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BP Dividend Yield Enters 'Sucker' Territory

Jeremy Glaser

Jeremy Glaser: I am Jeremy Glaser with BP's dividend yields has risen as the stock has fallen due to the oil spill disaster in the Gulf.

I'm here with Josh Peters, Morningstar DividendInvestor editor to see if this is an attractive dividend play or if investors should look elsewhere. Josh, thanks for talking with me today.

Josh Peters: Good to be here.

Glaser: So, should dividend investors be looking at BP for its over 7% yield right now?

Peters: Actually, last time I looked the yields was almost 9%, and that included a little bit of a bounce in the stock today. So, I mean, really, this is the kind of yield level, where the market is not perhaps screaming opportunity – you know, opportunity to earn a huge income, and perhaps huge capital appreciation as well. It's more of a sucker yield type of territory, where the price has fallen so far that it isn't just that this disaster can cost BP a lot of money, but conceivably could also force BP to cut its dividend at some point. That's what's now being priced into the stock. So to look at buying the stock today, I mean, it's not like buying a utility or a food stock or anything else with a normal sustainable yield, it's really much more of a deep value play.

Glaser: So it might not really be suitable for all investors who are just looking for income?

Peters: Yeah, I think that you really want to set the income component aside, and to say, if everything works out, if BP can manage its way through this disaster without having to cut its dividend, and in fact, we think that that is the most likely case that BP because of its size will be able to fund both its dividend and all of the litigation and recovery costs and other expenses associated with this, but it's subject to a very wide range of outcomes.

And it's not a dividend that you necessarily want to count on. You don't want the dividend yield alone in this expectation of income to be the reason you would consider buying the stock. Instead, you might buy it, because you think it's cheap, because the market has overreacted. Stock now trades at a fairly large discount to our fair value estimate, but with that it comes with a great deal of uncertainty. And I think that that level of uncertainty is something that a lot of more conservative dividend-seekers would probably just as soon avoid.

Glaser: Are there any names in the energy space that maybe are not so uncertain, but still have a reasonable dividend yield?

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Peters: You know, it's actually kind of interesting, I mean, over the last five, six years, for the most part, energy exploration and production companies have generated just tremendous cash flows, because the oil and gas prices have been high, and they're still pulling oil and gas out of the ground that was relatively cheap to find and extract. But you can't really go into the industry, and find a huge number of very attractive dividend yields.

Most of the companies, and ExxonMobil is really the ultimate case in this regard, prefer to repurchase shares when they have a lot of cash coming in. And to a certain extent that makes sense, because you don't want to set your dividend at a level that you have to have $80 a barrel oil in order to pay it, and if oil goes to $40, then you have to cut it; that doesn't really work all that well.

But I think ExxonMobil and some of the other American companies tend to be at the other extreme, where they're paying a dividend that is a lot lower than they really could afford to pay even if the price of oil were to continue to come down, and that doesn't really serve shareholders all that well, either.

What you do have still is the opportunity to look at two of the other giant foreign companies, Royal Dutch Shell is one; yield is over 6%; so also with Total, the big French oil company. These companies faced some of the similar risk profiles that BP does, except that they don't have a current catastrophe with their name attached to it, but in general, we tend to look at those firms, Royal Dutch Shell, in particular a little more favorably, and you're getting the big yield that you can't get from an ExxonMobil here in the United States.

Glaser: So what other opportunities would there be within the energy space?

Peters: Well, my favorite investment opportunities in the energy area are the companies that really don't have a great deal of commodity price sensitivity. I mean, no matter what you do, if you are investing whether it's Exxon, Chevron, in BP for the long run, to a great degree their profitability is going to be a function of the price of a barrel of oil or the price of natural gas; these are kind of difficult things to predict, and I try to figure out, 'well, is there any other way of making money?'

And to me that's really the pipeline industry, more than anything else. I mean, these companies aren't pulling the oil and gas out of the ground, but they are moving it around instead, and when they do that, they are usually taking it on a fee basis. There is very little commodity price sensitivity. They charge by the barrel, mile of transportation. If energy prices are very high, they make crimp demand a little bit, but typically volume changes are very modest.

And most of these are what we call wide-moat businesses. You have a pipeline. It's very difficult to compete with it. Truck can't compete with it; rail can't compete with it in terms of cost; other pipelines, it's very difficult to get all of the permitting and siting required in order to build a competing line right next to an existing line. They tend to have very good economics. They are regulated, including some price regulation, but a pipeline like Magellan Midstream Partners, is one of my favorites, for example, is able to raise prices on an index that's actually tied to and better than inflation.

So for something like that to offer yield into the 6%s and in some cases into the 7%s also in the industry, I think, those are better plays for income investors. You are not taking that where-is-the-price-of-oil-going-to-go type of risk. You're really just betting on American's willingness and in fact need to continue to consume hydrocarbon forms of energy. And I think in the long run, there are certainly going to be challenges in that area, but over the next 10 years or even 20 years, America's going to be addicted to oil. That's just how the economy runs.

Glaser: Josh thanks for talking with me today.

Peters: Happy to be here.

Glaser: For, I am Jeremy Glaser.