Is BP plc (ADR)’s 7.7% Yield Safe?

Oil Prices in FreefallA few months ago, I heard from a friend who had purchased shares of Denbury Resources Inc. (NYSE:DNR).

He figured the Texas oil producer would be a great investment. He backed up the truck and bought the stock last week “for the high yield,” which at the time was about nine percent.

The big payout apparently didn’t faze him, but it should have. What happened next underscores the most important lesson of income investing: stocks with supersized yields often come with supersized risk.

On Monday, September 21st, citing the impact of falling crude prices, Denbury announced that it would suspend its dividend payments starting in the fourth quarter. The move, management said, will save the company $22.0 million per quarter, which will be used to pay down debt. (Source: Denbury Announces Suspension of Dividend, Denbury Investor Relations, September 21, 2015.)

Is BP plc’s Dividend Safe?

It’s not the first time investors have been seduced by a big yield. Earlier this summer, Chesapeake Energy Corporation (NYSE:CHK) said it was getting rid of its dividend. More recently, Transocean Ltd (NYSE:RIG) announced plans to cut its third- and fourth-quarter distributions.

These cuts should not have shocked anyone. In the face of lower oil prices, energy producers are in a desperate need to conserve cash. The scary part is; more dividend cuts could be looming in the oil patch.

Case in point: BP plc (NYSE:BP).

Profits are the most obvious concern. Assuming oil prices at around $50.00 per barrel, the company is expected to generate $2.01 in earnings per share. However, the company is committed to paying out $2.40 per share in dividends annually.

Those numbers don’t add up. British Petroleum cannot maintain both its current dividend and keep the balance sheet intact. Even if management were to cut the dividend in half once again, the company’s payout would still be beyond its means.

This would be bad enough. However, business continues to deteriorate. Oil prices are in freefall, sitting at $43.00 per barrel at the time of writing. And last quarter, the company was dinged by an additional charge related to the 2010 Deepwater Horizon oil spill.

BP stock bulls will point out the company generated over $11.0 billion in cash flow during the first half of 2015, more than enough to cover the $3.4 billion or so paid out to shareholders as dividends. The problem is the oil business is enormously capital intensive. BP needs to pump billions of dollars into its business each year just to maintain current production, let alone grow operations.

Sources and Uses Chart

Source: BP 2Q 2015 Results Presentation

At current levels, BP’s dividend is not covered by free cash flow. Distributions, therefore, need to be funded from debt. The company should be able to sustain payments in the near-term. But if the oil price remains below $80.00 per barrel for more than one year, then management will have to choose between cutting the dividend or slashing capital spending.

Shareholders lose in either scenario. The market is betting on a dividend cut. Based on the prices of long-term options, traders see BP cutting its dividends by 15% by the end of the year.

Is It Time to Bail on BP?

Bottom line; if oil prices don’t rebound soon, income investors should be prepared to see their dividend payments cut once again. Personally, to protect the balance sheet, I would like to see the payout eliminated altogether. However, that might send too many income-focused shareholders running for the exits.

That is, if they haven’t exited already.

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