CEO Bernard Looney slashed BP’s shareholder payout during the pandemic and has not yet repaired the damage, despite reporting near-record profits this week.

Shares in this FTSE 100 heavyweight have now risen by 35% so far this year. That’s pushed BP’s dividend yield down to 4.2%, which is no better than the FTSE 100 average.

BP has always been a popular choice with UK dividend investors. But are the shares still a best buy for income? Here’s what I think.

A bulletproof dividend?

One thing I’m sure of today is that BP’s dividend looks pretty much bulletproof. City analysts expect this year’s payout to be covered six times by earnings.

That’s unusual for a slow-growing FTSE 100 business. Mature businesses usually pay out a higher proportion of earnings, to reflect their slower growth.

One possibility is that BP is pricing in the expectation of lower oil prices from next year. The latest broker forecasts suggest BP’s earnings will fall by 23% in 2023, as oil prices moderate. However, even then, the forecast payout would still be covered four times by profits.

Why I’m avoiding BP shares

I’ll be open. I’m not buying BP shares. Although I think the company’s dividend looks very safe, I think Looney is laying the groundwork for a less profitable future.

Instead of returning surplus cash to shareholders, he’s using BP’s record profits to repay debt and share buybacks.

I’m all in favour of debt repayment when times are good. But I’m less sure about buybacks. So far this year, BP has announced buybacks totalling $8.5bn. Interestingly, it’s almost exactly equal to BP’s capital expenditure so far this year of $9bn.

That seems remarkable to me. Energy production is a capital-intensive business, but BP is spending almost as much buying back its own shares as it is investing in long-term growth.

For me, the message is clear. Looney isn’t sure what the future holds for BP. But he’s betting that the company may be less profitable than in the past. Buying back shares now will shrink BP’s equity base, reducing the impact of lower profits on shareholders.

I might be wrong

Of course, I could be completely wrong. One concern shared by many people in the energy industry is that the current shortfall in new investment will mean that oil and gas prices stay high for a long time to come.

If that happens, BP shareholders could enjoy very strong results over the coming years.

Personally, I’m not convinced. Right now, the drive for net zero seems to have faded into the background due to concerns about oil and gas supplies. But taking a longer view, I don’t think the picture has changed.

In my view, the transition to renewable energy needs to continue. I suspect that BP knows this, hence its reluctance to invest in new long-term projects.

To sum up, I think BP’s current dividend looks very safe indeed. But I think growth may be limited and believe there are better options elsewhere for income investors.

Is that sustainable or might the shares fall back again? Figuring out the likely answer to that question could help me decide whether BP might be a good fit for my portfolio.

Why has the BP share price risen?

The obvious reason behind the rise in the BP share price is what has been going on in the energy markets. While oil and gas prices surging is bad news for most consumers, it is good news for profits at energy giants such as BP. Indeed, in its most recent quarter, BP reported a profit of $9.3bn.

That is roughly triple the $3.1bn it reported in the same quarter last year. In a capital-intensive industry like energy, profits can jump around a fair bit from quarter to quarter even in the ordinary course of business. But that is still a sizeable improvement in BP’s profitability.

Can that continue?

The answer largely depends on the energy price in my opinion. For now there are a lot of factors that could keep oil and gas prices high, from seasonal demand peaks in the northern hemisphere to supply constraints. But at some point, as is the way with a cyclical market like energy, I expect prices to ease off. If they fall far enough, I reckon the BP share price will follow.

Is now the time to buy?

Still, energy remains pretty lucrative for now. So, should I add some energy shares like BP to my portfolio?

I do not plan to, precisely because of the cyclical nature of the business. When energy prices are high, producers can effectively pump money out of the ground in large quantities.

But when that happens, often companies invest in new production capacity to take advantage of the high prices. As that comes online, supply starts to outstrip demand, pushing prices down. If that happens, profits at oil majors often falls. That could be bad for the BP share price.

So I do not think this is the point in the pricing cycle at which to consider adding BP shares to my portfolio. I think its high profits at the moment are primarily a reflection of where we are in the energy pricing cycle. At some point I expect prices to fall as part of that cycle.

Is BP the right oil major for me?

Even when that happens, I am not sure that BP will be a company I choose to invest in to get exposure to oil and gas.

Before selling this year, I held a position in Exxon. Unlike both Shell and BP, it did not cut its dividend during the pandemic. In fact it continued to raise it annually as it has done for over three decades, earning it the distinction of being a dividend aristocrat.

BP’s cut now looks premature to me given how buoyant the business performance has been recently. That has put me off the company’s management. So when the oil cycle dips again, if I do buy shares to try and benefit from that, BP would not be among them.

