With the current oil crisis dragging on far longer than initially anticipated, many big oil dividend stocks such as BP, Chevron (CVX), and Royal Dutch Shell (RDS.A) are offering tantalizing high-yields.
However, given the capital intensive nature of this business, the cyclical nature of the industry, and the unpredictable nature of crude and natural gas prices, many income investors are understandably concerned about just how safe these big oil dividends are.
Let’s take a look at BP’s business model, balance sheet, risks, turnaround plans, dividend profile, and valuation to see why this is one oil giant that is probably best avoided for conservative investors living on dividends, except perhaps by the most risk tolerant dividend investors.
Based in London, BP is one of the largest integrated oil and gas companies in the world with sales in excess of $225 billion last fiscal year. BP has three business segments: upstream oil & gas production, downstream (refining, lubricants, fuels, and petrochemicals), and its 19.75% stake in Rosneft, the Russian oil giant.
In the most recent quarter, BP was able to hold the line on total oil equivalent production of 2.26 million barrels per day, but lower oil prices resulted in much weaker year-over year profits. This left it up to the downstream business to do the lion’s share of generating actual replacement cost profits (profits after including cost of replacing inventories).
However, that segment was hit by falling refining margins due to too much supply of refined fuels and petrochemicals; courtesy of the epic supply glut the world is experiencing.
|Business Segment||Replacement Cost Profit||% of Profit|
Source: BP Q2 2016 earnings supplement
BP, and its European cousin Shell, have long been behind their American cousins Exxon (XOM) and Chevron when it comes to operating efficiencies. This means that their overall profitability is lower, putting them at a disadvantage when it comes to industry downturns. During these challenging times, maximizing cash flow and minimizing costs becomes imperative.
As seen below, BP scores the lowest marks of the group for each of the key profitability and efficiency metrics.
|Company||Operating Margin||Net Margin||Return On Assets||Return On Equity||Return On Invested Capital|
|Royal Dutch Shell||-2.9%||-2.0%||-1.3%||-2.6%||-2.09%|
That’s not to say that BP hasn’t been hard at work over the last two years slashing costs as it’s raced to adapt to a world of much cheaper energy prices. Capital expenditures are expected to be down 30-40% compared to BP’s peak spending in 2013, and cash costs are projected to decline by $7 billion from 2014 through 2017.
Source: BP Investor Presentation
These actions are greatly helping BP lower its production costs, which management believes will help the company immensely improve its free cash flows in the next five years from -$1.4 billion in the last 12 months to as much as $7 to $8 billion by 2020, even with $50 per barrel oil.
That’s courtesy of the new emphasis on slower declining production projects which the company has refocused its drastically smaller capital spending budget on. These projects, which include liquefied natural gas, or LNG export terminals in Oman and Indonesia have lower decline rates, and thus require less annual maintenance capital investment to continue producing consistent cash flow at a reasonable return on investment.
That’s especially true given that over 80% of its future projects are already under construction and have anticipated gross margins above its current portfolio average. This explains how BP is planning on both boosting production and margins simultaneously while investing the least of all the major oil giants.
Note, however, that past 2020, once these major projects are operational, the company’s supply of low hanging fruit for cost cutting and cost effective growth will be gone. In addition, most of the company’s refineries are located in Europe, where overcapacity and import threat from America are likely to keep pressure on downstream margins in the future.
And don’t forget that BP’s recent finalizing of its 2010 Deepwater Horizon disaster will also result in the company paying a remaining $22.2 billion in legal fees over the next 17 years; or $1.3 billion per year. That will serve as an unfortunate albatross around the neck of future dividend growth, likely putting any increases many years down the road.
Speaking of which, the 2010 Macondo oil spill brings up just one of the several major risk factors that investors need to keep in mind before buying shares of this battered oil giant.
There are three main risks to be aware of with BP.
First, BP’s terrible safety record, which culminated in 2010’s Deepwater Horizon rig explosion that killed 11, injured 17, and resulted in 2oo million gallons of oil spilled, was far more extensive and systemic than its peers.
Source: Awesome Stories
For example, prior to the disaster, which management expects to ultimately cost the company $61.6 billion, the company had received 760 fines from OSHA, the Occupational, Safety, and Health Administration. In contrast Exxon, which many analysts consider the best run major oil company on earth, received just one.
