Oil major BP (BP) appeared front and centre in the investing news earlier this week. The company announced a headline grabbing asset write-down, which it will book in its 2Q20, that could top $17.5b. That came as the firm lowered its average price forecast to $55 per barrel out to 2050, or around $20 per barrel lower than its previous baseline figure. BP sees demand reduction from COVID and a shift to renewable energy as being the main drivers of that.
At first glance, none of that looks particularly good for those mulling an investment here. I suppose the first place to start is with the dividend, with a reduction looking more likely now. I doubt that comes as much of surprise to anyone but it is worth pointing out nonetheless. Indeed, the last time I covered the stock I made the value case irrespective of a cut.
Anyway, back to the dividend, which is in a more precarious spot due to the company’s debt load. In terms of some numbers, a $17.5b asset write-down would lower BP’s shareholder equity to around $70b. That implies a current gearing level of around 45% given that net financial debt stands at circa $55b. Suffice to say that this is way above the company’s target range of between 20% and 30%.
Imagine a scenario in which the dividend is cut by circa 50%. That would see BP retain an extra $1b each quarter compared to current levels of cash outflow. To get gearing back down to the 30% area, it would then need to reduce net debt by circa $15b. An extra $4b in annual retained earnings certainly helps, hence the strong chance that management will announce a dividend cut soon.
On the flip side, the company is already taking big steps to lower its cash outflow. It reckons it can generate cash cost savings of $2.5b by the end of FY21, and it has reduced annual capital spending to $12b. Those factors led the company to lower its cash breakeven point to circa $35 per barrel for next year. Note that is lower than the current Brent crude price of circa $40.70 per barrel. Granted, it cannot sustain such a low level of capital spending for too long, but as a response to low prices this seems normal.
If we throw cash from asset disposals into the mix, there is a pathway for BP to reduce gearing while still paying its current dividend. It has announced over $10b in divestments since the start of FY19, which comes out of a planned total of $15b by mid-2021. It has so far received around $3b of that. That leaves $12b left to go, though the timing of the actual cash inflow is obviously uncertain. I guess that amounts to a slim chance that management will soldier on without a dividend cut, but let’s see. It certainly wouldn’t come as a surprise if it happened.
The best way to think about a long-term investment here is to use mid-cycle conditions. For instance, last year offered up a mild low-$60s per barrel Brent crude price environment. BP posted $25.7b in cash from operating activities that year, while underlying replacement cost profit clocked in at $10b. I have the latter figure worth around 50¢ per share, equal to an earnings yield of around 12.5% right now.
Now, BP saw itself throwing off $14b in 2020 free cash flow (“FCF”) before COVID. That was based on its $55 per barrel reference conditions (real terms, 2017) and $15b in capital expenditure. Even if you factor in slightly higher levels of actual depreciation, it strikes me that BP is still a $12b profit business at circa $60 Brent. COVID has wrecked that price environment for now, but this is pretty much in line with how the company sees the next thirty years in terms of average oil prices.
In per-share terms, the above profit figure works out to around 50p at current exchange rates. A conservative 10x multiple would then see you back above 500p per share, and we can still expect some level of cash dividends on top. The current share price is just over 320p. Cut or no cut, that looks like an attractive medium-term proposition.
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