BP's(LSE: BP) 7.1% dividend yield seems incredibly tempting, but here are three reasons to be concerned about the stock's dividend safety.
Break-even oil price raised
Firstly, the oil giant currently doesn't generate enough cash to pay for its generous dividend policy. With the price of crude oil trading just above $55 a barrel, BP needs to borrow cash and sell assets to fund shareholder payouts.
What's worse is BP now needs the oil price to be around $60 a barrel in order for it to balance organic cash flows, compared to earlier guidance of $50-$55 a barrel. And that's despite roughly 20% of its dividends being currently funded by the issuance of new ordinary shares via BP's scrip dividend programme.
This means that although the price of Brent crude oil has risen by almost 10% since OPEC agreed to curb output in December, the pricing environment remains challenging. BP's dividend isn't in danger of an imminent cut, but nor can the company continue to issue new shares, sell assets and borrow more cash indefinitely. Although these measures can stave off a dividend cut in the short term, they can reduce the company's long term earnings potential.
Recent spending spree
BP has made some big acquisitions in recent months, and this acquisition-led growth strategy could drive up costs. In the past three months alone, the company has agreed on deals worth more than $4bn, including its acquisition of a 10% stake in Abu Dhabi's largest onshore oilfields, and stakes in offshore licenses in Mauritania and Senegal held by Kosmos Energy.
Over the past year, BP has started eight major upstream projects, the largest number for more than five years. Looking forward, the oil major expects to add a net 800,000 barrels of oil equivalent per day to production by 2020. And in order to meet this target, BP plans to increase capital expenditure this year to the higher end of its previous guidance of $16bn-$17bn, at least level with or up from $16bn in 2016.
But while it's good to see the company invest in future growth once again, I'm concerned that management may be getting ahead of itself. BP is still currently unable to generate organic free cash flow, yet the company is borrowing cash to invest at a time of great uncertainty.
Falling downstream earnings
In recent years, BP has relied on the downstream side of the business to shield it from falling oil prices. That's because the 'customer-facing' business generates the stable cash flow needed to pay off debt and maintain its dividend payouts.
Recently though, its downstream fortunes have started to reverse, meaning BP is losing much of this vital buffer against weak oil prices. And it's also because of this that BP missed analysts' forecasts for its fourth quarter profits on 7 January.
Its break-even oil price doesn't leave a lot of room for manoeuvre. Investors may point to the solid balance sheet as a reason to be optimistic, but the company cannot increase its financial leverage indefinitely. Should oil prices drop back below $50 a barrel again, there could be renewed pressure on the firm to cut its generous payouts.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended BP. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.