Before we start off on the company in question, we would like to take a little trip down memory lane. In this instance, a rather famous product of Britain, Chancellor Gordon Brown, did something rather remarkable. Picture this, gold prices have been mired in the worst bear market of all time. 20 years where prices just kept grinding lower and lower.
Gold, the bastion of inflation protection lost 70% of its value as consumer prices doubled. It is at the exact massive inflection point, that Gordon Brown decided to sell all of UK’s Gold. That point has been dubbed as Brown’s Bottom by a multitude of commentators (See 1, 2, 3, 4, 5 & 6). What was impressive about that feat was that at the precise time the UK should have been bolstering its gold reserves, Gordon Brown decided it was time to exit. Sentiment can make you do that. 20 harrowing years of a bear market, where gold precisely failed to do what it was supposed to, can make an unbeliever out of anyone. What on the planet does this have to do with the company we want to talk about?
BP PLC (BP) reported its Q2-2020 results yesterday and predictably cut its dividend by 50%. While that was the appetizer for the event, the main course was the company’s announcement. It is going green, again. In case the presentation font overwhelmed you, allow us to break down the finer points. BP will begin to invest substantially more into renewable energy developments. It also plans to double down on its small bioenergy platform.
Source: BP Q2 Presentation
In the interim, oil and gas production is expected to fall by over 40% over the next decade. While planetary concerns were first and foremost on their minds, they did emphasize that their return on average capital employed or ROACE will increase from 8.9% to 12-14%. BP will move in this direction gradually, though and its annual capital expenditures will still be predominantly focused on oil and gas in the near future. Even, in 2025, more than 60% will be focused on traditional investments.
Source: BP Q2 Presentation
Investors cheered the move and the stock was up a big amount after the press release. That was rather notable considering that the company had just chopped its dividend by 50%. What should investors make of this?
Why This And Why Now?
The main reason for this move is that just like Gordon Brown, BP is tired of the harrowing bear market in oil and gas. The frustration can perhaps be best summed up in this chart comparing Tesla, Inc. (TSLA) and BP.
More importantly, it can be seen in the value the market places on $1 of sales of these two companies.
Even outside of the Tesla phenomenon, renewables of all stripes and colors have demolished BP’s returns.
BP is also likely aware that assets are flowing to ESG funds with a vengeance.
While the criteria remain flexible for many of these funds, none of them would currently sink much into BP. However, that may change as BP changes its strategy. The company wants to make sure that its focus on renewables makes it eligible for investment by these funds, at some point in the future.
Will BP deliver the excess returns it promises investors? Probably not. BP has struggled to deliver high returns on capital invested even during UP cycles. On the other hand, many competitors did deliver returns in excess of or close to 20% during even at modestly high price points.
Source: BP 2014 presentation
So, BP’s switch to renewables also represents its own failure to deliver high margins in the business even during cycle peaks.
Beyond Capital Invested
With so much capital chasing renewables, one has to wonder whether the longer-term returns will materialize, at least at levels suggested. Existing assets that produce electricity are likely to be retired slowly over time. If a rush continues to build large scale solar and wind farms, return on capital employed could drop appreciably for all players.
On the other hand, oil and gas companies have had it with the low return era. Even the normally counter-cyclical Exxon Mobil Corporation (XOM) has dialed back capex and reduced it from $33 Billion to $23 Billion for 2020. Its 2021 plans have been reduced to $19 Billion. Chevron (NYSE:CVX) guided that its Permian oil production will come in at 500,000 barrels for 2021, a good one-third below its initial target. All of OPEC cannot muster cash to meet half their budget needs at these prices, let alone invest capital for the future. It is pretty much written in stone now that return on capital for this sector will easily double from this point and dwarf anything offered in the renewable sector for the next decade. But that is simply as there are too little capital chasing opportunities.
Gordon Brown marked a radical turning point for Gold.
BP’s pivot will mark a big turn for oil and gas. While we do not doubt that the world will move towards renewables, meeting the demand in the interim will become progressively harder as less and less capital enters the space.
Monetary metals are already flying ahead and it is only a matter of time that the rest of the commodities join the party.
Source: Invest In The Best
Investors are shunning energy and financials and are in love with technology and healthcare. That also is due for a nasty reversion.
BP is signaling that a big change is coming but the bad news for BP shareholders is that the company has committed to mediocre returns by moving where the puck is and not where it is going to be. Wayne Gretzky would not approve.
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Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We are long energy equities.