The Deepwater Gunashli platform, offshore Azerbaijan. Source: BP website.
As the saying goes, something that looks too good to be true usually is just that. In the oil sector, BP (BP +1.24%) stands out among its peers for its unusually high dividend yield. BP's dividend stands at 5.8%, which is well above ExxonMobil's 3% yield. BP's payout even beats its European peers. Royal Dutch Shell yields 4.9%, which is still almost 100 basis points below BP.
In the stock market, the companies with the highest dividend yields in their sector often face unique risks that have pushed their stock prices down, and by extension, their dividend yields up. BP is no exception to this. Its business is under pressure from the downturn in oil prices, as well as a significant investment in Russian oil production that separates it from its peers. Fortunately, BP has received good news on each of these fronts recently, which could help alleviate any concerns about its dividend.
Strong earnings with a surprise contribution
Investors should take comfort that BP released fourth-quarter earnings that widely beat analyst expectations. The company lost $4.4 billion last quarter, due to the crash in oil prices. For the year, earnings per share fell 65% to $2.63 per share in 2014. But despite that, BP still generated $32.8 billion in operating cash flow last year, up significantly from $21.1 billion in 2013.
One reason BP's cash flow held up despite the collapse in oil prices over the past several months is its diversified business model. BP is an integrated major, which means it conducts upstream (exploration and production) as well as downstream (refining) businesses. Refining tends to do better when oil prices decline, because refining margins typically expand, which increases profitability. This helped the integrated giants like BP, ExxonMobil, and Royal Dutch Shell stay afloat during a horrible climate for energy companies. BP's downstream segment produced $1.2 billion in profit before interest and tax last quarter, up hugely from just $70 million in profit in the same quarter in 2013. This helped offset a 41% decline in upstream profits.
BP's earnings last quarter were also boosted by a surprise $470 million profit from its equity investment in Russian oil producer Rosneft. According to Reuters, analyst expectations called for as much as a $750 million loss from the Rosneft stake. Rosneft was a major source of uncertainty for BP over the past several months because of the increasing geopolitical risk of energy companies doing business in Eastern Europe. BP made a major commitment to Russian oil by taking a 19% stake in Rosneft. In its earnings report, BP management stated that Russia is a challenging geo-political environment, but reiterated its commitment to Russia, because it's the largest oil and gas producer in the world.
BP is equally committed to its dividend
BP management knows how much its investors count on the dividend. BP generated $9.9 billion of free cash flow last year, and with that cash flow, it distributed $5.9 billion to investors in dividend payments last year. BP sports a very high dividend yield, but it's a very good sign that its dividend is sufficiently covered by free cash flow. This indicates that the company can continue to support its dividend with its underlying operations, and even grow the dividend over time.
Indeed, after suspending its dividend in the aftermath of the 2010 Gulf of Mexico oil spill, BP has steadily grown the dividend since then. BP has delivered five dividend increases since it reinstated its payout in 2011, and its dividend growth rate is a satisfactory 7% per year in that time frame.
While investing in the energy sector seems like a scary thought, with the price of oil falling approximately 50% from its peak last year, it seems BP's dividend is sustainable. The company's oil exploration and production business was significantly pressured last quarter, but its downstream business is helping to blunt the impact of collapsing oil prices. In addition, BP's investment in Rosneft is positively contributing to its cash flow, and not serving as a huge anchor, like most analysts had assumed.
For these reasons, income investors have little reason to worry about BP's 5.8% dividend yield.
