Rewind to the last week of January 2016 and the outlook for oil stocks such as BP (LSE: BP) was dire, to say the least. The price of oil had tumbled to just $28 per barrel, which was its lowest level in many years, and there were various doomsday predictions about just how low oil was headed.
Since then, the price of oil has soared. In fact, it is now almost 80% higher than it was at the end of January and while some investors saw such a rise coming, few predicted that it would take place over such a relatively short time period. All of a sudden, oil stocks such as BP are once again en vogue and the company’s share price has already risen by 17% since its 2016 low.
Of course, for income-seeking investors BP remains a rather difficult stock to work out. On the one hand, it has a fabulous yield which seems irresistible. BP currently yields an incredible 7.5% and has stated that it remains committed to making the paying out of dividends at their current level a priority over the medium term.
However, on the other hand, BP remains a very risky income play. The price of oil may have surged in recent months, but it could just as easily slump once again. The supply/demand imbalance which caused it to fall is still in place and while reduced investment and exploration spend across the industry may cause supply to fall in the coming years, we are still some way off feeling the true impact of those decisions.
Profits under pressure
Furthermore, BP’s profitability has come under extreme pressure due to the oil price fall and this puts its dividend in real doubt. For example, in the current year it is expected to pay a dividend of 27.2p per share, and yet BP’s earnings per share (EPS) is forecast to be just 12.9p. And even though BP is expected to more than double its EPS in the 2017 financial year, dividends are expected to account for almost 100% of profit. This situation may be acceptable in the short run, but is unsustainable in the long run.
Clearly, BP’s profit needs to rise at a brisk pace or else the dividends is likely to be cut. And the challenge for BP is that its profitability is largely dependent upon the price of oil, thereby limiting its ability to influence future profitability. Therefore, buying BP equates to at least some extent to taking a view on the price of oil, although even if oil falls BP could prove to be a sound income play.
That’s because with BP having such a high yield, even a dramatic cut in its shareholder payouts would still leave it with an impressively high yield. And with BP being generally financially sound and well-diversified, a downturn in the price of oil or even a lack of further rise could cause the company’s position to improve relative to its peers, thereby providing upbeat long term profit growth.
So, while BP is a comparatively risky income play, and there is a realistic chance that dividends will be cut even if oil remains at $50 per barrel, it remains a potentially appealing buy for income-seeking investors.