In parallel, fund managers and pension funds touted their own ESG credentials, proudly owning up to selling old-fashioned polluting businesses that they might have held for decades, and buying shares emblematic of a greener, brighter future.
 
It was remarkable demonstration of how — in a few short years — the attitude to what has become known as ESG issues (short for ‘environmental, social, and governance’) has changed the investment landscape.

Green is good. But warm is better.

Perennial Footsie stalwarts Shell (LSE: SHEL) and BP (LSE: BP), for instance, had come to be regarded as some sort of living dead: their balance sheets might be loaded with oil and gas fields, certainly, but these were surely assets in name only — full of oil and gas that would never be extracted. ‘Stranded assets’ was the term in use.
 
Turn the clock forward to today, and the picture is a little different. And you don’t need me to tell you why.
 
Oil and gas fields that companies were selling off have been retained. Shell has reversed its decision not to develop its Jackdaw gas field in the North Sea. It may yet change its mind regarding the as-yet undeveloped Cambo field off Shetland.
 
It’s the same all over Europe. Germany — which had planned to phase out the production of electricity from coal by 2030 — is now bringing mothballed coal-powered power stations back on-stream.
Those COP26 pledges? Keeping homes warm — and factories working — trumps greenery, it seems.

Unloved shares bounce back

Shares in Shell were changing hands at around 1,600p at the time of the COP26 summit. BP, 340p. Today, Shell shares are priced at 2,350p, and BP shares priced at 450p.
 
Even perennially unloved Centrica (owner of British Gas) is in on the action, with its shares up 50% in a year.
 
‘Stranded assets’? I don’t think so. Nor do I think that we’ll see a return of that phrase any time soon. The ESG activists will hate it, but governments know that energy security is vital. There’ll be green energy projects aplenty — but the lesson has been learned: fossil fuels are a handy backstop.
 
And, obviously, the shares of green power providers have benefited too — Greencoat UK Wind is up almost 25% since COP26, for instance.
 
But — critically — they weren’t mispriced due to ESG concerns in the first place.
 
All those fund managers and pension trustees must be feeling pretty sheepish.

Play it again, Sam

We’ve seen this movie before, of course — and with some of the same stocks. Back in 2016, resources stocks in general came under the hammer: mining stocks, oil and gas stocks, and the engineering and support companies that supply such businesses.

The reason? Slowing China demand, which could possibly be permanent. Prices crashed.

But — as I’ve written before — the whole sector soon seemed massively over-sold, and I loaded up.

I bought into BHP at 596p, Shell at 1,295p, IMI at 773p, and Weir at 777p, for instance.

Current prices? At the time of writing, 2,230p, 2,345p, 1089p, and 1,4421p — and that’s in today’s fairly-awful market. IMI’s high point for the last year is 1,878p, for instance.

The moral: when a sector is mispriced, bargains abound — for those adroit enough to spot them.

A cash machine

We all know how energy prices have soared recently – we can see it in our electricity and gas bills, as well as at the petrol pump – and BP has benefitted accordingly. Replacement cost profit (BP’s preferred measure) in the second quarter of this year was $8.5bn, up from $2.7bn for the same period last year. Operating cash flow was $10.9bn supporting the assertion made in November 2021 by BP’s CEO, Bernard Looney, that the company is “literally a cash machine”.

Energy prices

But the Brent crude oil price has been falling recently and is currently trading at a seven-month low of around $90 a barrel. Forecasting oil prices is more of a lottery than a science but few are predicting a downturn soon. The US Energy Information Administration believes Brent crude will average $95 a barrel in 2023.

The oil price is also “manipulated” by the oil-producing nations who will have no hesitation in cutting production if they see a drop in demand.

Returns to shareholders

BP is currently paying dividends each quarter and the dividend yield is presently a respectable (if unspectacular) 4.5%.

However, this is not guaranteed.

In 2020, following a second quarter loss of $6.7bn due to the Covid-19 pandemic and the collapse in the demand for energy, BP halved its dividend and it hasn’t recovered much since.

But it has recently commenced a $3.5bn share buyback programme, due to be completed by the middle of November, having committed to using 60% of its surplus cash to repurchase its own shares.

Downsides

But the energy business is a dangerous one that brings significant risks for shareholders.

In 2010, an explosion on Deepwater Horizon, an oil rig operated by BP, killed 11 workers and oil was still spilling into the Gulf of Mexico three months later. The disaster is believed to have cost BP in excess of $60bn. The share price crashed by over 50% and, even today, it’s 30% below its pre-disaster level.

Energy giants like BP are also unpopular.

