I make these points as a prelude to discussing the oil and gas giant BP (BP.) not to be melodramatic, but because this is the background that won't go away. The consequences of Deepwater Horizon will be with BP for a generation, so any discussion of the company's ability to sustain its dividend must begin with a reminder of the incident that has the enduring potential to enervate BP. And it needs to be couched in such emotive terms to understand why BP's enraged plaintiffs - backed by plenty of legal and environmental lobbying - will keep coming back for more and more.
Yet BP and its dividend is an interesting subject for income-seeking investors. As I said in last week's column: "For anyone wanting to take a 10-year view, buying BP's shares for little more than eight times earnings and starting with a 5.5 per cent yield may turn out to be good business." So how well does that suggestion stand up to examination? Well enough, but only for those who can live with more risk than is generally associated with investing for income.
Let's explain, starting with a digression. City analysts focus too much on the month-by-month sequence of events that comprises the legal action against BP and its fellow defendants, especially Transocean, which owned the Deepwater Horizon rig, and Halliburton, which provided the wellhead services. In particular, analysts' current obsession is whether any - or all - of the defendants will be found grossly negligent by a US federal trial that ended in April. The court may not even make a judgment, but if it did find against BP, then that could expose the company to bigger settlements and more claims.
Against that, BP is becoming more belligerent in its own defence. Reporting first-half results last week, its chief executive, Bob Dudley, railed against the "false and fictitious claims" being made on the fund BP set up to compensate victims of the disaster and against the "unethical and potentially criminal behaviour" in the way the settlement programme was being run.
It makes for good copy, but the point to grasp is that BP's profits and, more important, its cash flow will be hit for years to come by claims payouts. There is no question about that, even though BP has charged over $42bn (£27bn) to its profits for the cost of Deepwater Horizon and has fully funded a $20bn pot to pay claims. Because more claims than expected have flooded in and because they have been met at higher levels than BP anticipated, the fund is almost used up - $19.7bn has been earmarked for payment (of which $11.8bn has already been disbursed). Some time this quarter the fund will be empty, so future valid claims will have to be met by BP. Will those claims be so high as to endanger a dividend that - running at about 23p a year - is still only about two-thirds its rate before Deepwater Horizon?
Probably not, but it may be close run. After all, the Macondo blowout was a transforming event for BP. In the three years before, its pre-tax profit averaged $30bn a year and free cash flow averaged almost $10bn. In the three years after, average pre-tax profit shrank to just below $18bn and free cash flow was minus $1.1bn. That BP's finances remained intact despite the costs was because the company became a seller of assets - $31bn was raised between 2010 and 2012 compared with $8bn in the three years before the disaster.
But a company can't be a systematic seller of assets and be successful. BP needs to stabilise and return to generating cash at roughly its level pre-Deepwater Horizon if its dividend is to be sustainable around its current rate. Look at it this way: assume that the Deepwater-Horizon effect morphs into a regular cash charge - although a tax-deductible one - on BP. Assume also that the charge runs at about $2bn a year (on top of the $20bn compensation fund, surely enough to satisfy a fair few claimants). Meanwhile, the cost of a 23p dividend - the current annualised rate - is about $6.7bn. Add in another $1bn as a contingency and BP needs to produce almost $10bn free cash annually for the dividend to be safe; although BP's finances are sound enough to allow plenty of variation around that.
Happily, that's pretty much the level of BP's average free cash generation in the three years 2007-09. Can you make an investment on that simple basis? I have. Although Deepwater Horizon will encumber BP for a lifetime - and rightly so - I feel sufficiently relaxed about it to put £20,000-worth of BP shares into the Bearbull Income Portfolio.
