Funny how things can change so fast, isn’t it? This time last year, BP was making $3.96 per share in profits and paying out $2.34 in dividends for a payout ratio of 59%. When I first started writing about BP, I mentioned that the principal risk for shareholders involved the following conditions occurring at the same time (or near in time to each other): adverse legal judgments from the Gulf oil spill, a substantial decline in oil prices, and trouble securing income from the Rosneft project that accounts for nearly 20% of BP’s income. I mentioned those two last risks in passing—as almost a throwaway line—and unfortunately for BP shareholders, that trifecta of events occurred simultaneously to cause profits to fall substantially.
Profits of $4 and $5 per share in 2011 and 2012 have given way to expected profits of $2.25 per share in 2015. That assumes oil prices around $55. The general rule for large, diversified oil companies is this: In ordinary energy times, profit margins are around 5%. In good economic times, profit margins are 7%. And, when energy prices are low, profit margins are around 2% or 3%. Even if oil stays in the $50-$60 range, BP will still make around $7 billion per year in profits after accounting for all expenses.
Still, there is a problem: With oil in the $50s, BP makes around $2.25 per share in profits while paying out $2.40 per share in dividends. Both Conoco and Chevron have experienced two-year stretches at some point in the past twenty years in which their dividend payments exceeded their profits (Exxon has not had this problem in the past half-century). It’s at the discretion of management how to respond, but usually the approach is this: Borrow money to pay the dividend, hold it steady, and raise it very slowly when energy prices increase. This approach can last for two or three years, but if the barrel price of oil hovered in the $40s and $50s for the next couple of years, shareholders would likely encounter a dividend cut.
If this business was not bound by a past dividend history anchoring expectations, you would probably conclude that the quarterly dividend ought to be $0.30, or half of the current payout, so that the company did not have to borrow to make dividend payments at the bottom of the cycle and would also have significant retained earnings to invest in new projects.
Yet, despite these concerns, and the acknowledgement that BP’s dividend would prove unsustainable if current conditions persisted for more than a year or so, BP stock still seems like a rather compelling purchase.
First, there is the company’s preparation for final judgments regarding the oil spill. BP sold assets quickly (I define quickly as 24-36 months) in the aftermath of the oil spill to position itself well for eventual payoffs. It has $29.7 billion in cash on its balance sheet right now, and a worst case scenario would involve a payout in the $18-$22 billion range.
The way I see it is this: Even if oil traded at $50 per share for a while, and even if the company had to pay out $22 billion in claims, BP would still be a company with $7 billion in cash making nearly $7 billion per year in profits. I like those kinds of bad-case scenarios.
Second, there is the question of low oil prices. Even with oil at $50 per barrel, there are only four dozen companies in the world that are more profitable than BP. Making $7 billion per year in profits is quite a lot of money. As a point of comparison, the Clorox Company is worth $14 billion in total. Two years of profits at BP with $50 per barrel oil could make you the owner of just about all the well-branded consumer bleach and trash bags sold in America today. If the status quo persisted for years, you might see a $1.20 dividend, or 3.1% dividend yield based on current prices of $38 per share. If oil shoots up north of $70 for an extended period of time, you’d be looking at possible dividend growth from the current yield point of 6%. Dividend fluctuations are regular occurrences in the industry (save for Exxon, Chevron, and Conoco), and a dividend cut would not mean that BP was in long-term danger. It would mean that oil was cheap for longer than contemplated, and the dividend had to be re-calibrated to align with profit expectations around $7 billion rather than $14 billion.
It seems to me that BP should be an above-average investment with oil in $50s, $60s, $70s, a great investment in the $80s and $90s, and an excellent investment if oil crossed the $100 barrier and stayed there. If oil remains in the $40 or $50 per barrel range for a few years, BP would probably perform in line with the S&P 500 from this point onward. It’s a nice little insurance policy—if oil stays low, your gas bill will be lower and many of the other blue-chip investments will have reduced expenses, and therefore higher profits, because their energy costs will be lower.
The long-term future for BP remains bright, even though it will likely take higher oil prices and legal clarity for BP to earn a higher valuation. This is a good example, however, of what contrarian/value investing looks like in the moment. No one wants to buy GE when the dividend is cut over 70% and the profits are 1/8th of the previous year. Yet, that was when the price of the stock was below $10. No one wants to buy Wells Fargo when the dividend gets chopped to a nickel and profits fell by over 60%. Yet, that is when the stock traded below $10. During financial crises, low energy prices, or any departure from normal conditions in an industry, there will always be a sizable gap between where profits are now and where profits will be when conditions recover.
BP is producing 1.1 million barrels of oil per day. In an absolute sense, BP is still making an eye-popping amount of profit. In a relative sense compared to its short-term past, it is not. The issue has been that BP sold oil at an average price of $99.24 per barrel two and three years ago, and sold oil for $87.96 per barrel prior to the start of the 2014 summer slide. Now, the forward-looking figures are in the $50s. People who buy BP at $38 per share are engaging in value investing, and they will receive significant income and capital gains eventually. The ride will be bumpy, and may take a while, and that is why BP best fits into a diversified, truly patient portfolio.