Bright Future Despite Lower 1H Results
BP p.l.c. (NYSE:BP) reported lower earnings in the second quarter and first half of 2023. This should not come as a surprise with the Brent crude marker price (CO1:COM) averaging $79.66/bbl in the first half compared to $107.94 in 1H 2022. Similarly, BP’s refining marker margin averaged $26.40 in 1H, compared to $32.20 in 1H 2022. Natural gas was lower as well, with the Henry Hub marker at $2.77/mmbtu vs. $6.06 last year. All these marker prices spiked following Russia’s invasion of Ukraine, but fell back to pre-war levels as it became clear Russia would find ways to get their product into the global market. Slow recovery in China from pandemic reopening also suppressed demand.
Despite the lower earnings, BP declared a mid-year dividend increase for the second year in a row. The company will now pay a quarterly dividend of $0.4362/ADS, up 10% from the previous level of $0.3966. Since the large cut at the start of the pandemic in 2020, BP has grown the dividend by a CAGR of 11.5% over the last 3 years, although it remains 29% below pre-pandemic levels. This is a similar reduction from the pre-pandemic dividend as Shell (SHEL), although Shell made a deeper initial cut and regrew it faster. US majors Exxon Mobil (XOM) and Chevron (CVX) did not cut their dividend in 2020 but have grown it much slower since then at a CAGR of 1.5% for Exxon and 5.4% for Chevron.
Along with the dividend increase, BP also announced buybacks of $1.5 billion in the third quarter after completing net buybacks of $4.5 billion in the first half. At first glance, the total amount of capital return may look aggressive. The company has stated they would spend 60% of surplus cash (free cash flow + divestment proceeds – dividends) on buybacks, yet surplus cash was only $2 billion YTD including a negative value in the second quarter. In line with the low surplus cash, BP’s net debt also grew in 2Q, up $2.5 billion from 1Q and $0.9 billion from a year ago.
While the capital return activity looks aggressive based on 1H results, it really signals confidence in the second half of the year. This is justified based on commodity prices, cash outflow timing in the first half, and company operations.
First, the commodity price environment looks supportive. For Brent, the CME futures curve only dips to $84 by year-end, still nearly $5/bbl above 1H actuals. Other forecasters, such as Trading Economics, show Brent increasing for the rest of the year, hitting levels in the $90’s by early 2024.
The higher price forecast seems justified with demand growth finally kicking in. Goldman Sachs (GS) estimated global oil demand at 102.8 mmbpd in July with demand exceeding production by 1.8 mmbpd in the second half. On the supply side, OPEC is showing discipline, and while production in the US is nearing records, it is expected to come back down as rig counts are back down to levels seen only during the pandemic or before 2017.
Second, BP had some unusual cash outflows in the first half that will not recur in the second half. BP’s annual fines payment of about $1.2 billion for the Gulf of Mexico spill was paid in 2Q. The company also spent a similar amount acquiring Travelcenters of America.
Finally, on the operational side, BP is now guiding for production growth in 2023 compared to last year. The company has started producing at new oil projects in the Gulf of Mexico and India in 1H. The second half will bring an LNG expansion in Indonesia and a production from a new field in the North Sea. BP is also doing well in its ongoing operations, already hitting its 2025 production cost goal below $6/boe. Actual costs were $5.94/boe in 1H, down 9.1% from last year. On the green energy side, BP grew EV charging, both in capacity and utilization. Charge points increased 70% from a year ago while electricity sold increased 170%. The company remains disciplined in its renewables growth. As mentioned on the earnings call, BP is investing in offshore wind in Germany, where the electricity can be used internally at refineries and charging stations. Other projects where there is less synergy, such as on the east coast of the US, are being deferred or renegotiated.
With these cash flow drivers in place, the ability for BP to cover its expanded dividend and buybacks in the second half appears more likely. Still, the company could do a better job of communicating its capital return policy, as it often draws questions from analysts on the earnings call. It’s worth going over the details so that we can show that the latest dividend and buyback announcement is not inconsistent.
BP’s capital return policy was rolled out at the time of the 2020 reorganization and remains officially unchanged.
