A concept borrowed from software sees "legacy companies" apart from innovative ones. In energy, that concept may be running out of steam.
With two of the planet's biggest oil and gas companies looking serious about growing through renewable projects, investors need to size up what sorts of returns and risks make sense for large energy companies that are redefining themselves.
Our writer dives deep into BP and Equinor and surfaces with a suggestion: big conglomerates can bring big strengths to the biggest change the energy business has ever made.
Equinor Strategy Summit, Norway, 2019 – Executives of Equinor (formerly known as Statoil) were holed up in a room drinking hot chocolate after a day of skiing. Strategy staff members presented them with a list of unidentified companies (“Company 1,” “Company 2,” “Company 3”) along with historical and projected returns. One had 10% return ambitions; another roughly the same, etc.
The executives were asked: Which companies do you think these are?
Shell? Ørsted? Exxon?
What happened next remains a mystery; but, according to Michael Wheeler, Equinor’s Principal of Corporate Strategy, who told the tale at a conference last year, the exercise led to a pair of startling realizations:
“Maybe oil and gas isn’t truly making as much money as we think.”
“Maybe [renewables-focused companies] are making more money than we think.”
Equinor has since made plans to become an “offshore wind major,” taking some of its oil and gas profits that would have been plowed back into drilling and investing them, instead, in renewables. The company aims to deploy 12-16 GW of renewables by 2035 (a 30-fold increase from 2019 levels). “We are going in this, and we are going in it big,” said Mr. Wheeler.
In finance parlance, fossil fuels and renewables are ‘apples and oranges.’ Different technologies, different places in the value-chain, different competitors: different risks. Investors ordinarily wouldn’t compare them directly. They may choose to invest in both for the sake of diversification. But oil and gas companies considering transition don’t have this luxury. As Mr. Wheeler pointed out: “investors don’t like oil and gas companies to diversify [for the sake of diversification]; they want to do it themselves.” Oil and gas companies, in a sense, must compare the two types of energy. The idea that the two would be compared, and that renewables would show favorably, suggests new possibilities for the decarbonization movement.
In 2018, Bill McKibben wrote, summarizing IPCC findings: “if the current flows of capital into fossil fuel projects were diverted to solar and wind power, we’d be closing in on the sums required to transform the world’s energy systems.” To conduct this flow of funds, Mr. McKibben and other activists have advocated divestment of fossil fuel companies and reinvestment into renewables-focused companies.
But what if investors didn’t need to divest to decarbonize? What if economic conditions within fossil fuel businesses justified a reallocation of funds into low-carbon energy sources, and all climate-conscious investors needed to do was go along? That possibility, provoked by Mr. Wheeler’s ski retreat story, is one that industry bellwether BP has also, more recently, asked its shareholders to consider. The shift may change the perception of what a multinational oil and gas firm provides to investors.
At the start of a three-day summit in September, standing in front of a slide titled “from IOC to IEC” (from International Oil Company to Integrated Energy Company), BP’s newly appointed CEO Bernard Looney shared BP’s ambition to “become a net zero company by 2050 or sooner.” Just the prior week, BP had announced its debut investment in offshore wind through a partnership with Equinor, paying the Norwegian giant $1.1 billion for a 50% stake in two projects off the U.S. East Coast.
Hailed by UBS analysts as “the most significant strategic pivot as yet among the majors,” BP’s transition plan contemplates a 40% decline in oil and gas production by 2030 coinciding with the deployment of 50 GW of renewables (20-fold increase from 2019 levels). Like Equinor, BP justifies its transition as a sound business decision. In an interview with the Financial Times, Mr. Looney said he “did not view BP’s decision to back renewables as a ‘moral’ choice,” inviting investors to focus purely on the economics of the company’s proposal.
During the three-day summit, BP did not directly compare fossil fuels and renewables side by side, as in the Equinor ski retreat, but indicated fossil fuel return aspirations of 12-14% while proffering target renewables returns of 8-10%. The implication: 8-10% returns are high enough to tempt some diversion of funds from fossil fuel investment.
This may be a safe assumption.
BP’s renewables return target comes after a long period of disappointing returns as an oil and gas company. From the start of 2000 to the end of the last calendar quarter – a period of over twenty years which saw global markets reshaped by the U.S. ‘Shale Revolution’ along with the Deep Horizon oil spill in April 2010 – BP’s annualized total stock return was roughly zero. (Trimming off 2020 pandemic losses and looking at the period from 2000-2019, annualized total stock returns were only modestly higher at 3%.)
BP shareholders, of course, hope that future oil and gas returns will exceed historical company results, particularly with a return of higher commodity prices. But when it came to projecting global oil demand, a major driver of oil prices, BP surprised analysts with a bearish prediction: rather than increasing in the 2020s and flattening in the 2030s, as previously forecast, oil demand remains flat at 2019 levels before declining in the 2030s. Natural gas demand, meanwhile, was forecast to be more resilient.
In downgrading its oil demand projection, UBS analysts alleged that BP had “[moved] the strategic goalposts,” while J.P. Morgan analysts, inclined to see a salutary purpose, interpreted the downgrade as a “necessary ‘stick’ in planning for the worst.”
Whether BP’s oil demand reforecast affected shareholders’ perception of the relative merits between renewables and fossil fuels is hard to know. However, in the flood of research reports following BP’s September summit, analysts tended not to question whether 8-10% renewables returns are good enough, but whether such returns are, in effect, too good to be true.
Of BP’s renewables target, Barclays analysts wrote that “the theory sounds good, but there is a very wide perception gap between the market and what the management team expect.”
RBC analysts wrote: “Renewables remains a ‘show me’ story, and we await evidence of [success].”
J.P. Morgan analysts agreed there is a “‘show me’ element” to BP’s energy transition targets and characterized the company’s valuation as “attractive pending execution.”
Responding to analyst skepticism, Mr. Looney has insisted that the company’s renewables return target is “not dream-like,” noting during the summit that BP’s solar joint venture, Lightsource BP, has delivered 17 solar projects since 2018 with returns typically in the 8-10% range.
The 8-10% renewables returns are only possible, a BP slide shows, after a 3-4% boost from BP's special competencies, including the company’s operational and project expertise, trading capabilities and ability to execute structured financings.
If taken as credible, the transition strategies of oil and gas firms like BP and Equinor complicate the investment strategies of climate-conscious investors. Divest all oil and gas firms or only some? Which ones make the cut?
Only a subset of oil and gas companies may be able to make the economic arguments BP and Equinor make. Some may not see a path to developing clean energy technologies at satisfactory returns. Others may project fossil fuel returns which outshine clean energy returns, depending on their view of future commodity prices and the cost-competitiveness of their reserves. However, supporting the ones that choose to pivot could mean supporting new, commercially viable avenues for decarbonization.