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Lost in transition: Big Oil searches for purpose as peak demand looms

image credit: “Sunrise over Hammerfest” by Seb Kennedy, licenced under CC BY-ND 2.0.

The oil industry is about to enter its final phase: managed decline. Even if there is a strong post-pandemic economic recovery that boosts oil prices at some in the 2020s, it will be Big Oil’s ‘last hurrah’ before global demand peaks definitively and gradually tapers off. Some say this might have happened already thanks to Covid-19, while others see the tide turning between now and 2030.

Either way, it is coming, and some oil companies are finally starting to wake up. BP acknowledged peak demand by committing to reduce its oil production by 40% within ten years, in a landmark new 2030 strategy that stole the headlines last week.

The British oil major, unlike many of its peers, has realised that doubling down and chasing market share in a declining commodity is a road to ruin. Instead, it will focus only on the cheapest, least carbon-intensive barrels in its portfolio, and sell the rest—even if prices pick up in the near-term.

In the first half of 2020, BP wrote off USD 9.7 billion in exploration expenditures after lowering its forward oil price assumptions by around 30% and concluding that a large chunk of its undeveloped acreage will never be commercially viable.

BP previously valued its exploration intangibles at USD 14.2 billion, so the company has effectively written off almost 70% of its exploration portfolio. The write-offs were spread across Angola, Brazil, Canada, Egypt, India and the US Gulf of Mexico.

On top of this, lower price assumptions prompted BP to write down the carrying value of upstream assets to the tune of USD 12 billion. And the company has identified another USD 43 billion of assets at risk of further impairment if assumed forward prices change again within the next financial year.

In the meantime, BP is aiming to sell USD 25 billion of out-of-the-money assets by 2025, and is laying off some 10,000 people from its global workforce. Even for a company with a total market capitalisation of USD 58 billion, these are big moves. BP is not alone; Shell, ExxonMobil, Chevron and others are all struggling too and contemplating similar moves.

BP will not cease investing in the upstream altogether, but to avoid another string of failed oil bets it will set the bar higher. New projects must demonstrate an internal rate of return (IRR) in the “mid to high teens” (in percentage terms) against a theoretical carbon price of up to USD 80/tonne. And they must be able to deliver return on investment within a ten-year timeframe, or 15 years for upstream gas projects.

This is because BP realises that thereafter, the risk of such assets becoming stranded increases significantly with anticipated higher carbon taxes, waning demand and softening prices as the world shifts inexorably towards cleaner fuels. The clock is already ticking, even for cleaner-burning natural gas—Big Oil’s much-heralded ‘bridge’ fuel to a net zero emissions future.

Out of the frying pan…

So far so good. Business as usual poses risks that are no longer palatable. It is refreshing to hear this from one of the big five oil majors. Others will surely follow suit, particularly European peers subject to greater climate risk scrutiny from ESG-orientated investors than their US rivals.

Where BP’s strategy shows fragility is in how it intends to replace lost oil revenue.

CEO Bernard Looney speaks passionately about converting BP from an international oil company (IOC) into an integrated energy company (IEC) with a broad mix of wind, solar, bioenergy and hydrogen fuels alongside gas assets with carbon capture, and some legacy oil production. Under his leadership, BP’s optimism towards the energy transition is palpable (the video embedded in the below tweet is worth a watch, not least for the soundtrack!): 

Looney’s passion is commendable and has earned him an almost cult-like following within BP rank and file, according to company insiders. This is important, as the CEO will need to bring BP’s remaining 60,000-strong global workforce with him—including lifelong upstream engineers and geophysicists—on a journey into the unknown world of decarbonisation.

The strategy envisages a ten-fold increase in green investment delivering a 20-fold hike in installed renewable power generation capacity to 50 GW—all by 2030. This will inevitably involve acquisitions, but there is no certainty that this volume of high quality assets can be found in time.

This is particularly pertinent considering that BP says it needs IRRs on renewables projects of around 10%. The International Energy Agency estimates that solar PV and wind project IRRs are typically in the range of 5% to 8%.

To achieve above-market returns, BP will need to take on early-stage projects in riskier emerging markets and invest resources in de-risking them. It will also need to leverage assets by loading them up with cheap debt, and mercilessly drive out capital costs by negotiating the best possible prices on supply of wind turbines, solar panels and civil engineering services.

It will also need to carefully engineer projects to maximise power output, push for the highest possible tariff in highly competitive power markets, and then sell a big share of the project for a considerable mark-up once it is up and running.

This is not part of the Big Oil playbook: companies like BP prefer to commit very large sums to a small number of capital-intensive, high-return projects with other equity partners and no leverage, and sit on them while the bumper margins rain money for years. With a high cost of entry, competition is limited and the privileged few share the spoils.

Squeezing Big Oil-sized profits from a high number of smaller, lower margin renewables and low-carbon investments will require BP to re-calibrate its entire business model, investment thesis and operating culture.

It is hard to see where BP offers a competitive advantage in this space, against seasoned pure-play renewables developers with a track record in profitably nurturing wind and solar assets from initial site selection through to first power.

Low-value proposition

Until now, investors bought BP shares because they promised outsized dividends and stable value growth through thick and thin. They were a stable of UK pension fund managers seeking gold-plated, above-market returns for their hard-working fiduciaries.

That value proposition has been turned on its head. BP last week halved its dividend and suspended share buybacks until it reduces its corporate debt pile by 14%, to USD 35 billion. This was unavoidable and entirely necessary. BP was living beyond its means, as are other oil majors.

BP’s new purpose is to “reimagine energy for people and our planet”, and “help the world reach net zero and improve people’s lives”. It says it wants to be “valued” by shareholders, and promises they will be rewarded down the line.

