In light of the recent history for BP shares, I understand why investors might be skeptical of this oil giant. The share price has gone nowhere, the dividend is frequently considered a candidate for a cut, and the debt burden is high. However, I wanted to share you with my basis for having a rosier outlook regarding the future for BP stock as well as the role that a potential dividend cut plays in my analysis of BP’s intrinsic value.
BP Share Price History: No Growth Since 1998 Due To Oil Spill
In January of 1998, BP stock traded at $38 per share. That is the same price that exists today. What gives?
The enormous culprit is the deadly Gulf of Mexico oil spill in 2010 which has a full tally cost of $62 billion for BP shareholders. That is extremely high and unlike any other costs from clean-up and subsequent litigation that any of us have seen in our lifetimes. For comparison, the total costs for Exxon shareholders in the aftermath of the ExxonValdez oil spill was $2 billion or an estimated $7 billion after you factor in inflation. This tragedy created 8x more expenses than its closest reference point. To quote Daniel Jacob of the Justice Department: “I know of no other more expensive man-made corporate disaster. The number is huge.”
How did this oil spill transform the business that backs up your BP shares?
Well, prior to the spill, BP had 3.1 billion shares outstanding (including the American depository receipts run through Citibank). It traded at an average price of just above $60 in the year preceding the spill. This means that all of the BP stock in the world tallied up to a total value of $186 billion.
To contextualize those $62 billion in costs, I think of it like this: BP had to sell off a third of its business to meet both the fair and unfair obligations that arose from the accident. When you buy a share of BP stock today, you are only purchasing something that has two-thirds of the firepower it did back in the late 1990s and early 2000s.
I’ll use 1998 as a reference point because that is the last time that BP happened to trade at a price of $38 per share. Back then, each share of BP that you purchased represented about a one in three billion ownership claim on 1.6 million barrels of oil that were being produced each day. Sounds pretty sweet. BP was paying out a dividend yield over 3.3%, making BP stock responsible for 10% of the entire income in the British pension system.
However, your interest in BP stock now only represents output of 1.2 million barrels of oil production per day. The fact that the stock has been able to pay out large dividends to shareholders, and generally retain its market value per share, is a testament to the strength of mega-capitalization enterprises.
How many businesses out there could stomach a $62 billion liability and still remain solvent, yet alone still be able to pay cash to its owners while the price of the commodity it sells ends up collapsing? Not many.
I understand why stocks like BP are unfashionable with the general investor community. You can look at stocks like Facebook which seem to double in value every two years, and it looks like a much sexier way to build wealth. Meanwhile, the price of BP stock stagnates. And all it does is pay out a dividend, which a majority of the investor community has labeled at risk of being cut.
But I see it a different way. These nineteen years have been awful for BP. If you could travel to Great Britain in the 1990s and meet a pensioner and ask him what his worst-case scenario for a BP investment would be, I doubt he could have even fathomed a $62 billion liability and a commodity collapse of 75% between 2008 and 2015. If both those conditions were present at the same time, you would have thought that BP investors would have lost their shirt.
And yet, BP has been a moderate compounder of wealth during these last nineteen years. That is what attracts me to it—so many awful events have been inflicted upon the core operations and the results for BP stakeholders have been moderately positive. I like the fact that you can put your hard-earned savings into a business that can withstand torrents of abuse and still create a bit of wealth for you. If you take care of the downside, the rest will take care of itself. Imagine how great it is going to be owning BP oil shares when conditions improve.
BP Shares Have Paid Out Over $40 In Dividends Over The Long Term
Since 1998, each share of BP has paid out a dividend of $40.32 if you did not reinvest. Amazingly, despite a dividend cut and periods of unstable dividend growth, shareholders continued to receive large torrents of cash from this oil giant. The terms of your investment were loosely analogous to this: “Each dollar that you invest today will give you pay you $1.06 as a share of the oil drilling and refining profits that will arrive in a lumpy fashion over a nineteen-year time period.”
This is the kind of asset that has a special place in your heart if you are in the early stages of your investing life and you’re trying to establish passive cash flows for your household’s balance sheet. There aren’t many assets out there that passively give you more than $10,000 in income over a nineteen-year period in which your starting capital is $10,000. You stick a couple hundred shares of BP into your portfolio, and then find a dozen or so other assets with similar cash-generating capabilities, and you are well on your way to collecting thousands of dollars per month that will enable you to spend your life being a permanent investor always selecting a new asset each month.
