The outlook for the oil sector is rather negative at the present time, with there being little sign of a sustained rise in the price of black gold in the coming months. As such, companies such as BP (LSE: BP) are seeing their sales come under severe pressure which, despite their best intentions, could realistically lead to a cut in dividends.
In fact, while BP recently stated that maintaining its dividend is a priority, shareholder payouts are expected to exceed earnings in the current year and be at roughly the same level as net profit next year. This means that unless there is a continued rise in BP’s bottom line in 2017 and beyond, dividends may be forced to fall so as to put BP in a healthier financial position for the long term.
However, this is not necessarily bad news for the company’s investors. That’s because, as well as improving the health of the company, a dividend cut could positively catalyse investor sentiment in the stock and push its share price up to at least 430p over the medium to long term. This may sound counterintuitive, but the market seems to be nervous regarding the sustainability of a number of oil companies, so BP placing its own finances above those of shareholders (in the short run at least) could make it a more appealing buy relative to its peers.
For example, if BP were to cut its payout ratio from 100% to 67% next year, thereby allowing additional capital to be made available for reinvestment, it would mean that the company trades on a yield of 5.2%. This appears to be rather generous for a company which offers the size, scale and earnings growth prospects of BP, since its bottom line is expected to rise by 12% next year for example. In fact, were BP to have the same yield as the FTSE 100 of 4%, its shares would be trading at around 430p under the lower payout ratio, which is 30% higher than their current price level.
Furthermore, BP’s shares would not be expensive at 430p, either. They would trade on a price to book value (P/B) ratio of just 1.07 which, considering how profitable BP is and the appeal of its asset base, would still indicate upside potential. Additionally, it would put BP on a price to earnings (P/E) ratio of 16.9, which is not a particularly high rating given BP’s expected rate of profit growth.
So, while the oil sector is a tough place in which to operate and there are challenges for incumbents such as BP, it does not necessarily mean that there are no capital gains on offer. Clearly, investors are not enticed by BP at the present time, as evidenced by its share price fall of 27% in the last year. However, with a low valuation, the scope to post excellent earnings growth and a yield which is likely to remain healthy even if dividends are cut, BP could mount a turnaround in the medium to long term and soar to at least 430p per share.