There are repeated calls for windfall taxes to be imposed on their “excess” profits. Liz Truss has ruled this out, but these taxes are popular with voters.

Some argue that energy companies should be nationalised.

Clean energy

BP’s current strapline is “Performing While Transforming” as it seeks to re-position itself from carbon energy to green energy. It claims to be “reimagining energy” and is seeking to be a net-zero company by 2050.

But the world’s green energy transition will take decades, and the demand for oil is not expected to peak until at least 2028, some say 2040. Research by McKinsey forecasts peak gas demand to be in 2037.

Here’s what I am doing

So, am I going to add BP to my long-term portfolio?

Yes, because whether we like it or not, the demand for oil and gas is here to stay. Even at 445p, there appears to be scope for further share price growth and the dividend should help to reinforce this.

But what makes one income stock safer than another? There is a list of criteria that I’d follow to find the best dividend shares.

The list

First, I’d look for shares that offer an above-average dividend yield. The current average yield for FTSE 100 firms is around 4%. So I’d be aiming for something greater.

Next, I’d want to see affordable dividends. I don’t want to buy shares in companies that might cut their dividends any time soon. It can happen, especially if the business is uncertain about its future earnings.

As dividends are typically paid from earnings, I’d look for a dividend cover greater than one. Dividend cover is measure of affordability and it looks at how well a company’s dividend is covered by current earnings.

One factor that provides some comfort is how long a business has been paying dividends to shareholders. Ideally, the best dividend stocks will have a long history of distributing consecutive payments. Some established shares have a dividend record spanning multiple decades.

I’d consider that to be safer than a business that switches its dividends on and off like a light switch.

Lastly, I’d look for rock-solid balance sheets. I want my selection of dividend stocks to survive over many years. To do so, I reckon it needs to have low levels of debt and high levels of cash flow.

Which dividend stocks?

So let’s look at which income stocks meet my criteria right now. First, I’d consider energy giant BP (LSE:BP). With a forecast dividend yield of 4.5%, it’s one of the lowest-yielding stocks in my list.

That said, I also think it’s the safest. That’s because it has a particularly large dividend cover of 5.9x, implying it has more than enough earnings to be able to sustain its payout.

The energy sector is in focus right now. Russia’s war in Ukraine has led to the supply of gas and oil being severely restricted. As countries seek to diversify their energy sources, shares like BP could remain in demand for the foreseeable future.

Bear in mind that there are some risks of higher taxes on excess profits. That said, with the new UK Prime Minister in place, I think that is now less likely.

Also, if the world enters a deeper recession, lower oil prices are possible. In this scenario, BP’s earnings and cashflow could suffer.

One factor that gives me some comfort is that BP has a long history of paying dividends. In fact, it has been making regular payments for over 30 years. This level of reliability makes BP one of the safest dividend shares that I would buy right now.

Similarly, I’d also consider iron-ore miner Rio Tinto, which offers a whopping 12% yield and a rock-solid balance sheet. I’d also look at Phoenix Group Holdings. This pensions business is on an 8% dividend yield. I particularly like that it has 13 years of history. Six of these years even experienced back-to-back dividend growth.

Industry tailwinds

The short answer in my opinion is that, despite cresting to a new high, the BP share price could indeed keep rising. Although a number of factors influence the company valuation, I reckon that if energy prices move up much more from where they are today, that could well boost BP shares.

There is definitely reason to believe that energy prices could keep rising. During the pandemic a lot of companies slashed their exploration and development budgets. That is now coming home to roost, as supply has tightened. That is a long-term structural issue and could support high prices in coming years. On top of that, the war in Ukraine has led to dramatic changes in global oil supply. They could continue and may also contribute to even higher energy prices in future.

However, the opposite could happen. We have seen many times that oil is a cyclical business. Higher prices will reduce some discretionary demand for energy. Big producing countries may be tempted to pump more oil to take advantage of prices. An industry awash with cash and eyeing massive profits may restart mothballed projects, leading to increased production. That could push oil prices down, which I think would be bad news for the BP share price.

BP or not BP?

In fact, I reckon that the high BP share price seen today has more to do with the industry trends as a whole than the company specifically. Shell touched a price within 3% of its 12-month high today as well.

On that basis, if I was bullish about oil prices and wanted to expose my portfolio to the sector, I would consider whether buying BP shares was the best way to do it. After all, it demonstrated a willingness to cut its dividend during the pandemic while rivals like Exxon stuck with theirs. That is why Exxon is a Dividend Aristocrat unlike BP.

BP has also been trying to reshape itself into a much broader type of energy company rather than focusing just on fossil fuels. But I think the business model for some non-fossil-fuel energy sources remains unproven. That might mean that BP’s profit margins in the coming decade do not match those of some more focused rivals.

