The 2020 energy industry downturn, caused largely by demand declines stemming from the coronavirus pandemic, appears to have marked a turning point for industry giant BP (NYSE:BP). It now has big plans to shed its old focus on oil and natural gas and shift in a cleaner direction. On the surface that sounds great, and is definitely in line with the clean energy zeitgeist — but investors shouldn’t go along for this journey blindly. Here’s some important background, and three charts you need to consider.
The dividend cut marks the spot
In August BP cut its dividend in half. To be fair, the energy sector was reeling at the time, and the integrated energy giant was preparing for what would be a tough second half, financially speaking. Indeed, revenue fell 35% year-over-year in 2020, with a per share loss of just over $6. It was a pretty ugly year.
But that isn’t really shocking. The energy industry is highly cyclical, and low oil prices lead to weak financial results. What was actually a bit of a surprise was BP’s decision to drastically overhaul its business, shifting hard toward a clean energy future. The plan is bold.
For example, BP expects a 20-fold increase in its renewable power generating capacity by 2030, and a 10-fold increase in electric vehicle charging points. Backing that will be a 10-fold increase in spending on its “low carbon” business, with around 40% of its capital spending going in this direction. On the flip side, its hydrocarbon business (think oil and natural gas) is expected to shrink by 40%.
Let’s think this through
This is no small change, and there are two reasons to be worried. First, BP has been down this road before, back when it started to describe itself as “Beyond Petroleum”. The company spent billions on the effort in the early part of the century, but within a decade was winding down and/or selling businesses that simply didn’t live up to management’s profitability expectations. After selling a solar project in 2011, one cheeky news publication even jested that BP stood for “Back to Petroleum”. It is fair for investors to wonder if this time around will end differently.
The second big question is whether or not BP can even afford to do this, and that’s where some important charts come into play. Number one is the company’s balance sheet strength compared to that of industry peers.
As the chart above shows, BP’s debt-to-equity ratio is at the high end of its peer group — and by a fairly wide margin, with the 2020 industry downturn leading to a rapid acceleration of the trend. With plans to invest a huge amount of money into new businesses, it is reasonable to wonder if BP has the financial strength to handle the giant shift it is undertaking. Yes, part of the transition will involve selling assets, but with the industry in the doldrums BP will basically be selling into industry weakness — the very opposite of what you’d like to see as a shareholder.
The second chart shows BP’s interest coverage, which is terrible right now. In fact, as you can see above, the oil giant isn’t actually covering this expense. That makes sense given the industry downturn. Oil companies tend to make a lot of money when times are good, and much less when times are tough, like they are today.
But here’s why this is important: BP is looking to undertake a potentially expensive transition right when it has the least financial leeway. Moreover, the change includes shrinking its oil business, which is the main driver of returns when times are good. A big debt pile and terrible interest coverage isn’t a great starting point, especially when part of the plan is to materially shrink the business that has historically been BP’s main revenue-driver in industry upturns.
The last chart kind of brings the story back to the “Beyond Petroleum” issue. Return on capital employed, the data underlying the above comparison, is effectively a metric that examines how well a management team uses its shareholders’ money. As the chart above shows, BP has been at the low end of its peer group for most of the past decade. And now it has decided it will change its business in a material way — after having tried and failed in a similar, previous attempt that didn’t produce the kind of returns that management was expecting.
Notably, in a recent bidding process for offshore wind opportunities in the United Kingdom, BP materially outbid competitors, including European peer Total. It wasn’t a small difference, either, with BP’s bid nearly doubling what Total was willing to pay for the projects the French company was able to pick up in the auction. BP dramatically outbidding peers so early in its business shift isn’t a reassuring sign of management restraint and prudence in light of its previous clean energy foray. Investors would be justified in wondering if BP has been a responsible enough steward of shareholder cash to warrant their trust in this giant transition effort.
Other options are available
BP isn’t the only major oil company looking to shift gears and go in a cleaner direction — and given the above trio of charts, it looks like it may not be in the best position to effect such a drastic change. If you are still interested, you might want to look at Total, which is taking a more measured approach and has a better track record when it comes to investing its shareholders’ money. Indeed, BP’s direction may not be wrong, but that doesn’t mean BP is the right investment option for the trip.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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