The Fundamentalist: BP pays dividends

LONDON (ShareCast) - If you are a contrarian investor, oil giant BP is not the investment for you, as brokers have been queuing up to talk up the shares following the company's forecast-busting third quarter results.

Charles Stanley upgraded the stock from 'hold' to 'accumulate' after BP declared underlying third quarter earnings of $4.7bn that were comfortably ahead of market expectations of $3.2bn.

Killik & Co., meanwhile, said the results 'provided further reassurance that, in the current oil price environment, the attractive 6% dividend yield is sustainable.'

That 6% yield has now eased to around 5.7% after the shares reacted positively to the third quarter update, but it is still a return which knocks into a cocked hat the 3.3% return offered by the best easy access savings account I could find.

Of course, the BP dividend is not guaranteed, and the very fact that the dividend yield is half as high again as the 3.8% returned by the FTSE All-Share index is testament to the fact that the market reckons BP may struggle to maintain its dividends if events move against them.

BP's dividend cover is 2.0 on an historic basis, but is forecast to decline to 1.1, which means the market thinks the company will barely be earning enough next year to finance its dividend payments.

This does not preclude the possibility of BP borrowing money to maintain its dividend until better times arrive. Chief executive officer Tony Heyward has spoken of using 'the capacity of our balance sheet while the industry cost structure adjusts,'

If the market is wrong to worry about the sustainability of the BP dividend then for BP's dividend yield to move to the market norm of 3.8% would require the share price to rise from 574p to 861p. On the other hand, if it has got it right, the dividend yield could be adjusted down to 3.8% by a cut in the annual divi from 32.7p to 21.8p.

Which of the above two scenarios is more likely?

Not surprisingly, the answer depends on where you see the oil price moving in the near to medium term.

Back in February, BP chief executive officer Tony Heyward said: 'On the basis of our current plans, we expect 2009 cash flows to balance at an oil price of between $50 and $60 a barrel, with that break-even point continuing to reduce as upstream volumes grow, the full turnaround of the downstream is realised, and our ongoing cost initiatives deliver further benefits across all parts of the group.'

In the third quarter of 2009 the average realised price achieved by BP was $68.08 per barrel for Brent crude and $68.12 for West Texas Intermediate (WTI), comfortably above the $50-$60 break-even area, but well down on the $115.09 (Brent) and $118.07 (WTI) seen in the third quarter of last year.

The oil price since then has improved further still, while the group said it expects to cut more costs this year than it had initially planned, raising its full year cost savings target to $4bn from $3bn. Costs for the first nine months of this year were down more than 15% from last year, BP said.

Heyward certainly makes the right noises concerning the company's commitment to its dividend pay out. 'Our aim remains to strike the right balance for our shareholders between investing for the future, providing current returns via the dividend, and ensuring an appropriate and prudent level of gearing,' the BP boss said at a company presentation earlier this year.

Anglo-Dutch rival, Royal Dutch Shell, meanwhile, felt confident enough this week in its near-term future to lift its dividend by 5% to 42 cents a share, which possibly is a good omen for BP.

Longer term, BP has the mouth watering prospect of exploiting what it has called a 'giant' oil discovery at its Tiber Prospect in the deepwater Gulf of Mexico, which could hold more than 3bn barrels, though it is one of the deepest wells ever drilled in the oil and gas industry, which could present a few extraction problems.

It was also the only major Western oil firm to be successful in its first-round bid to develop an Iraqi oilfield. BP intends to spend up to $20bn with China National Petroleum Company on the 'supergiant' Rumaila field Iraq.

Next year, it intends to spend in excess of $1bn on drilling its two concessions in Libya, both of which are enormous, with one block the size of Kuwait and the other the size of Belgium.

This level of expenditure highlights another danger to the sustainability of the dividend. BP has to - sooner or later - invest to exploit these assets and when push comes to shove, if it needs to free up funds to do so then a high dividend yield will offer the tempting option of cutting the dividend, if only because it can pull the usual managerial sleight of hand of passing it off as 'rebasing' the dividend.