My move on the BP share price

So I do think oil prices may stay high and even rise more in coming months as winter bites. In that case the BP share price may move above the year high it hit today.

But I am more attracted to some rival oil companies with what I see as a more targeted strategy and better record of dividend maintenance. I will not be acting on the surging BP share price.

Profiting from a high oil price

Oil giant BP (LSE:BP) has seen its share price climb by over 14% in the past month. At the time of writing, the shares are trading at 446p.

For the three months to 30 June, the firm reported that underlying profit increased to $8.5bn from $2.8bn during the same period in 2021. In addition, revenue grew by 85% to $69.5bn.

Given these sparkling results, the business announced that it was paying a quarterly dividend of ¢6.006 per share. It’s also embarking on a brand new $3.5bn share buyback scheme, this is another indication that the company is in a strong financial state.

High oil prices essentially increase the value of BP’s produce. There’s risk, however, that this trend begins to fade as the market becomes better supplied with oil. This could lead to inferior future results for the business.

Regardless, BP’s net debt fell from $32.7bn to $22.8bn, year on year, while operating cash flow stands at $10.9bn.

With a total of £1,800 to spend on the shares in this stock per year, I may be able to purchase 400 shares in that time. With the current dividend payment at $0.22, this could give me $88, or £74. That’s equivalent to 4.1% of my initial investment and may be reinvested.

A global brand

Second, shares in Coca-Cola HBC (LSE:CCH) are up 24% in the last three months. For the six months to 1 July, the drinks manufacturer reported that revenue grew nearly 30% to €4.2bn.

Also, operating profit fell by 21.3% to €275.7m. What explains this decline? It was mostly caused by higher costs and the impact of inflation. Additionally, the company decided to suspend operations in Russia following the invasion of Ukraine.

Russia provided a not insignificant proportion of the firm’s sales, so this ceasing of operations naturally had a detrimental impact on revenue figures.

Despite this, investment bank Deutsche Bank upgraded the company, arguing that it still looked cheap. Indeed, it increased its price target from 2,525p to 2,600p.

My other £1,800 could buy me 86 shares in Coca-Cola HBC in a year. With a dividend payment of €0.71, this may equate to a payment of €61, or £51.

Added to the potential payment from BP, this could mean a total annual dividend payment of £125. I could use this to buy more shares in the future, thus gradually increasing my holdings in each stock.

Overall, these businesses could provide growth in the coming months and years. While both face different challenges, I’m quite confident that they can overcome these in the long term. With that in mind, I’m putting my money where my mouth is and investing £300 per month in these stocks.

That metric can be calculated by dividing capital expenditure (CapEx) by operating cash flow (OCF). In other words, it is the amount companies spend on new projects as a proportion of the money they make in a year from normal business activities.

A higher CapEx/OCF means a company is investing more for tomorrow. By contrast, a lower CapEx/OCF could mean a company is paying out big dividends and doing share buybacks at the expense of investing.

Beware of cannibals!

Paying out dividends and buying back shares returns capital to shareholders. However, when done unsustainably, this de-capitalises the company. Essentially, the firm cannibalises itself.

Unfortunately, this is a well-known problem in the oil and gas space. The great intellects of our time, like Greta Thunberg and that bearded bloke from Extinction Rebellion, have decreed that fossil fuels have no future, and should be outlawed by the end of the decade.

That sentiment makes companies in the sector understandably reluctant to spend billions on multi-decade projects to find and extract new supplies.

Peak oil could be far, far away

Despite all of the wind farms, solar panels and hydroelectric plants that have popped up in the last decade, 2021 saw more global demand for oil than any previous year on record.

That record won’t last for long: 2022 is on track to see an even larger quantity of the black, viscous liquid being demanded.

Some analysts even predict we may not see oil demand peak until 2040 — in stark contrast with those more starry-eyed forecasters who believe peak oil will arrive in just two years’ time.

Personally, I’m not hopeful that peak oil will come any time soon. If it seems like a challenge setting up electric vehicle charging points in the UK, imagine what it will be like in the Congo, where burning coal and firewood are the dominant energy sources.

The global population now stands at eight billion, with 85% of those people living in the developing world. If people in poor countries are to live like us in rich countries — which they have every right to aspire to — they are going to need to consume a lot more energy.

CapEx/OCF: Brits on top!

Looking at CapEx/OCF with trailing 12-month data, I find that Shell dominates the field, spending 38% of OCF on sustaining capital investments.

BP comes narrowly behind with 34%.

Interestingly, both of those UK-listed companies trounced their US-listed competitors, with one exception: ConocoPhillips came neck-and-neck with BP, investing 34% of OCF.

