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A Slick Look at BP's Dividend

Monday, June 14, 2010 | Costas Bocelli

As I continue to watch the video footage of the oil spewing from the broken riser pipe, dumping thousands of gallons of petroleum into the Gulf of Mexico daily, it pains me to see the severe environmental and economic damage it is leaving in its wake.

BP, the primary company responsible for the accident, has made several attempts to plug the leak that is over 5,000 feet below sea level.  As I write this, on day 51 of this disaster, the attempts have not been successful.

Relief wells are being drilled to intercept the damaged pipe, which should be the permanent solution to ending the leak.  The problem to this solution is that it takes time to reach the extreme depths of the well.  The estimated date of a permanent solution puts it in the month of August.

Since the day of the disaster on April 20, the cost of the accident has exceeded $1.4 Billion.  BP’s stock (SYM: BP) has lost over half of its market capitalization in weeks.  The total costs are unknown, but based on a permanent plug in August, the costs will easily exceed $3.0 Billion.

These costs do not include litigation judgments and economic reimbursements.  The truth is, no one knows what the total cost incurred to BP will be.

BP is a very strong, well capitalized company, with over $20 Billion in annual profit.  The company boasts one of the most coveted dividends in the marketplace.  As of today, BP distributes $3.36/year in disbursements to its shareholders, or $10.5 Billion annually.  The payouts are on a quarterly basis of $0.84 every 3 months.

Investors' main concern, which is currently being highly debated in the media and political circles, is whether BP will cut or suspend the dividend payments to shareholders until the final costs can be quantified to ensure payment of all claims can be fulfilled.

The dividend payment is so significant that it accounts for over 13% of all dividend payouts on the entire FTSE 100 Index in the U.K.  Many pension funds and fixed income investors rely heavily on these payments.  So, this decision is very important on many levels, and can have significant implications.

The U.S. Government is putting extreme pressure on BP to suspend these payouts, and wants the company to use these proceeds to cover the costs first.  The quarterly dividend equals $2.6 Billion in disbursements.

The question that needs to be answered: Will BP cut the dividend?

To answer this question, one only needs to look at the options market in BP.  The options market looks into the future to derive its values, as options are a time valued contract based on specific expiration dates.  The options market must take into account five major inputs.

The five major inputs are: stock price, strike price, expiration date, implied volatility premium, and carry cost.

The carry cost, usually the input that can be predicted with reasonable certainty, has become the wild card input in BP.  The carry cost of the strike price is comprised of the risk free interest accumulated minus dividend disbursements due.

What the options market is telling you in regards to the answer ...

BP’s stock on Thursday afternoon is trading at $32.46 per share.  If you look out to the BP January 2011 30 strike Calls and Puts, you may find the answer.

Jan 2011 expiration is in 225 days.  The risk free interest rate carry is 0.86% on the 30 strike, which is about $0.16.  If BP continues paying the regular quarterly dividend of $0.84, that would capture 2 payments, which is $1.68.  From this, the carry cost of the 30 strike is interest minus dividends, or ($1.52).

Knowing what the cost of carry on the strike roughly should be, you want to look at the reverse-conversion market on the Jan 2011 30 strike that is actually trading in the market.  The reverse-conversion market is simply the carry cost market, which is the difference between the actual stock price in present day, 32.46, and the synthetic stock market created from the corresponding Put and Call value on the Jan 2011 30 strike.

The Jan 30 Call is trading for 7.95 and the Jan 30 Put is trading for 6.10.  The synthetic stock price is 31.85 (Synthetic stock formula is Call minus Put + Strike price).

The synthetic stock price, 31.85 minus the current actual stock price, 32.46 equal ($.061).  So, the reverse conversion carry cost market is trading at a large discount, far different than ($1.52). 

This is your confirmation that the market believes BP will be cutting the dividend before the next announcement date of July 27 from the BP company website.

What is the probability of this happening?

Based on the smart money moving the Calls and Puts this much in the options market, the odds are greater than 50% that there will be some type of adjustment to the dividend.  The options market is pricing the Calls and Puts as if the dividend is payable at $0.30 per quarter instead of the current $0.84 per quarter.  That puts the probability in the 65% to 70% range of a dividend cut.

In the near future you will find out how BP will handle this very sensitive issue and difficult decision.  Do they appease the U.S. Government and make an adjustment to the dividend, which will infuriate the shareholders, or does BP hold firm?

Based on BP’s decision making process during this entire ordeal, I will bet the options market gets it right.
Costas Bocelli signature
Costas Bocelli
Contributing Editor
Channel Trading Secrets
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