Is BP’s (BP) 6.7% Dividend Yield Safe?

BP Company About to Cut Its DividendThe oil industry is drowning in a sea of $40.00 oil.

You don’t need an MBA to figure out energy producers are earning less money on each barrel of crude they haul out of the ground. As a result, these companies could soon be forced to cut spending, slash dividends, and abandon buyback programs.

Case in point: BP p.l.c. (NYSE:BP). Last week, the energy giant posted dismal quarterly earnings, significantly underperforming against even the dismal estimates of most analysts. (Source: BP, last accessed August 7, 2015.)

Just how bad is the outlook for the company? And what does it mean for investors?

The primary issues BP faces at the moment are dividend sustainability and capital growth. While it is determined to preserve its dividend even in this environment of low crude prices, the company’s operating cash flow is insufficient to maintain dividend payments and the capital spending budget.

Cash flow in the first half of this year is down almost 50% compared to last year, from $16.1 billion to $8.1 billion. (Source: BP, last accessed August 7, 2015.) BP’s strategy so far has been to suspend or write off unprofitable projects, sell assets, and refinance debts in an effort to maintain that dividend.

But how long can such a strategy last?

Profits declined in the second quarter to $1.3 billion, a significant slump from the $1.7 billion estimated by analysts. Adjusting for the Deepwater Horizon liabilities, net losses were $6.3 billion. (Source: BP, last accessed August 7, 2015.) Capital investment dropped by 20% to $4.7 billion, as compared to the same quarter last year.

Upstream operations profits shrank to only $228 million, down from $4.05 billion last year and $372 million in the first quarter of 2015. (Source: BP, last accessed August 7, 2015.)

BP faces a serious crisis, where it must cut expenses to maintain dividends while adjusting to a low-price environment.

“Oil prices will be lower for longer,” says CEO Bob Dudley, and BP faces issues far greater than its global rivals. (Source: Bloomberg, last accessed August 7, 2015.) The company is concentrating on investment discipline, operating performance, asset sales, and dividends in an effort to streamline its operations. In an admission of dark times ahead, BP says that it expects reduced refining margins and lower levels of turnaround activity in the third quarter 2015.

In perhaps its most telling indicator of how it perceives the future, BP again slashed its full-year capital expenditure plan to under $20.0 billion, after having already lowered it by 13% earlier this year. (Source: Financial Times, last accessed August 7, 2015.)

How did this happen? And what does it mean?

The main reasons for BP’s woes are of course low oil prices. But there is also this quarter’s $10.8 billion expense stemming from the 2010 Deepwater Horizon oil spill in the Gulf of Mexico. Total projected expenses and liabilities related to the Deepwater Horizon spill are in the ballpark of $55.00 billion. (Source: The Wall Street Journal, last accessed August 7, 2015.)

While plenty of analysts have given the all-clear signal concerning 2010 oil spill liability issues, this is an optimistic oversimplification at best and in any case part of a grimmer picture.

The amount BP will ultimately have to pay as a result of this event is subject to extreme uncertainty, with the final exposure and cost to BP contingent on several key factors. At present, it’s not possible to reliably measure these future obligations in terms of cost. In accounting terms, they are being reported as contingent liabilities.

What does this mean? Capital expenditure is being slashed across the board.

In late July, BP announced it was suspending its exploration and production campaign in Libya, writing off approximately $600 million. (Source: Bloomberg, last accessed August 7, 2015.) The company cited the lack of safety due to the ongoing civil conflict, and inadequate infrastructure damaged by previous fighting.

On August 4th, BP confirmed its cancellation of exploration activities off the coast of Uruguay. (Source: BP, last accessed August 7, 2015.) The reasoning is simple; it’s just not economical to gamble cash on prospective new wells which BP does not have the funds to develop in any case.

Also to consider is the reduced profits from BP’s 19.75% ownership of Rosneft, Russia’s national oil company, which is itself facing both low oil prices and western sanctions.

The result of all this is that BP is caught between the proverbial rock and a hard place. It has massive liabilities issues, a hemorrhaging cash flow issue, and is seeking to keep its shareholders happy.

Where the company is headed is anyone’s guess. But make sure you steer clear of its stocks.