BP: So What If It Cuts The Dividend?

by The U.K. Income Investor

Equinor, the Norwegian oil firm formerly known as Statoil, announced a dividend cut yesterday. I doubt the news comes as a shock to anyone given the times we find ourselves in. Heck, we even had a recent trip into the bizarre world of negative oil prices earlier this week. As usually happens when one dividend goes, focus then turns to the remaining members of the group. That typically means taking a good look at BP (BP) stock as far as British investors are concerned.

The key number to bear in mind is $20,500m. That’s the total amount of cash that BP will spend on its CapEx and dividend this year. I base that number on the revised $12,000m CapEx budget, plus its $8,500m annual dividend bill. On that basis I estimate the breakeven point for BP is a shade over the $50 per barrel mark. That’s the price at which it could probably cover cash outflow with the cash generated from its operating activities. It generated $25,700m last year with Brent at $64 per barrel.

We are obviously a million miles away from those prices at the moment. Brent crude currently trades around the $22 per barrel mark, while downstream conditions have also tanked because demand for end products has collapsed. Brent has averaged around $40 per barrel so far this year. Assuming that remains the case heading into 2021, I estimate it would cost BP north of $9,000m in annual operating cash flow compared to last year. It would therefore need to finance a circa $4,000m shortfall with respect to dividends and CapEx this year.

Balance Sheet

In the past, none of this mattered that much; everyone knows that energy is a cyclical business. It was only a few years ago that we entered the last price downturn. Typically, the majors like BP smoothed out this volatility as far as shareholder dividends were concerned. I note that the company has generated around $29,000m in retained earnings over the past fifteen or so years. Or put another way, it earned $29,000m more than it paid out by way of dividends during that time. I doubt most long-term shareholders really cared if some years were lean while others were plentiful.


This time might be different. BP’s projected cash burn is actually not too bad, but it entered the crisis more leveraged than its peers. Its balance sheet held around $77,000m in gross debt at the end of last year, albeit inclusive of $10,000m worth of lease liabilities. I have that equal to around 2x last year’s cashflow after netting out the cash pile. It’s hard to see how that is commensurate with its current credit rating should net debt increase further.

On the plus side, BP retains ample liquidity. It had around $21,000m in cash and equivalents at the end of last year, enough to cover short-term debt maturities and this year’s dividend. I estimate that its dividend and debt maturities amount to around $32,000m out to 2021. It stated that it had around the same amount in cash and undrawn credit facilities at the end of 1Q20.

Finally, BP expects to receive around $6,000m from asset sales this year – mostly from the sale of its Alaskan business to Hilcorp. That is hitting a snag as the buyer is struggling to raise finance in the current environment. Needless to say, if BP does manage to realize that cash then it will go someway to bolstering its finances. That said, it would not surprise me to see a dividend cut on the basis of the above.

Valuation

With all that said, here’s why I don’t actually care if BP does end up temporarily cutting its dividend. The company’s reference conditions pivot on a Brent crude oil price of $55 per barrel (real terms, 2017), as well as assumptions about its refining margins. Anyway, BP reckons it was on course to generate around $23,000m in pre-tax free cash flow next year under these reference conditions. Let’s call it $14,000m or so after taking tax into account.


Needless to say, that type of cash generation more than covers its annual dividend bill. More precisely, we’d be looking at somewhere in the region of $6,000m in annual surplus cash flow. Although this is just guidance, it doesn’t strike me as particularly fanciful. BP already generated $10,000m worth of free cash flow last year, albeit with an average Brent oil price that was around $6 per barrel higher than its reference. It will realize over $1,400m or so each year simply through reduced payments relating to the Gulf of Mexico oil spill a decade ago.

Anyway, that $55 per barrel is more like $62 per barrel after taking into account inflation. All things considered I think it represents a reasonable mid-cycle figure. In some years it will be more, in other years it will be less. Overall, BP covers its dividend with change left over debt reduction, share buybacks, and so on.

The shares currently trade for 315 pence each on the back of a 34 pence per share annual dividend. Cut or no cut, there is a good chance you will get your investment back within a decade. If it also commands a mid-cycle valuation of 10x free cash flow, then you are looking at a share price north of 550 pence. If you can stomach the short term ugliness in the energy patch, then you should do well from these levels.

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