BP has made meaningful and necessary efforts to improve the safety of its equipment and employees.
However, given that the largest new oil fields being discovered are in deep offshore, and that ultra deepwater production is expected to be the fastest growing source of oil in the coming decades (according to Rystad Energy, an oil & gas consulting firm), there is always the risk that BP will eventually revert to its more lackadaisical safety systems.
The second major threat to BP, and especially its dividend, is of course the unpredictable nature of oil prices.
As you can see below, the world has been in a massive supply glut of crude for several years now. This has resulted in record high inventories of oil that, even once demand begins to outstrip supply, will take years to work off.
In fact, even if long-term demand outstrips supply by one million barrels per day, it would take about 8.5 years to work off the current inventories in developed nations alone.
That isn’t to say that oil prices will languish at $50 per barrel or so for all of that time. After all, oil prices are largely based on futures markets, which are forward looking. Prices could jump past $60 if the current glut becomes a large enough deficit.
However, there is a major wildcard in the mix, one that has bedeviled all attempts to predict when the crash would end – US shale producers.
Shale producers both big and small have made amazing strides at using new drilling techniques. These include using horizontal drilling, longer laterals, multiple frack stages, and as much as 20,000 tons of frack sand per well to increase production and lower costs.
This is largely why, with oil now at $50 per barrel, we’re seeing the number of US drilling rigs climbing in eight of the past 10 weeks. In other words, the risk is that US oil companies have become so efficient that they can profitably produce oil at even today’s prices.
With over 3,900 drilled but uncompleted wells, mostly in US shale formations such as the massive, prolific, and low cost Permian basin, US oil production could literally increase seemingly overnight. There is also a large amount of oil sitting offshore in storage tankers.
This helps explain why oil prices haven’t soared more on the long awaited agreement by OPEC to finally cut production.
The markets know that OPEC members are notorious for cheating on their quotas, and even if the Cartel can make members toe the line on production, there is a very real chance that US shale production could quickly step in to offset any declines in OPEC production.
In other words, the long and painful oil war Saudi Arabia began over two years ago in order to regain market share may end up failing completely but with oil prices at half their previous level. US shale producers could continue gaining much greater control of the oil market in the years to come.
Unfortunately for BP, it doesn’t have the ability to stop producing oil in many areas where its cost of production exceeds the current price of oil.
Traditionally, U.S. and Western Europe oil and gas companies explored locally. Once all the local supply was used up, they had to turn to oil-rich countries around the world to continue growing.
Many of these foreign countries do not have the technological know-how or expertise to pull the oil up themselves, but they are able to extract lucrative deals by partnering with Western oil companies.
These contracts usually require Western oil companies to produce a daily quota of barrels and pay the country a certain price per barrel that may have little direct or immediate relation to the prevailing market price of oil.
Even when the price of oil drops, the Western companies still have to produce the amount agreed to under contract. The host country gets paid first and the price agreements may continue to cause losses for the foreign partners regardless of an increase in market pricing.
In other words, to get comfortable investing in a major oil company like Exxon or BP, an investor needs to be aware that it’s not just the cost of production in each part of the world, but the contracts and sunk costs each company has.
Given BP’s poor track record and weak profitability metrics compared to peers, the company is likely saddled with a number of unfavorable production contracts that are causing cash flow to bleed even faster.
Finally, there is one final risk all oil dividend investors need to be aware of – rising interest rates. While BP is far from being a bond-like stock, higher interest rates over the coming years could have a major impact on BP in three ways.
First, the company’s balance sheet (which I’ll discuss in more detail later), contains $55 billion in debt. Much of these loans will need rolling over (i.e. refinancing), in the coming years. If interest rates were to increase 2.75% over the long term, BP’s annual interest cost could increase by as much as $1.5 billion. That would come to 20% of BP’s expected free cash flow growth in the next five years.
Of course, that’s assuming that BP doesn’t pay off much of its total debt by then. While this is possible, doing so would only further hinder the company’s already abysmal dividend growth prospects.
