?
What you really need to focus on when it comes to dividends
One way to judge whether dividends are sustainable or not is to look at the dividend payout ratio. This simply looks at whether a company has enough earnings coming in to actually cover the dividends being paid out.
You can calculate the ratio out by dividing earnings per share (EPS) by dividend per share. The rule of thumb is that the ratio should be more than 1.5, and ideally 2. Those firms with a ratio of less than one will probably need to cut their dividends.
It’s clear that in the case of BP, the oil giant falls short. Headline EPS of 32p in 2015 and projected profits of 22p this year are simply not enough to cover a dividend of 40p, producing ratios of 0.8 and 0.55 respectively. Indeed, the dividend would have to fall to just under 15p for the payout ratio to rise to a comfortable level.
BP is a good illustration of why investors need to focus on the sustainability of dividends, rather than just the juicy-looking yields. I covered this topic in more detail in the magazine a few months ago. (If you’re not already a subscriber, now’s a good time to sign up).
Alternatives to BP
That’s not to say that we’d give up on the oil sector altogether. As my colleague Alex Williams has argued, the price has fallen so far and so hard that the best-placed companies could now be in a good position to take advantage for the future.
And with oil companies cutting production and Saudi Arabia and Russia rumoured to be discussing a potential deal (though it’s very much rumour at the moment), prices could recover (or at least bounce) sharply.
The chief executive of Exxon (NYSE: XOM) thinks that the company could be successful at a lower oil price of around $50 a barrel. Exxon has a much more sustainable yield of 3.7% and has enough cash on hand to take over weaker competitors.
This article is taken from our FREE daily investment email Money Morning.
Every day, MoneyWeek’s executive editor John Stepek and guest contributors explain how current economic and political developments are affecting the markets and your wealth, and give you pointers on how you can profit.
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