Why BP plc’s Ambitious Dividend Policy Is Sustainable

BP plc (NYSE: BP  ) currently boasts an impressive dividend yield of 4.6%. This is not only significantly higher than what other Big Oil players are offering, for instance ExxonMobil's (NYSE: XOM  ) 2.70% and Chevron's (NYSE: CVX  ) 3.50%, but it is also a product of sustained generous increments in dividend payouts ever since the infamous 2010 Gulf of Mexico spill. The board hiked last year's dividend by 8.8%, and increased this year's first-quarter payout by 8.3%, outlining a clear pattern of continual dividend increases.

BP's dividend increments over the past year have not only hooked income investors, but also reeled them in, in droves. However, despite the promising prospect for income investors, more and more scrutiny is being directed toward the sustainability of BP's ambitious dividend policy. Sensibly, this scrutiny is derived from the fact that dividends are contingent on profit margins, an area that BP is not doing reassuringly well. While BP's upstream segment received a boost from rising crude oil prices in the first quarter, its exposure to the downstream segment continues to weigh heavily on overall margins. And despite BP's various asset divestments in the refining segment, investors still need stronger reassurance that the oil major will successfully circumvent the challenges in the refining segment and sustain its attractive dividend over the long term.

Weaknesses in the refining sector
High exposure to the refining sector is hurting not only BP, but other refiners as well. In addition to higher feedstock prices in the U.S. due to the narrowing WTI/Brent spread, and low demand for refined products in Europe due to a slackened economic recovery, the overcapacity in the global refining space has led to a supply gut, which has effectively suppressed prices levels for refined products and reduced overall industry profits.

Governments in different parts of the world continue to expand their existing refining capacity, including giving subsidies to select companies in order to allow them to counter the low-margin environment. In China, for instance, there are plans to add refining capacity this year and next year, despite its current 12 million barrels per day refining output outstripping domestic demand. In the Middle East, too, Saudi Arabia, which is predominantly focused on producing oil, started shipping refined products from its 400,000 barrel per day full conversion refinery complex in Jubail last year, signaling increased refining capacity in the Middle East and Asia.

Calculated divestments will sustain dividends
As earlier mentioned, BP has engaged in various asset divestments in the refining segment. It has been selling assets since the 2010 spill and sold businesses worth $22 billion in 2013 alone, which included underperforming downstream assets. This year and the next, it plans to unload an additional $10 billion worth of assets.

In addition, BP plans to cease operations in its 102,000 barrel per day Bulwer Island oil refinery in Queensland, Australia, by mid-2014, allowing it to sell the key asset or convert it into a fuel import terminal.

BP's well thought out divestments in the refining segment as well as its greater concentration in the higher margin upstream business will benefit shareholders, and here's why.

At the risk of stating the obvious, proceeds from the asset sales will be allocated to BP's bulging dividend purse. The bigger plot within this move is that BP will be able to sustain its dividends at a time when margins will be unpredictable, owing to the restructuring of the business to shift the predominant focus to upstream activities. This essentially means that BP will be able to buy time as it restructures and realigns its priorities. Moreover, increased demand for BP's stock—owing to the consistent dividends it will be able to issue from asset sales proceeds—will put it in a position to raise additional capital as and when needed through equity or even debt, enabling it to secure capital to allocate to the higher margin upstream segment.

Going forward, BP will be able to shift its focus on getting a slice of the demand for crude oil in Asia, which as earlier mentioned, has tremendously increased its refining capacity. The overcapacity in Asia, which translates into high demand for crude oil, means that oil players largely exposed to the upstream segment will be able to sell their crude oil at a premium, securing plum profits in the process. BP, which is headed toward heavier exposure to the upstream segment, will be able to enjoy these comfortably high margins from areas such as Asia, allowing it to sustain its dividends in the long term.

Foolish takeaway
In the short term, BP will be able to sustain its dividends through the proceeds it gets from its assets sales. In the long run, BP's deliberate rebalancing of its earnings mix to derive a bigger portion of earnings from the upstream business will allow the oil major to grow its overall margins at a relatively higher pace than now, thrusting it into a position to sustain its ambitious dividend policy.

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