Plunge in Oil Price Expected to Pressure BP's Dividend
BP (BP) has the most delicate balance sheet of any of the oil majors, and its leverage finished 2019 above the high end of management's target range.
Following last week's unexpected plunge in oil prices, which we believe has potential to keep oil near $35 per barrel or lower (below the firm's breakeven point) for the foreseeable future, BP's lack of balance sheet capacity puts greater pressure on its dividend.
Therefore, we are downgrading BP's Dividend Safety Score from Borderline Safe to Unsafe.
The chart below shows BP's gearing ratio, which divides the firm's net debt by its net debt plus equity to show how much of its financing comes from debt. Companies with lower gearing can afford to add more debt to their balance sheets during industry downturns until the commodity price environment improves.
BP's gearing ratio has increased from about 16% in 2013 to 31% at the end of 2019. Management previously targeted a gearing range of 10% to 20%. Rather than take more aggressive actions to improve BP's balance sheet following the 2014 oil crash, management opted to raise its gearing target to between 20% and 30% instead.
Source: Simply Safe Dividends
For comparison, Exxon and Chevron's gearing sits below 20%, and Royal Dutch Shell's ratio was 25% last year. BP's gearing is even worse if lease debt is included (we think it should be), reaching 35.3%; Shell's gearing hits 29.3% with leases.
While Exxon and Chevron can temporarily afford to borrow tens of billions of dollars during this downcycle to protect their dividends without taking their gearing beyond 30%, BP has nowhere to go if $35 per barrel oil prices persist for long.
In 2019, BP reported that its breakeven oil price to cover capital spending and dividends was $55 per barrel. Brent oil averaged $63 per barrel, helping BP generate about $28 billion of operating cash flow.
This results in about $4 billion of retained free cash flow after covering BP's $15 billion of capital expenditures, $8 billion dividend, and $1 billion of annual payments related to its Gulf of Mexico oil spill going forward.
However, in 2018 BP stated that its post-tax earnings swing $2 billion to $2.5 billion for every $10 per barrel movement in oil. If the price of oil remains near $35 per barrel this year, then BP's cash flow could fall by about $5 billion to $7 billion, all else equal.
BP would then have a cash flow deficit to plug, and its balance sheet can't afford to take on incremental debt. Other companies are able to cut back non-discretionary capital spending in this environment, but in 2016 BP said $15 billion to $17 billion of annual investment was needed to sustain production.
With the firm's spending already at the low end of that range ($15 billion), it's hard to imagine BP having many levers to pull without sacrificing future production.
The company does have some asset divestitures in the works to help its balance sheet, having announced $9.4 billion of sales but only received $2.8 billion of proceeds so far.
BP hoped to deliver an incremental $5 billion of divestitures by mid-2021, but the current oil price environment could make this a tall task and perhaps even jeopardize some of its existing agreements.
Even if most of the already announced deals go through, the proceeds won't make much of a dent in BP's $55 billion adjusted net debt balance after covering this year's projected cash flow deficit (barring a major improvement in oil prices).
Prior to the oil price cash, BP saw a path to improve its pre-tax free cash flow generation to about $15 billion by 2021 as a number of major projects ramped up production. But this assumed a Brent oil price of $55 per barrel.
Management was also banking on a $1 billion free cash flow contribution from BPX Energy, a shale producer BP acquired for $10.5 billion in 2018. However, U.S. shale is in the crosshairs of Russia and Saudi Arabia's market share war, perhaps jeopardizing this target.
Source: BP Investor Presentation
Simply put, the economics of some of these projects are unclear at $35 per barrel oil, and 2020 was expected to be a transition year anyway with minimal production growth to help offset lower prices.
BP believed its breakeven point could fall to around $40 per barrel in 2021 if everything works out, but even that would not be enough to cover the dividend in today's environment, much less make progress on improving the balance sheet.
In February 2020, CEO Bernard Looney discussed the company's three highest priorities and stated that his job was to deliver on all of them:
"Every conversation that we have had with the owners of our company comes to three subjects typically. Get your gearing down, get it back in range, make sure that dividend is protected and sustained, and please do something in the energy transition.
Now depending on where you are in the world and depending on who you're talking to, the order of importance varies. Sometimes people want, first and foremost, to be on the energy transition, sometimes people only want a dividend. But in almost every conversation, all three have been present. And our job is to deliver on all three."
However, the oil market's unexpected turn could force him to make a hard decision on the dividend, and protecting the balance sheet should arguably be the first objective in this environment. Conservative income investors may want to look elsewhere for yield.