One source of confusion is in the various price sets used to formulate the capital return policy. The first price set referenced defines what is meant by a “resilient” dividend. As stated in the policy, BP expects to have enough cash flow to cover the dividend when Brent is at $40, the refining marker margin is at $11, and Henry Hub natural gas is at $3. BP wants to maintain a margin of safety for the dividend if prices stay low for an extended period, rather than raise the dividend too much only to have to cut it later as it did in the early 1990’s, in 2010 following the gulf coast oil spill, and in 2020. Extra cash generated when Brent prices are above the $40 level is therefore directed to debt payoff and buybacks.
In setting dividend increases, BP refers to a different, $60 Brent price set. At those prices, buybacks should reduce the share count enough so that the dividend per share may be increased 4% per year while still being covered if the oil price goes back down to $40. The 11.5% average annual dividend increases the company actually did over the last 3 years is not inconsistent with this policy as the price environment above $60 Brent has allowed the company to reduce share count at a faster pace. Additionally, improving the company’s cost structure also enables faster dividend increases in a given commodity price environment.
The next area of confusion is around the definition of “surplus cash flow” and the dedicated 60% / 40% split between its usage for buybacks and debt reduction. The surplus cash flow applies to the current full year period, which explains why buybacks continue following the low surplus cash flow in the first half. As discussed in the first section, there are several reasons for the company to be confident about surplus cash flow expanding in the second half.
Finally, we have to clear up what is meant by “strong investment grade credit rating” as it pertains to BP’s desire to continue reducing debt. The policy states “Target further progress withing an ‘A’ grade credit rating.” On the 2Q earnings call, the CFO explicitly stated that BP has no intention to pursue an AA rating. That suggests the policy of using 40% of surplus cash flow used to pay down debt has a limited forward life. While the company may be happy with an A+ rating, they clearly intend to maintain some net debt. Once that point is reached, we can expect even faster buybacks and/or dividend increases as long as the price environment results in some surplus cash generation.
Following these guidelines within the expected pricing environment, I expect BP to continue growing the dividend by at least 10% per year and reach pre-pandemic and even pre-spill dividend per share numbers before the end of the decade. This should be manageable even with the company’s increase in renewables in the second half of the decade.
Financial Model Update
I have updated some of the assumptions in the model I last used in my February article. First, I increased the hydrocarbon margins for 2023 based on a Brent price of $81.70/bbl. This is an average of 1H actuals and the futures curve for 2H. The full year assumption is up from $77 in my last model. I also increased the Brent price assumption to $75 in 2024 and 2025 even though the company is still using $70. I also increased the assumed interest rate on debt to 5.5% and explicitly subtracted the $1.2 billion annual gulf spill payments from cash flow. That does not affect income as the total cost of future fines was accrued years ago when the fines were announced.
I am being extra conservative in my estimate of when the company stops reducing net debt, despite the announcement this quarter that they would not seek an AA rating. I still allow net debt to go to zero before reallocating the free cash flow to higher dividends and buybacks. For this reason, the large bump in dividends could happen earlier than 2028 as shown in the model.
As in the past, the model calculates a book value for the company each year by adding net income minus dividends and buybacks. It also calculates a share count from the buyback value. Finally, I estimate a price/book value for the company correlated to return on equity levels. This allows the share price to be estimated.
The results show that BP stock price reaches $69.31/ADS in 2030. This is less than my last model result due to the higher interest rates and gulf spill fine impact on cash flow. Dividends grow at 10% per year until 2028 when the net debt goes to zero, allowing a large increase in dividends. Total return comes out to 13% per year annualized. This is based on a starting share price of $36.90 and a 7 year, 5 month period from 8/1/2023 – 12/31/2030. Net debt ratio hitting zero in 2027 allows for a large bump in the dividend in 2028. While this is one year later than in my last model, the $3.78 dividend possible in 2028 is higher than the previous record of $3.36 paid the year before the gulf spill.
BP is still on track for growth despite the lower price environment in the first half of 2023. The recent dividend raise and buyback announcement demonstrates the company’s confidence in not only a commodity price recovery but also its delivery of hydrocarbon and green energy projects. The company has clearly not abandoned oil and gas and has indicated they will invest responsibly in clean energy only when the returns are sufficient.
My latest financial model update which is more conservative with its specific subtraction of cash flows for gulf oil spill fines still shows an attractive total return of 13% per year through 2030. The expected oil and gas price environment should allow dividend growth of at least 10% per year until debt targets are achieved, with an even bigger increase afterward.