- BP is one of the most shareholder-friendly companies in the investing universe.
- The company defended its dividend in previous downturns.
- However, BP is likely to cut its dividend in the ongoing downturn.
The global recession that has resulted from the coronavirus has triggered numerous dividend cuts, particularly in the vulnerable energy sector. Even Royal Dutch Shell (RDS.A) (RDS.B), which had not cut its dividend since World War II, threw the towel and slashed its dividend by 66% in this quarter. As the vast majority of the shareholders of BP (NYSE:BP) are holding the stock for its generous 9.7% dividend, it is only natural that they have become worried about a potential dividend cut. In this article, I will discuss why BP is likely to cut its dividend this year.
The spread of coronavirus has caused a severe global recession. To provide a perspective, the global economy is expected to contract 3% this year whereas it contracted just 0.1% in 2009, in the worst financial crisis of the last 80 years. The global demand for oil products has plunged due to the lockdown in many countries and the collapse in air traffic. Consequently, the price of oil slumped to a 20-year low in the second quarter, though it has retrieved part of its losses lately. Moreover, the refining marker margin of BP slumped to a 10-year low in March.
All these factors have created a perfect storm for BP. The oil major will suffer not only from the depressed oil and gas prices and refining margins, but also from its reduced production. Due to the production cuts that OPEC and Russia have agreed, the oil majors will be forced to cut their production in many countries. In addition, some growth projects of BP have been delayed due to the pandemic.
The results of BP were daunting even before the peak of the pandemic. In the first quarter, its earnings slumped 67% over last year due to the suppressed oil prices caused by the outbreak of coronavirus. Commodity prices were much worse in the second quarter. It is thus natural that BP is expected by analysts to lose $0.08 per share this year. Due to all these headwinds facing the business of BP, Morgan Stanley recently stated that it expects the company to cut its dividend by approximately 50%.
While all the above headwinds do not bode well for the dividend, BP has repeatedly proved that the dividend is its top priority, even under the most adverse business conditions. In fact, BP has proved one of the most shareholder-friendly companies in the investing universe. It is remarkable that the dividend yield of BP has remained above 5.0% over the last five years.
In 2010, BP was forced to suspend its dividend amid public outrage, after its catastrophic accident in the Gulf of Mexico. However, it resumed paying dividends just three quarters after that accident, the worst accident in the history of the oil industry, even though the accident resulted in excessive liabilities.
The next downturn for BP was the collapse of the oil price from $100 in mid-2014 to $26 in early 2016. During the three-year period, 2014-2016, BP reported an aggregate loss of $0.5 billion or $0.15 per share. However, the oil major maintained its generous dividend, which amounted to $18 billion throughout that period. In other words, BP paid that excessive amount to its shareholders even though it did not make any profit during that period.
The reluctance of BP to cut its dividend in these two fierce downturns is a testament to the commitment of its management to defend the dividend even under the most adverse conditions. It would thus be natural for some investors to conclude that the company will behave in the same way in the ongoing downturn, which has been caused by the pandemic.
Unfortunately, this is far from true. BP is as shareholder-friendly as it gets, but its dividend policy and the excessive liabilities from its accident in Macondo have taken their toll on its balance sheet. Since the accident in 2010, BP has paid $67 billion for its liabilities. This amount is 78% of the current market cap of the stock ($85.9 billion). Even worse, the oil giant is still paying appreciable amounts for that accident every year. In 2019, nine years after the accident, BP paid $2.4 billion (24% of its earnings) for the accident. The company expects to pay another $1.0 billion this year. Therefore, the accident continues to burden the cash flows of BP significantly.
Moreover, BP has accumulated an excessive amount of debt over the last decade. In the last 12 months, its interest expense has slightly exceeded its operating income ($2.32 billion vs. $2.28 billion), while its net debt (as per Buffett, net debt = total liabilities - cash - receivables) currently stands at $146.0 billion. This amount is nearly twice as much as the market cap of the stock and about 15 times the earnings of the company last year and hence it is excessive.
As mentioned above, BP is expected to lose $0.08 per share this year. Given its high debt load and the fact that its current dividend amounts to $7.6 billion per year, it is evident that BP will struggle to maintain its current dividend. Even worse, unlike the previous downturns, the ongoing downturn is associated with much higher uncertainty, as the duration and the severity of the pandemic are unpredictable. The pandemic will almost certainly subside from next year thanks to a potential discovery of an effective vaccine but BP will need to burn ample cash to maintain its generous dividend.
Before the pandemic, BP had stated that it intended to sell assets worth $5 billion until mid-2021. Management recently reaffirmed its commitment to these asset sales but also stated that it may not be able to achieve its goal due to the downturn caused by coronavirus. BP will certainly be better served to avoid selling assets during a recession, as the transaction price will inevitably reflect the underlying business environment.
Moreover, in the latest earnings presentation, the management of BP was very careful in its statements regarding the dividend. Management reiterated its commitment to grow the shareholder distribution but only in the long run. It also stated that the Board of Directors meets every week due to the pandemic in order to evaluate the strategy of the company, including the dividend policy. It is thus evident that a dividend cut is under consideration.
BP is still attractive
While a dividend cut is always a negative development for income-oriented individuals, investors should not conclude that BP is unattractive if it cuts its dividend. Even if BP slashes its dividend by 50%, it will still be offering a 4.9% dividend yield.
Even better, the pandemic will not last forever. There are many vaccine studies underway and a vaccine is likely to be discovered early next year. Consequently, the pandemic will subside and the energy market will recover the latest from next year. It is remarkable that the oil market has already discounted part of a recovery, as the oil price has rallied to a three-month high of $36. When the pandemic subsides, the demand for oil products will recover towards last year's levels and the oil price will return to higher levels. In fact, the oil price will recover well before the fundamentals improve, as always. It is thus reasonable to expect the stock of BP to return to the level it was just before the outbreak of coronavirus, around $40, the latest in three years from now. If this occurs, the stock will offer a 40% return without including its dividends. Moreover, as soon as the oil price stabilizes at higher levels, BP will gradually raise its (reduced) dividend. To cut a long story short, those who believe that the pandemic will attenuate from next year will be well served to remain invested in BP.
BP has repeatedly proved that it is one of the most shareholder-friendly companies in the investing universe. However, thanks to its extremely generous dividend policy and the excessive liabilities it has incurred from its major accident and the downturn in the energy market between 2014 and 2016, the oil major has accumulated an excessive debt load. As a result, it is likely to cut its dividend. It is also worth noting that BP does not have an extraordinary dividend growth record to defend, as it had suspended its dividend in 2010. Therefore, it is likely to cut its dividend in order to strengthen its financial position in the current downturn. On the other hand, the stock of BP remains attractive and is likely to highly reward those who can wait for the pandemic to subside.
This article was written by
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