With the current oil crisis dragging on far longer than initially anticipated, many big oil dividend stocks such as BP, Chevron (CVX), and Royal Dutch Shell (RDS.A) are offering tantalizing high-yields.

However, given the capital intensive nature of this business, the cyclical nature of the industry, and the unpredictable nature of crude and natural gas prices, many income investors are understandably concerned about just how safe these big oil dividends are.

Let’s take a look at BP’s business model, balance sheet, risks, turnaround plans, dividend profile, and valuation to see why this is one oil giant that is probably best avoided for conservative investors living on dividends, except perhaps by the most risk tolerant dividend investors.

BP – Business Description

Based in London, BP is one of the largest integrated oil and gas companies in the world with sales in excess of $225 billion last fiscal year. BP has three business segments: upstream oil & gas production, downstream (refining, lubricants, fuels, and petrochemicals), and its 19.75% stake in Rosneft, the Russian oil giant.

In the most recent quarter, BP was able to hold the line on total oil equivalent production of 2.26 million barrels per day, but lower oil prices resulted in much weaker year-over year profits. This left it up to the downstream business to do the lion’s share of generating actual replacement cost profits (profits after including cost of replacing inventories).

However, that segment was hit by falling refining margins due to too much supply of refined fuels and petrochemicals; courtesy of the epic supply glut the world is experiencing.

Business Segment Replacement Cost Profit % of Profit
Upstream $29 million 2.1%
Downstream $1.513 billion 107.2%
Rosneft $246 million 17.4%
Corporate -$376 million -26.6%
Total $1.412 billion 100%

Source: BP Q2 2016 earnings supplement

Business Analysis

BP, and its European cousin Shell, have long been behind their American cousins Exxon (XOM) and Chevron when it comes to operating efficiencies. This means that their overall profitability is lower, putting them at a disadvantage when it comes to industry downturns. During these challenging times, maximizing cash flow and minimizing costs becomes imperative.

As seen below, BP scores the lowest marks of the group for each of the key profitability and efficiency metrics.

Company Operating Margin Net Margin Return On Assets Return On Equity Return On Invested Capital
BP -3.1% -2.7% -1.9% -5.3% -3.12%
Royal Dutch Shell -2.9% -2.0% -1.3% -2.6% -2.09%
Chevron -2.3% -0.6% -0.3% -0.5% -0.39%
ExxonMobil 5.5% 4.5% 3.1% 6.1% 5.11%
Industry Average 0.7% -1.4% -0.9% -2.0% NA

Source: Morningstar

That’s not to say that BP hasn’t been hard at work over the last two years slashing costs as it’s raced to adapt to a world of much cheaper energy prices. Capital expenditures are expected to be down 30-40% compared to BP’s peak spending in 2013, and cash costs are projected to decline by $7 billion from 2014 through 2017.

BP

Source: BP Investor Presentation

These actions are greatly helping BP lower its production costs, which management believes will help the company immensely improve its free cash flows in the next five years from -$1.4 billion in the last 12 months to as much as $7 to $8 billion by 2020, even with $50 per barrel oil.

That’s courtesy of the new emphasis on slower declining production projects which the company has refocused its drastically smaller capital spending budget on. These projects, which include liquefied natural gas, or LNG export terminals in Oman and Indonesia have lower decline rates, and thus require less annual maintenance capital investment to continue producing consistent cash flow at a reasonable return on investment.

That’s especially true given that over 80% of its future projects are already under construction and have anticipated gross margins above its current portfolio average. This explains how BP is planning on both boosting production and margins simultaneously while investing the least of all the major oil giants.

Note, however, that past 2020, once these major projects are operational, the company’s supply of low hanging fruit for cost cutting and cost effective growth will be gone. In addition, most of the company’s refineries are located in Europe, where overcapacity and import threat from America are likely to keep pressure on downstream margins in the future.

And don’t forget that BP’s recent finalizing of its 2010 Deepwater Horizon disaster will also result in the company paying a remaining $22.2 billion in legal fees over the next 17 years; or $1.3 billion per year. That will serve as an unfortunate albatross around the neck of future dividend growth, likely putting any increases many years down the road.

Speaking of which, the 2010 Macondo oil spill brings up just one of the several major risk factors that investors need to keep in mind before buying shares of this battered oil giant.

Key Risks

There are three main risks to be aware of with BP.

First, BP’s terrible safety record, which culminated in 2010’s Deepwater Horizon rig explosion that killed 30 and injured well over 200, was far more extensive and systemic than its peers.

 

For example, prior to the disaster, which management expects to ultimately cost the company $61.6 billion, the company had received 760 fines from OSHA, the Occupational, Safety, and Health Administration. In contrast Exxon, which many analysts consider the best run major oil company on earth, received just one.

BP has made meaningful and necessary efforts to improve the safety of its equipment and employees.

BP

However, given that the largest new oil fields being discovered are in deep offshore, and that ultra deepwater production is expected to be the fastest growing source of oil in the coming decades (according to Rystad Energy, an oil & gas consulting firm), there is always the risk that BP will eventually revert to its more lackadaisical safety systems.

The second major threat to BP, and especially its dividend, is of course the unpredictable nature of oil prices.

As you can see below, the world has been in a massive supply glut of crude for several years now. This has resulted in record high inventories of oil that, even once demand begins to outstrip supply, will take years to work off.

BP

In fact, even if long-term demand outstrips supply by one million barrels per day, it would take about 8.5 years to work off the current inventories in developed nations alone.

That isn’t to say that oil prices will languish at $50 per barrel or so for all of that time. After all, oil prices are largely based on futures markets, which are forward looking. Prices could jump past $60 if the current glut becomes a large enough deficit.

However, there is a major wildcard in the mix, one that has bedeviled all attempts to predict when the crash would end – US shale producers.

Shale producers both big and small have made amazing strides at using new drilling techniques. These include using horizontal drilling, longer laterals, multiple frack stages, and as much as 20,000 tons of frack sand per well to increase production and lower costs.

This is largely why, with oil now at $50 per barrel, we’re seeing the number of US drilling rigs climbing in eight of the past 10 weeks. In other words, the risk is that US oil companies have become so efficient that they can profitably produce oil at even today’s prices.

With over 3,900 drilled but uncompleted wells, mostly in US shale formations such as the massive, prolific, and low cost Permian basin, US oil production could literally increase

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