So how do you get your hands on those few hundred shares?
Well, if you don’t already have the assets paying dividends and you aren’t earning a lucrative salary from your day job, you can purchase a relatively modest amount and let those BP shares compound upon themselves over time.
For someone that bought 100 shares of BP in 1998, and chose to reinvest rather than collect and spend their dividend payouts, the cumulative amount of money that the BP investor would have collected is $69.94 which got reinvested at a price of $45.32.
Why did each initial share of BP go on to produce $69.94 per share rather than $40.32 per share? Because of the rapidly expanding share count. The person who spends each dividend still has the same number of 100 BP shares. But if you reinvested, you picked up an additional 154 shares that augmented your initial 100 share investment and left you with a total of 254 shares.
For a so-called “busted” or “go nowhere” stock, you grew that $3800 investment into 254 shares worth $9,652 which pays out an annual dividend of $609 per share. The money you set aside nineteen years ago would be yielding 16% per year today. Considering how bad the general circumstances have been, BP stock managed to make its way because the profits were higher than people gave it credit for and a lot of those profits got shared with shareholders.
Even if the growth of the dividend didn’t come in the neat and tidy manner that investors prefer, the amount of cash generated compared to your initial investment amount was quite large and cumulatively substantial.
And don’t forget the upshot that arose from the oil spill. While there is no question that the sale of a third of BP’s business destroyed value for shareholders, the benefit is that the uncertainty about litigation knocked the price of BP stock down into the $40s and then the $30s and even briefly into the $20s where shareholders got to collect 5%, 6%, and even 7% yields. Those 254 shares were adding 15-20 additional shares per year through reinvestment because the reinvestment price has been so low.
And since people tend to contribute to their investment holdings over time, the results could have been even better. Imagine if, during this past oil crash or today, you filled out an electronic debit from your checking account to add another 150 shares of BP to your account at an average price of $35 or so. You’d have 414 shares paying out about $1,000 per year in cash dividends.
For a lot of people, the thought of making receiving $1,000 per year from a single investment holding sounds far-fetched. But all it took was a $3,800 and $5,250 investment with some time spaced out for some high cash dividends to get thrown in there.
This is one of the best known secrets among sophisticated estate planners for the affluent. It is no coincidence that the trust funds for Queen Elizabeth are filled with shares of BP’s major peer Royal Dutch Shell. The chattering class is highly critical of slow growing cash cows. And yet, giant oil stocks like BP have effectively offered you a full rebate on your initial investment by giving you cash payouts that have equaled your initial investment amount within ten to twenty years depending on whether you reinvested. The stock price doesn’t move around all that much, but the cash dividends keep piling up creating a disparity in which your actual total return is much higher than the total return you think you’re getting based on looking at the BP stock price alone.
And the kicker is that this has been a poor stretch for BP. It was overvalued in the 1990s. It is undervalued now, making for a weak comparison period. It had to deal with the oil spill that cost $62 billion. It had to deal with wild fluctuations in the price of oil. It took all of that abuse, and still created value and returned good chunks of income to shareholders. Imagine what happens when BP goes through a period of more favorable conditions.
If The BP Dividend Gets Cut
This year, BP stock is on pace to generate $8 billion in profit (you can see why I like this holding so much). That is the reality of the earnings power behind each BP share you buy which exists completely independent of the capital allocation decisions of BP management.
Right now, the BP dividend sits at $2.40 per share. With 3.1 billion shares of BP outstanding, this means that BP is currently on the hook for $7.4 billion in annual dividend payments to its shareholders. Obviously, this consumes nearly all of its profits and makes it difficult for BP to fund the purchase of new oil well sites without borrowing. Also, all it takes is a 5% or so dip in the price of oil for BP’s profits to fall below the amount that it has regularly pledged to pay to its shareholders.
A lot of times, people like the dividend cut is the end of the world for any of their holdings. I think this response is an especially foolish viewpoint to have regarding cyclical stocks, and more often than not will lead to regret when you see the subsequent recovery and dividend growth.
