Many established industries are experiencing profound disruption. Incumbents must adapt to survive and not all will reinvent themselves successfully to remain dominant players in the future. The energy sector is a case in point, with a green revolution forcing oil majors to rethink how they do business. While London-listed energy giant BP (BP.) appears to now want to grasp the nettle with new green targets, there could be a treacherous road ahead for the company and its new chief executive.
Free cash flow to rise
Green transition has started
Reliance on oil and gas to continue
Last year could have been peak oil demand
Still paying off Deepwater Horizon
The company sees its recent revamp as a reinvention – another one – but the oil crash of 2020 has shown a splash of green spending does not mean it will cease to be a fossil fuel company any time soon. At the same time, greater take-up of electric vehicles and major decarbonisation plans mean oil demand will no longer keep climbing.
In 2018 , we moved BP to a sell recommendation. This was on the basis of it being “stubbornly unprepared” as the world slowly moved away from fossil fuel consumption.
Two years on, the company’s new chief executive, Bernard Looney, has said 2019 was possibly the historic peak for oil consumption. He has launched a major restructuring. This will see oil production decline while investment shifts towards renewables and other green endeavours instead of replacing oil reserves.
So what does this mean for shareholders over the coming years? BP has long been a reliable dividend payer, and a core income holding in many portfolios, alongside Royal Dutch Shell (RDSB). But the dividend was slashed in half in August, while brokers' earnings forecasts suggest it will be a long road back to 2019 profit levels.
The day before Mr Looney took over BP in February, he said the company’s “fundamental principles” would remain unchanged under his leadership, including a commitment to growing free cash flow. While the oil crash took the free cash flow growth goal out of his hands in the short term, consensus estimates compiled by FactSet see this climbing from $4bn (£3bn) in 2020, less than half of the 2019 figure, to almost $10bn in 2022.
This kind of growth should help underpin prospects for the payout, through the new policy of a 5.25¢ quarterly base dividend and 60 per cent of surplus cash going into share buybacks. But buybacks will only come after net debt has come down to $35bn, however. As of 30 September, it sat at $55bn. Broker RBC Capital Markets sees it staying above target until at least 2023, although asset sales could speed up debt reduction.
Despite committing to BP’s fundamental principles, Mr Looney has a mandate for change. The former upstream boss arrived at a time when oil and gas companies had started setting net zero carbon targets, and BP had already committed to operating in a manner “consistent” with the Paris climate goals in 2019.
The Paris Agreement contains a goal to limit global warming to well below 2 degrees, and ideally to 1.5 degrees, while net zero carbon means offsetting all carbon emissions from the refineries and oil and gas projects that stay in production. Offsetting on a major scale will require carbon capture technology to become cheaper and more effective, while the number of trees planted to offset emissions from any one oil and gas major would be enormous.
More promising is BP's aim to cut emissions from its own operations by 30-35 per cent and work towards a 35-40 per cent reduction in the “emissions associated with the carbon in upstream oil and gas production”. In emissions parlance, the former is scope 1 emissions and the latter scope 3. Scope 3 carbon emissions refer to those from the use of BP's products, such as a car filled up with its petrol.
Achieving these goals will require significant spending on both low-carbon energy projects and retrofits to make existing operations greener. Last month, BP announced it would team up with Danish renewables major Ørsted to supply a refinery with wind power. This will save around 80,000 tonnes of CO2-equivalent emissions a year. A great achievement, but one that still looks small beer compared with BP’s 49m tonnes of scope 1 emissions in 2019.
This just the start, however. Mr Looney and new finance chief Murray Auchincloss aim to increase green spending from $500m to $5bn a year between now and 2030. Total annual capital spending is around $20bn.
Another example of the scale of BP’s green ambition is its plan to increase renewable generating capacity from 2.5 gigawatts (GW) to 50GW. For context, the newly greenlit Dogger Bank offshore wind farm in the North Sea will cost £6bn and have capacity of 3.6GW. So BP has a long way to go and a lot to spend to get to its renewables goal.
Joining the green gold rush
BP is not the only major going green, although it does have some of the most ambitious goals. Shell, Total (Fra:FN) and smaller player Repsol (Spa:REP) also want to get to net zero emissions by 2050 and increase their exposure to renewables.
Analysts at Morgan Stanley studied this shift to renewables in November. A quick look at the players reveals a potential difficulty for BP and its sector-mates, compared with established players, which are largely European utilities with sizeable wind assets, such as Iberdrola (Spa:IBE) and EDF (Fra:EDF). Specifically, the broker put the weighted average cost of capital (WACC) – the cost of accessing funds to invest in projects – at around 4 per cent for the renewables-exposed utilities compared with 8 per cent for the oil majors. The difference between WACCs chiefly reflects the higher risks associated with oil operations, which makes equity funding more expensive for the majors.
However, the broker's research also holds some hope for the green ambitions of big oil companies as it believes there should be enough projects to go around. A major problem when lots of companies race to invest in similar projects is that returns on investment often decline. However, that does not necessarily need to be the case with renewables given forecast sector growth is very high over next decade at 2,500-4,000GW. A single current-generation wind turbine is around 13MW, or 0.013GW, so getting to that forecast is hundreds of billions if not trillions of dollars in investment away.
Despite these massive numbers, BP will remain an oil and gas company for the foreseeable future. After this year’s restructuring, BP’s holdings are split into exploration and production, refining and marketing (also known as trading), and its stake in Russian oil producer Rosneft. RBC Capital Markets analyst Biraj Borkhataria reckons that while BP’s new energies business will grow in importance over the next decade, it will still nowhere near dominate earnings. “We see BP’s new energies earnings increasing from essentially 0 per cent in 2019, to [around] 17 per cent of group earnings by 2030, the highest in the sector,” he said.
The question is whether dividends based on carbon-intensive cash flows will keep investors around. Forecasts don’t see the oil price recovering much beyond $50 per barrel in the next few years and gas won’t return to the 2018 level of $3.10 per million cubic feet (mcf) anytime soon, either. Those prices, along with tight refining margins, mean earnings will remain under pressure. BP is still paying for the Deepwater Horizon disaster as well, with RBC forecasting a $1.6bn cash charge this year. .
But there is another side of this coin: BP is cutting thousands of jobs. It will also likely sell off more assets in the medium term to help counter concerns about its debt levels. That said, it is hardly a good market to be selling fossil fuel assets into. Berenberg forecasts the free-cash-flow yield to climb from 7.9 per cent last year to 17.9 per cent in 2022. While the forecasts yield is strikingly high, the future is very uncertain and cutting costs can only take the company so far.
Mr Looney will face major headwinds when implementing his plans: a weaker long-term oil price, a higher cost of capital than competitors in the renewables space – making profits more difficult – and greater concern from investors over environmental stewardship. Earning are forecast to recover in the next few years, but BP is not the set-and-forget investment of yesteryear, with oil no longer able to drive profits in all cycles.
We flagged confusion over its more-climate-friendly plans in 2018 as a reason to sell. Now there are ambitious goals. But even if they are all met, BP will still rely on strong oil prices to drive profits, as 2020 has shown. Investors hunting for reliable long-term income stocks should look elsewhere while companies with established positions in renewables offer a more attractive green option.
|ORD PRICE:||263p||MARKET VALUE:||£53bn|
|FORWARD DIVIDEND YIELD:||6%||FORWARD PE RATIO:||14|
|NET ASSET VALUE:||406ȼ||NET DEBT:||75%|
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