This means trusting BP’s claims that a pivot into renewables, electric car charging networks, hydrogen and bioenergy will not only replace but surpass lost oil revenues. BP says its strategy will lift return on average capital employed (ROACE) from 8.9% in 2019 to 12-14% in 2030.

But with BP stock having lost 39% in value since the start of the year, shareholders might be wondering why they shouldn’t sell up now and instead buy shares in Danish wind developer Ørsted, which have risen 30% over the same timeframe.

BP is hoping to follow in the footsteps of Ørsted, which successfully morphed into a global offshore wind leader, from its origins developing hydrocarbons in the Danish North Sea under its previous incarnation as Danish Oil and Natural Gas (DONG).

DONG was able to leverage generous support in its home market from a government aggressively pursuing a wind-based industrial strategy that gave rise to Vestas, the world’s biggest wind turbine manufacturer.

The renewables bonanza of the early 2010s that propelled DONG’s green metamorphosis no longer exists. BP is pivoting into this sector just as support schemes are being rolled back in favour of cut-throat reverse price auctions that pitch hungry developers against each other. With no alternative route to market, projects are now bidding below the wholesale power price in some tenders, spurred on by plummeting wind and solar PV capital costs

This is great for consumers. But it leaves scant opportunities for lumbering, debt-laden oil companies casting around for a way to emulate a dying industry’s glory days.

Big Oil companies are great at accessing cheap finance, marshalling enviable resources into capital-intensive endeavours, achieving economies of scale and boosting margins via sophisticated trading and optimisation.

Those attributes can make a valuable contribution to the energy transition, but do not guarantee Big Oil a path back to profitability.

Stuck between a rock and a hard place and facing an existential crisis, some oil majors are opting to stick while others twist. The odds of success seem slim either way.

This article was first published in Energy Flux, a free weekly newsletter covering all manner of topics relating to decarbonisation, disruptive energy technologies and the race to achieve net zero carbon emissions. Reproduced here by kind permission of the good folks at Energy Central!
Sebastian Kennedy's picture

Thank Sebastian for the Post!

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Discussions

Matt Chester's picture
Matt Chester on Aug 10, 2020 4:22 pm GMT

Thanks for these insights, Sebastian. On BP's proposed shift towards more clean energy sources, many in the industry express understandable skepticism about how much they're really investing and working on that switch vs. then some sort of greenwashing. What would your response be? Do you think the transition is in earnest or is there a degree of trying to get some green PR in play while maximizing gas and oil assets all the same? 

Sebastian Kennedy's picture
Sebastian Kennedy on Aug 10, 2020 4:53 pm GMT

BP has embarked on a journey, and they are about to pass the point of no return. Committing to a 40% crude production cut by 2030 and investing $5 billion every year in low carbon is a major undertaking with big repercussions for shareholders - not just greenwashing (although there is a huge PR effort attached to this new strategy). It would be extremely damaging for BP reputationally not to follow through on this commitment, so you have to assume they are serious about it - which means the company's fortunes will become tied to a higher carbon price, the commercialisation of emerging low carbon tech etc. BP may or may not succeed commercially, but either way having them 'onside' will certainly help the cause of decarbonisation.

Gary Hilberg's picture
Gary Hilberg on Aug 14, 2020 3:19 pm GMT

Sebastian - very concise and well thought out piece.  Your identification of the massive market difference between current big oil and renewable is very correct.  The differences in returns, time horizons and competitors will make this transition very difficult.  One area that some majors are engaging in which could balance their transition is renewables fuels and plastics (both bio and recycling).  For BP which does not have a large downstream segment anymore this will be more difficult.  

The key issue that I see for this transition is that their previous solid returns were based on the expectation that peak oil/gas was going to be supply based, now we expect it to be demand based.  Basic economics tells us that this will drive the price down continuously so margins will be continue to be squeezed.  

Sebastian Kennedy's picture
Sebastian Kennedy on Aug 14, 2020 5:00 pm GMT

Thanks Gary. That's an interesting point about peak oil being demand-driven, not supply-driven. I recall years back respectable forecasters such as the IEA (and the UK government) were anticipating $100-plus oil as the norm while supplies dwindled over the years. Seems quaint in hindsight!

The pricing outturn will be influenced, inter alia, by how many big companies follow BP by cutting oil production and diversifying their investment portfolios. If there is a wholesale shift then those left (ExxonMobil, Chevron) will have more of the market to themselves and presumably the margin squeeze won't be so painful. But if they all maximise oil and gas production while they still can, the effects will be much worse for all. 

Gary Hilberg's picture
Gary Hilberg on Aug 17, 2020 8:54 pm GMT

Sebastian - oil is such a unique product, I can't think of another commodity whose "cost" of production is routinely measured by the price "needed" by the producing country to maintain their national budget.  These countries (Saudi Arabia, Kuwait, Nigeria, Libya ....) will continue to produce with or without the majors as we have seen with the recent price crash.   We do not know if we have seen the peak, but once the peak is confirmed the commercial reserves math will be very interesting.  

Matt Chester's picture
Matt Chester on Aug 17, 2020 9:58 pm GMT

We're hearing about these countries talk about cleaner and/or alternative energies, knowing that the future is not in oil-- whether that happens in 20 or 30 or 70 years or whatever it is. Do you think any of them are really operating towards that with urgency, though, or are their hedges still pretty moderate and slow? It seems to me like they feel like they can still 'take their time,' if you will

Gary Hilberg's picture
Gary Hilberg on Aug 18, 2020 6:20 pm GMT

Matt - in my view, it is all about the consumers.  Once the OECD countries hit peak oil, India and China will be the major growth markets for oil.  China is investing massively in electric car infrastructure and last report I saw had more electric buses than the rest of the entire world.  Once oil demand starts to decline, the economics flip. 

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