Where should you invest for income in the oil and gas sector? One option is to aim big and choose BP (LSE: BP), which offers a 6%+ dividend yield. But the BP share price has lagged the FTSE 100 this year as oil prices have weakened.
An alternative approach would be to focus on profitable mid-sized producers that are still able to ‘move the needle’ with new oil discoveries.
The obvious choice in this sector is FTSE 250 firm Tullow Oil (LSE: TLW). Tullow’s share price is up by 19% this year, thanks mainly to recent news of a “substantial and high value oil discovery” in Guyana.
However, its shares fell by 5% on Thursday afternoon, after the firm said it had been forced to scrap a $900m sale in Uganda.
In this article, I’ll examine each company’s income credentials and give my view on the latest news from both firms.
BP gets $5.4bn boost
During the 2014-16 oil market crash, BP boss Bob Dudley prepared the company for an extended period of lower oil prices. This effort is now paying off. Although oil prices have weakened this year, BP’s profits have remained stable and spending on new projects has been able to continue.
Production rose by 4% during the first half of the year and cash generation remained strong. A $5.4bn deal to sell its Alaskan assets should help to speed up debt reduction and support newer projects.
The BP dividend yields nearly 7%
Oil stocks have been hit by lower oil prices and economic uncertainty. Despite solid progress, BP shares are currently on sale at less than 11 times 2019 forecast earnings, with a dividend yield of 6.6%.
This year’s forecast payout of $0.40 is unchanged from 2018, but should be covered 1.3 times by earnings. Dividend cover is expected to rise to nearly 1.5 times in 2020, which suggests to me that we could soon see a return to dividend growth.
At current levels, I think BP shares provide good value for income investors.
Is Tullow a more balanced choice?
Tullow Oil’s Lake Albert project in Uganda is one of the firm’s biggest finds of recent years, with more than 1.5bn barrels of discovered recoverable resources.
The company and its larger partners, Total and CNOOC, had been due to make a final decision on investment later this year. However, Tullow’s smaller size and heavy debt load means that it couldn’t fund its share of development costs. So the three firms had agreed a $900m deal that would reduce Tullow’s stake from 33% to 11% and fund the firm’s future costs.
Unfortunately, the three firms haven’t been able to settle a tax dispute relating to the sale with the Ugandan authorities. So the sale deal has now fallen through and will need to be renegotiated.
Dividend risk?
I think Thursday’s news highlights the risks shareholders face from the firm’s net debt of $2.9bn, which is equivalent to roughly 10 times 2019 forecast net profit. By way of comparison, BP’s net debt is equivalent to about five times forecast net profit.
Tullow’s 2.6% dividend yield should be covered generously by earnings this year. But the group’s ongoing debt obligations worry me. If cash becomes tight, the dividend could have to be sacrificed (again).
I don’t think Tullow has the diversity or financial strength needed to be a good income buy. I’d rate BP as the better dividend stock.