It comes down to two decisions. BP can keep its dividend, and add to its $59 billion debt load or deplete some of its $25 billion in cash reserves. When the price of oil advances, BP won’t be able to increase its dividend much (if at all) because it will need to reorient itself to a more desirable dividend payout ratio and it will also want to use the additional cash flows to deleverage. In this scenario, the upside is that you get to keep collecting your $0.60 per share BP dividend but the downside is that there won’t be much growth in the rate of the dividend.
In the alternative, BP could cut its dividend to something like $1.20 per share ($0.30 quarterly) which would only require an annual transfer of $3.5 billion in cash to BP’s shareholders. Obviously, the downside here is that you would only be collecting half your cash flows and you would no longer be able to reinvest large amounts of cash at this deflated price for the stock. But the upside is that you will experience high single digit dividend growth from that lower $1.20 rate. BP could shore up its finances in the immediate sense by keeping $5.5 billion in retained earnings each year, and if oil goes up to the $75-$85 range, BP could find itself only paying out $1.20 in dividends while earning nearly $6 per share in profits. That permits BP to protect its shareholders with a strong balance sheet in the mean time while also rewarding them with higher dividend growth once the dividend has been rebased.
Would you rather have a 6.5% dividend with 0-3% annual growth for five years or a 3.2% dividend with stronger finances that grows at 8-10% for five years? The future isn’t clear, nor is it clear which option is in the best long-term interest of BP shareholders.
However, I think you should fixate on those $8 billion in profits. And the fact that BP makes over $20 billion in profits, even at its lower production capacity of 1.2 million barrels per day, when oil flirts with $80-$100 per barrel. The point is that torrents of profits are being generated, and large chunks of those profits will get shared with you over time. The manner and timing is not clear, but the fact that you will receive gobs of income relative to your initial investment amount is highly likely. If you focus on this “what” rather than the “how”, you can have a more permissive attitude towards speculation about the BP dividend. It also helps if you diversify and are never reliant upon the distribution decisions of a single Board of Directors.
If The Share Price of BP Recovers
Jeremy Siegel has referred to the reinvestment of dividends at favorable valuations as a turbo-charger of wealth when the stock price eventually increases because you are able to capture a rise in not only the initial shares that you purchased but also the shares that you acquired through dividend reinvestment. I documented this effect in my analysis of Johnson & Johnson stock which referred to their reinvested dividends as a “coiled spring” during the 2005-2013 time period before shooting up from $70 to $115.
Regarding BP, we’ll stick with our earlier example of 100 shares purchased in 1998 that have grown into 254 shares through nineteen years of dividend reinvestment. Well, if the share price of BP goes up to $65 within the next to two to three years, you not only have those 100 shares going from $38 to $65, but those 154 self-generated shares going along for the ride.
Those 154 shares that got added through dividend reinvestment will be worth over $10,000 when the share price of BP eclipses $65. Considering that your initial investment was $3,800, that’s pretty significant jump because it all involves self-generated funds increasing in value over time.
If BP is set to trade at $65 per share in 2019, there is an upshot to having the price languish in the $30s and $40s. I’m not saying this is preferable, but I am saying that taking advantage of a 5-7% dividend yield to rack up some new shares through reinvestment will be looked upon fondly when the share price goes up in value.
That is why I don’t you should lament the days when your investments are undervalued. If the investment is repurchasing its own stock, or you are auto-reinvesting, then you want to be accumulating as high of an ownership position as you can. The market price has enabled BP to do this for these past few years, and eventually, you will see a shift from BP being labelled a stinker stock into a glorious outperformer. Cheap shares plus high amounts of cash getting reinvested equals large capital gains down the line.
If you look at the BP share price history over the past two decades, there have been no capital gains. But this shouldn’t lead you to conclude that a similar fate awaits the 2017-2037 stretch. The past twenty years have included a $62 billion liability, a shift in the share price of BP from overvaluation to undervaluation, and crazy recent gyrations in the price of oil. Also, when you include the effect of a reinvested BP dividend over that time, the investment performance has been moderate while the impairments to the core business have been extreme. This is a business that has withstood a lot of abuse, and still kept sending cash to shareholders while retaining a majority of its economic engine that existed before the oil spill. Better business conditions, a better starting valuation, and the high likelihood of meaningful cash payouts make BP a core dividend stock for the next generation.
Originally posted 2017-01-05 22:47:30.