Prices Give BP a Boost But Investors Stay Wary

The Issue

BP’s strategic pivot toward the energy transition was among the most ambitious of its peers. But arguably the company was in the weakest position to execute its plans as it struggled under a high debt burden and the same limited cash flows that crimped investment across the industry. A little more than a year after unveiling its new approach, the UK supermajor looks in better shape to be able to execute its vision but the jury is still out as far as investors are concerned.

Debt Reduction

When BP set off on its new low-carbon strategy the company was hamstrung with historically high debt that made it impossible to cover its dividend, reinvest in its oil and gas operations and build its transition businesses. In just over a year, BP has cut its net debt by more than 20%, exceeding the target it set for itself to lower its borrowings below $35 billion.

Despite BP’s success in reducing its net debt, the company’s gearing ratio — calculated by Energy Intelligence as the ratio of net debt to shareholder equity — remains the highest of its peer group. While its debt load is more manageable, its 46.9% gearing remains elevated even relative to its own average of 31.86% from 2010-19.

CEO Bernard Looney has in the recent past stated that BP will continue to allocate some 40% of its “excess” cash flow to debt reduction, but the company’s third-quarter results saw it choose to further accelerate shareholder returns rather than allocate additional capital to reducing debt.

Cash-Flow Rebounds

BP’s biggest tailwind has been the meteoric rise in oil and natural gas prices. The company’s cash flow from operations, which is still largely driven by oil and gas realizations, jumped more than 50% between second-quarter 2020, when it detailed its strategic shift. and third-quarter 2021. The increase was driven by oil and gas realizations that increased more than 75% over the period. “I think we're a cash machine at these types of prices,” Looney told analysts.

While realizations may be driving near-term performance, Looney has pledged to investors that a shift to higher-margin production will result in a more profitable fossil fuels business even as production eventually declines. “We are focusing our oil and gas portfolio over the next decade in a volume sense,” he said. “We actually believe we'll create more value.”

Disciplined Investment

Like its peers, BP has pledged not to return to profligate ways even if oil and gas prices push higher. The company will invest about $13 billion this year and sees spending within its $14 billion-$16 billion range in 2022.

Upstream volumes have held generally flat, with oil ticking down and gas inching up, as BP has prioritized its global gas portfolio within its overall transition strategy. The company forecasts overall hydrocarbon production to be roughly stable through to 2025 before declining by some 40% — about 1 million barrels of oil equivalent per day — through to 2030 as BP shifts its attention to energy transition businesses that should begin to show positive cash flow.

Meantime, BP has increased its “pipeline” of potential renewable energy projects to 23 gigawatts. It is now targeting a final investment decision on 20 GW worth of wind and solar projects by 2025 and a 50 GW renewable portfolio by 2030.

Increasing Divestments

A more positive commodity price outlook has also strengthened asset markets, helping BP to sell $5.4 billion in assets so far this year. One key question for BP’s strategy going forward is whether it can continue its current pace of divestments.

Large producers are coming under increasing pressure to wind down assets rather than pass off their emissions to others. Furthermore, regulators in many developed countries are becoming more aggressive in ensuring that companies don’t transfer the liabilities for decommissioning mature fields to operators who do not have the financial strength to fund them.

BP executives had said they expect sales to accelerate, upping their divestment estimate for this year from a $4 billion-$6 billion range to $6 billion-$7 billion. Between 2020 and 2025 the company hopes to bring in $25 billion from asset sales. The windfall from asset sales has helped turbocharge debt reduction, allowing the company to direct more of its free cash flow to shareholder returns.

While some might argue that hanging onto oil and gas assets a little longer might be good in the current price environment, BP’s production goals are closely tied to its emissions reduction targets. If environmental liabilities cut into valuations or public scrutiny makes sales difficult, BP may not be able to pay debt, shareholders and invest in the energy transition at the same pace. It could also complicate BP’s efforts to reach net-zero emissions.

Shareholders Give Lukewarm Response

Shareholders have reaped the windfall of BP’s improving financial fortunes. In the third quarter, Looney announced that BP would start a $1.25 billion share repurchase program — above what would have been called for under its financial framework after having wrapped up an earlier $1.4 billion buyback. He also increased the dividend some 4% as BP looks to repair some of the damage of its decision to cut its dividend 50% in August 2020. "The reason that we've done more is confidence," CFO Murray Auchincloss said. "Overall, we feel a lot of confidence in the underlying performance of the business."

The payouts, alongside Looney’s pitch to shareholders that the company is “performing while transforming,” have resonated to some degree. BP’s price performance over the past year has outperformed the broader FTSE 250 market benchmark over the past year. But it trails its oily US competitors over the near term and remains the worst-performing supermajor over a five-year period. Although notably, none of the supermajors have beat the broader market over the last five years.