Chevron (24%), Exxon (23%) and Occidental Petroleum (22%) were the laggards of the pack.

A flaw in my analysis is that some of that CapEx spending will have been to branch out into renewable energy projects. I would have to dig further into the companies’ accounts to find out exactly how much was spent on sustaining the oil and gas side of their businesses.

So, what’s next for BP and should I be looking to add this stock to my portfolio?

Long-term performance

If I’d bought £1,000 of BP shares five years ago, today I’d have £995, plus dividends. Those dividends would actually have been pretty sizeable at around £200 over the five years. So, in terms of the share price alone, that’s not a great return, but the overall return isn’t too bad at all.

In fact, in the years leading up to the pandemic, BP was trading around 20% higher than it is today. And that could partially reflect the near $25bn dollar writedown on its assets in Russia. But it could also reflect a possible downturn in the oil market.

Outlook

BP’s share price is elevated from 2021 simply because oil prices have been higher this year. Its upstream, downstream and trading segments are all making more money.

In early August, BP said that underlying cost replacement profit — its preferred measure of profit — rose to $8.45bn in the second quarter from $6.25bn in the first and $2.8bn in the second quarter a year earlier.

The figure was well ahead of analysts’ expectations of $6.8bn, partially due to an “exceptional” oil trading performance.

But there’s a lot of uncertainty in oil markets right now. In fact, OPEC suggested last week that it looks like there might be a surplus of oil on the global market this year, and this could see it consider cutting production accordingly.

And these concerns were compounded on Monday as Chinese economic data renewed global recession concerns. The central bank in China — the world’s largest crude oil importer — cut interest rates as data showed the economy slowing unexpectedly in July.

In response, oil prices fell around 4%. Brent crude futures had fallen $4.75 to $93.40 a barrel by midday.

Some analysts have suggested that oil could fall even further. In fact, Citi suggested oil could fall as low as $60 a barrel this year amid forecasts of a global economic downturn.

Will I buy BP stock?

I’m bullish on oil in the long run, as I think we’re entering a period of scarcity with likely higher commodity prices and increased global competition. But I see oil falling this year as the global economy goes into reverse. As such, I won’t be buying BP shares now, but I’ll keep a close eye on them and will look for a better entry point later this year.

Is BP a good stock to buy for my portfolio today though? Let’s take a look.

Are BP shares worth buying?

To say that BP is doing well at the moment would be an understatement. With oil and gas prices at such high levels, the company is literally minting money.

This is illustrated by its recent second-quarter results, posted earlier this month. For the period, the company generated a profit of $8.5bn (its highest in 14 years) versus $2.8bn a year earlier. Meanwhile, operating cash flow was $10.9bn, up from $5.4bn a year earlier.

As a result of this strong performance, BP was able to pay down debt significantly, ending the period with net debt of $22.8bn versus $32.7bn a year earlier. On top of this, it raised its dividend by 10% and raised its share buyback programme to $3.5bn for the third quarter, from $2.5bn in Q1. All in all, it was a bumper set of results.

Low valuation and attractive yield

Yet this strong performance doesn’t seem to be factored into the share price. BP now trades at just four times this year’s estimated earnings per share. That’s a very low valuation. In other words, BP shares appear to be cheap right now.

Additionally, there’s a nice dividend yield here. With BP projected to pay out 22.8p in dividends for 2022, the prospective yield is around 4.5%. That’s attractive in the current low-interest-rate environment.

So, overall, there’s a lot to like about BP shares at present, in my view.

How long will the good times last?

The big question, for me at least, is how long these good times (i.e. high oil prices) will last. Because history shows that oil prices can rise and fall significantly, leading to boom and bust periods for oil companies like BP (and their shareholders).

My personal view is that the good times could last a few years. I say this because during Covid-19, oil companies globally dramatically cut back on traditional energy investments. This created a massive supply and demand imbalance and this is likely to take time to unwind.

However, I don’t expect them to last forever. And this creates issues for me as a long-term investor. Because when I buy a stock, I want to own it for at least five or 10 years, or even longer.

And looking out five or 10 years into the future, I have no idea what oil prices are going to be doing. They could be where they are today. Or they could be a quarter of what they. The fact that the world is making a major shift to renewable energy certainly creates uncertainty.

It’s worth pointing out that BP is making its own transition to renewable energy. And the massive profits it’s generating today will certainly help with this. However, this transition is still in its early days, and there’s no guarantee it will pay off.

My move now

Putting this all together, I’m happy to leave BP shares on my watchlist for now. All things considered, I think there are better, safer stocks I could buy today.