Second, and a more immediate concern, is that higher US interest rates could put pressure on the dollar to appreciate relative to other currencies. Since oil is priced in dollars, this means that oil prices fall as the dollar rises. Over the coming years, assuming the economy is strong enough to absorb higher rates, oil prices could feel a natural headwind courtesy of the Federal Reserve’s efforts to normalize interest rates.
Finally, we can’t forget that a lot of investor money has been flooding into high-yield dividend stocks, BP included, because interest rates around the globe have fallen to their lowest levels in history.
In the case of oil stocks, while income investors’ desperate quest for yield hasn’t resulted in record highs, it has helped to cushion the blow to their share prices. If Treasury yields normalize to higher levels, BP’s high yield won’t look as attractive as it does today, especially considering how risky the company’s dividend is.
Which brings me to the biggest reason to avoid BP: it pays one of the least secure dividends you can find among its peers.
Dividend Safety Analysis: BP
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. BP’s dividend and fundamental data charts can all be seen by clicking here.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Investors can learn about the most important financial ratios for successful dividend investing here.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
BP has a Dividend Safety Score of 9, suggesting that the company’s dividend is much riskier than most dividend stocks; thanks to several negative factors.
Among the most important is BP’s weak balance sheet. The oil industry is incredibly capital intensive, meaning that absolute debt loads are generally high across all integrated energy producers. However, compared to peers such as Exxon and Chevron, BP’s debt load of $55.7 billion is higher and more dangerous, limiting its financial flexibility during industry downturns.
As you can see below, BP’s leverage ratio, interest coverage ratio, and debt / capital ratio are all far worse than either its large rivals or the industry average. This also explains why it has a worse credit rating than Exxon, Chevron, and Shell.
|Company||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Current Ratio||S&P Credit Rating|
|Royal Dutch Shell||3.96||10.44||28%||1.10||A|
Sources: Morningstar, FastGraphs, Simply Safe Dividends
Given such a high debt load, the risk of potentially rising interest rates, and an industry as cyclical and unpredictable as oil, the current dividend cost of $5.5 billion per year may not be sustainable for much longer.
After all, BP has been willing to take a credit downgrade in February of 2016, caused in large part by its defense of its payout. Further downgrades would mean much higher debt refinancing costs going forward, so management can’t allow its credit ratings to drop much further before it begins to threaten the company’s future long-term growth prospects.
The slump in energy prices has hit BP’s business hard. Sales growth has been less than -20% year-over-year for seven straight quarters. As seen below, annual free cash flow per share slumped to just 51 cents last fiscal year, and the business isn’t generating positive free cash flow today.
As a result, the company’s payout ratios have spiked to unsustainable levels, which require BP to raise debt, sell assets, and burn through precious cash on hand to continue paying dividends.
You can see that BP’s leverage has increased over the past decade, giving it less flexibility to weather the current storm.
Overall, in my opinion, BP’s dividend has high risk of being cut if oil prices don’t begin a meaningful recovery in the near future. The nasty combination of high financial leverage, negative free cash flow, a deteriorating credit rating, capital-intensive operations, and dependence on unpredictable commodity markets make BP a risky business to invest in.
Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
BP’s dividend growth score of 2 indicates that the lack of security of the current payout means that investors shouldn’t expect any meaningful growth from the dividend for at least several years.
In fact, due to the unsafe nature of the company’s payout, current shareholders will be lucky to avoid a dividend cut over the next year or two unless oil prices drastically improve in the coming quarters.
Now given that after the 2010 Deepwater Horizon oil spill BP sold $75 billion worth of assets to guarantee it could cover any legal liabilities it would incur, which has BP sitting on $23.5 billion in cash at the moment, you might think that BP might be better positioned than most oil giants to sustain its current dividend. Or even potentially grow it, albeit slowly.
However, while the lawsuits over the Macondo incident are indeed pretty much settled at this point, management expects that future cash costs over the spill will come to over $22 billion. In other words, pretty much wiping out the company’s war chest and leaving almost no room for dividend growth.
That being said, BP remains committed to the dividend for now. In fact, the company is planning an additional $3 to $5 billion in asset sales this year, and then $2 to $3 billion more annually to help keep the payout going until oil prices inevitably recover.
