Looney was also addressing multitudes, ranging from the activists perfecting the art of shutting down BP’s headquarters to the politicians that may one day shut down its projects or markets. These are exceptionally interesting times for any new oil CEO. While the world remains heavily dependent on oil and gas, the implacable challenge of climate change suggests the industry is mortal after all.
That an oil major of BP’s stature acknowledged this reality represents a milestone for the industry. Milestones are markers, though, not terminals. As Looney also acknowledged upfront, much of the detail is TBD, with an analyst day due in September.
The big question for investors (and, indeed, activists) is what this means for the thing that defines any oil major: how it deploys capital.
There is a tension in funding energy transition with revenues from oil and gas: The objective is inherently bearish for oil, while the thinking behind the funding is necessarily bullish. The added twist here is that, as Looney intimated at one point, oil majors have gotten an F from investors in the management of that core business over the past decade, as return on capital collapsed.
In effect, investors already doubtful of the industry’s capabilities in its core business are being asked to believe it can profitably invest in a set of new activities. What’s more, the old and new businesses have fundamentally different return profiles (at least as currently constituted), which is why Looney fielded so many questions about BP’s dividend.
Oil and gas exploration and development is traditionally a higher-return, long-duration business. When oil majors are regarded as rock solid, this is great. Consider a project with an internal rate of return of 20% and a life span of 30 years on an 8% cost of capital. The implied net present value equates to more than 100% of the original investment. Cue champagne.
Push that cost of capital to 12% and limit the life span to 20 years — as investors shy away and screws tighten on emissions — and the implied value, while still positive, drops to only about half of the capex. In theory, renewable-energy projects could offer better overall economics than that second case; while they sport lower rates of return, they also offer growth and a lower risk profile. Plug in a 12% rate of return but with a 6% cost of capital and 30-year horizon, and the net value is more than two-thirds of your outlay.(4)
Math is fun, of course, but pulling that kind of thing off inside a giant incumbent is the innovator’s dilemma on steroids. Hence, BP is also overhauling its corporate structure, combining the old upstream and downstream operations into one unit and, in a McKinsey-esque flourish, creating cross-division “integrators” for functions such as strategy. This would have been a major event even without the energy transition stuff. It remains to be seen how the matrix works in practice. One obvious question is what would happen if the sustainability integrator wanted to veto a project proposed by the production and operations division (imagine the reply-all email chains, for starters).
In addressing all this in September, BP will need hard targets linked to incentives. Top wish-list items would be transparent assumptions for carbon pricing in guidance and, beyond that, straightforward breakeven oil prices incorporating transition-related inputs and dividends. Similarly, near-term capex guidance for non-fossil fuel investments are needed.
Beyond this, BP’s roughly 20% stake in Russian oil major Rosneft Oil Co. PJSC should be considered for disposal. While Looney defended Rosneft’s sustainability credentials on Wednesday, convincing investors the Russian major is all-in on a green future seems a rather tall order. Sure, BP’s equity share of Rosneft accounts for 30% of its own production. But then volume isn’t the point, and $15 billion would help address a priority: reducing leverage.
It is good that BP has put a vision out there, even if details are yet to come. As it fleshes out the strategy, there will be an ongoing need to keep it focused, understandable — and unconventional.
Too often, the industry conversation on transition centers on this or that technology, such as carbon capture, aimed at shoring up the existing business rather than reconsidering it at a more fundamental level. As Harry Benham, an oil-industry veteran turned chairman of transition-advocacy group Sandbag, put it to me on Wednesday, a century-old industry built on extraction and thermal systems is now locked in a battle with an adversary that operates in a completely different way: “manufactured electrical energy.” And that’s it.
(1) I’ve borrowed the math here from a recent report by UBS titled “How fossil capex restrictions could lead to convergence of the energy and utility sectors.”
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Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal’s Heard on the Street column and wrote for the Financial Times’ Lex column. He was also an investment banker.
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