BP's Dividend Cut Was Painful, But Better Days Are on the Horizon

The oil and gas industry has been one of the most heavily impacted from the coronavirus. Not only have commodity prices been under pressure because of a global supply glut, but the pandemic wreaked havoc on global demand. As a result, oil prices have sunk to under $40 per barrel in the United States. Weak oil prices have led to multiple dividend cuts across the oil and gas industry, even from global super-majors. The most recent example was a 50% dividend slash by U.K.-based BP plc . While a dividend reduction is never welcome by investors, the move was necessary for BP as the company struggles to keep profits afloat. With the dividend cut in the rear-view mirror, BP still sports a high forward yield of 7.5%. Even better, the reduced dividend level will enjoy much better coverage, while allowing BP to invest more heavily on growth and improve the balance sheet by paying down debt. As a result, BP's painful dividend cut and corresponding drop in share price could represent a buying opportunity. Tough Times Lead to Steep Losses BP is one of the largest oil and gas companies in the world. It is a fully integrated company and operates in two segments: upstream and downstream (mostly refining). BP has greatly improved its portfolio via the addition of low-cost reserves and has markedly increased its production in recent years. However, the oil major is now facing a perfect storm due to the pandemic, which has caused a collapse in global demand for oil and refined products. These challenges have been clearly reflected in the company's poor earnings reports to start 2020. In early August, BP reported financial results for the second quarter of 2020. Due to the collapse in oil and gas prices, as well as refining margins, BP reduced its production by 3.3% over last year's quarter and swung to a loss of $6.7 billion, reversing a profit of $2.8 billion in the same quarter the previous year. BP saw some improvement in its business in the weeks since its earnings report, thanks to a modest recovery of oil prices, though refining margins remain suppressed. Low oil prices and suppressed demand are lingering headwinds that are expected to remain for the rest of 2020, and perhaps into 2021. Therefore, the near-term picture remains highly uncertain for BP, and all the global supermajors for that matter. Investors should expect continued volatility in the short run. But the company is taking steps to right-size its production and improve its balance sheet, actions that will be beneficial in the long-run. Dividend Cut: Painful But Necessary Along with its second-quarter earnings report, BP announced a 50% reduction in the company's quarterly dividend. Going forward, BP will pay a quarterly dividend of $0.315 per ADS, equating to an annualized payout of $1.26 per ADS. There were many reasons for the dividend cut, including the steep operating losses to begin 2020, as well as a need to invest in new areas and also pay down debt. But despite the dividend cut, BP has solid long-term growth prospects. BP grew its output by 10% in 2017, 8% in 2018, and 4% in 2019. Since 2016, it has brought 23 major projects online and has another 12 major projects in its pipeline. Thanks to the ramp-up in projects, the company can add 0.9 million barrels per day to its production base, when the energy market recovers. The new reserves have 35% greater cash margins and 20% lower development cost than base reserves. Moreover, BP drastically reduced its operating expenses. It expects job cuts and other measures to create $2.5 billion in savings by the end of 2021. These actions are met with a renewed focus on capital discipline. BP now invests only in projects that are profitable below $40 per barrel. BP's various cost-savings measures, including the dividend reduction, all have the goal of preserving cash flow, which is a sound policy in a recession. BP simply cannot continue to lose billions of dollars each quarter and remain a viable business. It also needs to deleverage, and has made progress in this regard. For example, net debt at the end of the quarter was $40.9 billion, $10.5 billion lower than in the first quarter. BP's gearing ratio at the end of the quarter was 33.1% compared with 36.2% at the end of the previous quarter. Improving the company's balance sheet by paying down debt will benefit the company by lowering its annual interest expense, and improving coverage of the dividend. Analyst estimates call for BP to report a full-year loss of $1.60 on a per-share basis. Next year, BP is expected to return to profitability with positive earnings of $1.51 per share. Therefore, the revised dividend payout of $1.26 per share is likely to be sufficiently covered for 2021 and beyond, assuming continued recovery in earnings-per-share. Although the dividend cut was difficult, BP stock still provides a high yield of 7.5%. This is a strong yield in an investing climate of extremely low yields and rock-bottom interest rates. BP is therefore an appealing stock for income investors, and even more so now that the dividend is once again covered by underlying earnings. Final Thoughts After having incurred two fierce downturns in the past decade -- the oil spill in the Gulf of Mexico and the collapse of oil prices since 2014 -- BP is now facing a fiercest downturn in the energy market due to the pandemic. As a result, the stock is trading near a 20-year low. As BP has greatly improved its portfolio with low-cost reserves and we expect the energy market to begin to recover from next year, BP stock has become a potential buying opportunity.

BP's Dividend Cut Was Painful, But Better Days Are on the Horizon

BP has become an appealing stock for income investors.

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