Thanks to its plans to cut capex spending to $17 billion this year and to $16 billion next year (representing more than a 30% drop in spending versus 2013), the company is confident that it can begin generating free cash flow if oil prices climb above $50 to $55 per barrel.
“We are sticking to our financial frame and this is putting us on track to rebalance organic sources and uses of cash by 2017 at $50-55 per barrel. This will allow us to sustain our dividend while still maintaining the flexibility to grow.”
Bob Dudley, group chief executive
Given that Brent crude, the global standard, is currently $52, this might give investors hope that maybe BP’s dividend outlook isn’t as bad as its current sky-high yield may indicate.
However, there are three key things for investors to remember. First, selling off assets to support the dividend is a short-term solution only; one that results in lost cash flow going forward.
Second, in its latest investor presentation, BP clarified that its dividend won’t be covered by free cash flow at around $52.50 per barrel, but merely that operating cash flow will cover capital expenditures. In other words, around $52.50 in Brent oil prices, BP will start generating free cash flow.
However, remember that the key to securing the dividend, much less growing it, means that BP needs to generate over $5.5 billion in free cash flow. Given management’s latest guidance, that won’t occur until crude hits much higher prices and remains there for a prolonged period of time.
That’s because BP’s operating cash flow needs to be able to cover all its operating costs, including debt service, capital investments, the dividend, and the ongoing Deepwater Horizon liabilities. That isn’t likely to happen, at least according to management, until around $65 per barrel. Meanwhile, dividend growth would likely have to wait until crude hits, and stays above $70 for several quarters.
Given the uncertainties about global economic growth, and the slowing increase in oil demand, this level might take years to achieve. In fact, based on BP’s plans through 2020, I think a best case scenario is BP maintaining the current payout through 2018, and only being able to raise the dividend modestly in 2019.
Source: BP Medium-Term Outlook Presentation
A third reason to not expect much payout growth from BP is the company’s inconsistent dividend growth track record. As you can see, BP is hardly a dividend aristocrat (learn about all the aristocrats here), meaning management has proven more than willing to cut the payout in previous times of industry downturns or company distress.
Unlike oil giants such as ExxonMobil, or Chevron, which have long histories of growing dividends steadily over time, even during trying industry conditions, BP doesn’t have a streak to defend. BP’s annual dividend growth of just 1.4% per year over the last decade underscores its struggle to reward shareholders with meaningful income growth. Considering the company’s strained balance sheet and costly production contracts, capital preservation will remain a major priority if oil stays low.
In addition, unlike many US companies, which tend to see every dividend increase as an ongoing commitment to pay at least that much going forward, European firms are far more apt to variable dividend payouts as their earnings rise and fall.
In other words, BP investors who are mainly concerned with consistent, secure, and growing income should be doubly concerned about BP’s prospects.
BP isn’t generating profits at current oil prices. This makes traditional valuation methods such as the P/E ratio ineffective.
However, even when we look out to as far as two years in the future, when most analysts think that oil prices should have recovered nicely, BP’s forward P/E ratio sits just over 70, suggesting the company’s stock is rather overvalued or a major increase in earnings is around the corner.
What if you aren’t concerned with capital gains (i.e. price appreciation)? Surely that 6.6% yield makes BP an attractive buy, right? Especially considering that BP’s average five-year dividend yield is 5.4%.
In reality, of course, such a high-yield indicates that the market is pricing in a likely dividend cut, which could cause the share price to sink further.
In other words, no matter which way you look at it, either from a potential capital gain or income generating method, BP appears far from the screaming value that one might expect on offer during what some are calling the worst oil crash in almost 50 years.
In my view, BP is far more likely to be a value trap than a bargain. Many times you get what you pay for.
While the unpredictable nature of oil prices means that one can’t necessarily declare BP’s current dividend in imminent peril, a few things are safe to conclude.
With a far more leveraged balance sheet, ongoing legal costs associated with the 2010 Deepwater Horizon disaster that serve as a competitive disadvantage, a number of costly fixed production contracts with foreign countries, and far less efficient operations than large, US rivals such as Exxon and Chevron, BP represents one of the riskier big oil dividend stocks you can own today.
Reaching for yield is more tempting than ever in today’s environment, but it’s also more important than ever for income investors to stay disciplined and continue executing effective dividend investing habits.