The BP dividend has experienced a heck of a decade. Prior to the Gulf Oil spill in 2010, the history of the BP dividend was a thing of beauty. There had been no cuts to the BP dividend since the creation of American traded ADS shares in 1999, and even before that, the BP dividend had never been cut since the London shares switched to a quarterly dividend payment style in 1993. From 1964 through 1993, the BP dividend was paid out in two installments: a “final” BP dividend in July that generally increased each year, and a much lower interim BP dividend that was paid in January and experienced some ebbs and flows with the business cycle.
Although this fact doesn’t get as much attention now, the BP dividend was once regarded as so reliable that it constituted 10% of the overall income created for British pensions in 2010. At the time the ADS was created in 1999, the BP dividend sat at $1.20 and offered a 4.5% dividend yield. By the start of 2010, the BP dividend had grown to $3.36 per share, and was offering a 12.72% yield-on-cost just eleven years later for those that scooped up shares of BP when the ADS was created in 1999 (as an aside: the difference between an ADR and ADS is that an ADR involves a large bank like JP Morgan or Citigroup buying large blocks of foreign stocks on their home exchanges and then issuing receipts to American investors that give rise to a contract claim for ownership, whereas an ADS actually represents the foreign company issuing shares in the United States.)
In the days before the oil spill, it was not unusual for BP to have the capacity to earn somewhere between $6 and $8 per share when oil traded between the $70 and $110 range. The BP dividend of $3.36 was well covered because it only consumed 56% of profits, giving the BP management team a significant amount of downside protection when oil got cheap as well as a significant amount of incoming profits that could be used to fund new projects. This excellent business model took the price of BP stock to a high of $79.80 in the years before the Gulf oil spill.
Since 2010, BP has encountered something close to a perfect storm: the extraordinarily expensive litigation associated with the Gulf Oil spill, the impairment of assets in Russia, and the collapse of oil to $30 per barrel that has given BP management little room to regain its footing in the years after selling off assets to accommodate the large settlement from the oil spill. These adverse business events, of course, have affected the safety of the BP dividend.
At first, the suspension of the BP dividend in the aftermath of the oil spill was political. BP management obliged President Obama and the populist sentiment of America that wanted BP shareholders to be punished for the harm caused by the oil spill. But even as the BP dividend was suspended, the strength of the business remained quite sound: BP earned $8.06 per ADS in 2011 profits. With the stock in the $20s and $30s, it looked like a very good deal. If you could look past the temporary elimination of the BP dividend, you could see that there was an extraordinarily excellent enterprise generating an almost unprecedented 26.67% earnings yield. If things worked out satisfactorily, you stood to make near 20% annual returns for a five-year stretch. With oil near $90 per barrel, it looked like the oil spill impairment would be temporary, and the lucrative profits would propel the BP dividend to new heights after a temporary working through the short-term politics of the time.
Then, three things happened over the next five years: the Russian government seized some of the joint venture assets with BP, causing billions of dollars in writeoffs. The settlement for the BP oil spill came in at the high end of estimates, costing the shareholders approximately $20 billion. And then, to truly threaten BP’s ability to timely recover from these events, the price of oil fell from $90 to $30 per barrel. The loss of assets, exorbitant legal expenses, and a 67% decline in the price of the core commodity have once again called into question the safety of the BP dividend.
For long-term BP shareholders that are a bit depressed reading all of this, I’ll offer a bit of good news: BP management made the extremely correct to sell off assets in 2011 to raise cash prospectively for the litigation expenses. That was a brilliant move. Coming up with $20 billion in assets in 2012 and 2013 only impaired long-term earnings to about a third of the extent it would have impaired BP to try and sell those assets now. If BP waited until 2016 to sell off assets, there would no discussion at all about the safety of the BP dividend: it would’ve already been cut.
Fast forward to the current $30 oil environment, and the safety of the BP dividend is affected by the following factors: A $57 billion debt position, $32 billion of which needs to be paid in the next five years; a $31 billion cash position, approximately $17 billion of which will need to be depleted to pay off the ongoing expenses from the Gulf oil spill litigation; and earnings of around $2 per share when oil is at $30 (compared to the current $2.40 per share dividend commitment).
If I were an income investor analyzing the BP dividend for my own purposes, I would treat the dividend as effectively around $1.20 per share. Prospective investors would get a yield somewhere around 4%. That’s the threshold of what the company can easily afford based on current profits. It would be a perfect set-up for high dividend growth when the price of oil recovers, and it would also protect the balance sheet that currently sports the highest debt level in the industry at $57 billion (and the debt-to-cash ratio will worsen as BP makes due on its legal obligations that the funds are currently earmarked for).
The real question, then, for those interested in value investing and the long-term income generating potential of the BP dividend is this: What price will oil be at roughly over the medium term, and after all the asset sales, what will BP’s profits look like at that price? If we can answer that question, then we can make a good guess about the long-term future of the BP dividend.
After all the asset sales, BP currently has the capacity to produce 1.1 million barrels of oil and oil equivalents per day. My five-year projection is for an average sale price of $75 per barrel, based on the fact that the production cuts are expected to take shape and the average oil cycle moves in three-year increments. If that happens, then BP will have normalized earnings of roughly $5.50 per share. If BP targets a long-term dividend payout ratio of 40%, that would mean we should see a long-term dividend of something like $2.20. Loosely speaking, my prediction is something like a BP dividend cut from the current $2.40 to $1.20, and then a five-year repair job that takes the BP dividend back up to $2.20 or so five years from now.
Why does this interest me? Because that projects a whole lot of income from an initial price point of $29 per share. The idea of collecting 7.5% in 2020-2021 from a 2016 purchase, as well as laying claim to a future earnings yield of 18.96%, is incredibly attractive because there is a lot of capital gains that can get created during this adjustment period as the BP stock price would like adjust to the 3-4% dividend and 8-10% earnings yield that is usually offered to prospective investors during times of typical commodity pricing.
The margin of safety principal does protect you. The premise of “margin of safety” is that if things go well, you do really well; if things do okay, you get satisfactory returns; and if the business encounters bad news, you are protected from losses. That is exactly what happened to enterprising investors in the aftermath of the cut to the BP dividend in 2010. The oil spill was in April 2010, and investors that bought in June 2010 after the BP dividend cut have generated 4% annual returns through the present day.
That’s how the margin of safety principle is supposed to work: oil fell by 67%, litigation expenses came in high, and unexpected bad news hit BP’s Russian assets, and yet, BP investors since June 2010 have kept pace with inflation because the initial price right. The uncertainty surrounding the BP dividend, caused by the oil prices, have put the margin of safety principle on display yet again for those considering the stock. And it is almost certain that 2016-2021 will treat BP shareholders between than 2010-2015 so those 4% returns that were generated in poor times ought to turn into high double-digit returns when good/satisfactory times follow the initial $29 price.
Originally posted 2016-02-15 18:15:37.