Jeremy Warner: BP's dividend looks safe enough

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The Independent Online

Outlook So far, so good. The bumper profits reported by oil companies for last year, fuelled as they were by the sky-high oil price, were plainly not going to last into these recessionary times, so there had been fears that even the mighty BP would succumb to the dividend-cutting trend set by the rest of corporate Britain, depriving investors of yet another once-trustworthy source of income in an increasingly income-scarce world. The evidence of yesterday's first-quarter figures is surprisingly reassuring; the payout may survive intact. Yet that's a big "may".

The $2.6bn cost of the quarterly dividend is just about covered by earnings, but not by cash flow once stock gains are stripped out, forcing BP to borrow more in an effort both to sustain the payout to shareholders and to maintain a decent level of capital expenditure.

Obviously, if the oil price deteriorates further, then the company could be in trouble supporting this approach. Fortunately for investors, there are a number of reasons for believing both that this won't happen and that BP may be able to manage its way through the volatility even if it does.

First, oil futures are indicating that the price of oil could soon be rising again, albeit probably by not very much. This is not because of green shoots. To the contrary, BP's chief executive, Tony Hayward, is not optimistic about prospects for a recovery any time soon. He's planning on continued decline in worldwide industrial production, though at a slower pace than we have seen to date, for the remainder of this year. Rather it is because of the likelihood of further cuts in oil production by Opec.

Second, costs are falling across the board. Since 2007, the company's cost base has fallen from $32bn to $28bn, and there is plenty more momentum where that came from, both in terms of the company's own efforts to improve its operational performance and massive price deflation in the supply chain. Previously squeezed capacity has given way to a glut.

On one level at least, the downturn has been good for oil companies. Scarcity in the supply of services and equipment has been transformed into a state of massive oversupply.

It wasn't that many years ago that $50 a barrel would have been considered a relatively high oil price, even in the midst of a boom. What's happened since then is that the costs of extracting oil from the ground have inflated massively.

Maintaining production at current levels also requires exploration and development in ever more inhospitable and environmentally sensitive places. Producing oil in the quantities demanded has simply become a whole lot more expensive.

Yet in every cloud there is a silver lining. The recession is causing these cost pressures to ease somewhat. Assuming the oil price holds good, the outlook for BP for the remainder of this year is therefore one of steady earnings improvement. Last year's bumper returns when the oil price reached nearly $150 a barrel have gone, possibly never to return.

Third, BP is operationally a much better run company than it used to be, with production now growing strongly – it would have grown even more, but for the Opec cutbacks – and improved capacity utilisation in downstream activities.

Unlike the giants of the mining world, which became caught up in the hyperbole of the super-cycle, the oil majors were generally more cautious in approach during the boom. From bitter experience, they knew that high commodity prices wouldn't last. Oil companies are accustomed to managing extreme volatility in the price of what they produce, and had therefore prepared themselves better for the downturn. Unlike the miners, they also eschewed top-of-the-market mega deals.

And fourth, debt gearing at BP is still a relatively modest 23 per cent, which leaves a lot of headroom for further borrowings before there's any hint of trouble from the bankers.

Concern over the BP dividend looks overstated. Despite the challenging environment, BP aims both to carry on investing in its peerless reserve replacement ratios and improving dividend payouts. There seems to be every chance it will succeed. In any case, BP shares on a dividend yield of 8 per cent would seem a manifestly better investment than 10-year gilts on 3.5.