Eoneren/E+ via Getty Images
Eoneren/E+ via Getty Images
One look at the performance gap between the major indices and big oil, and it's easy to run screaming for the hills as they have gone opposite directions with nervousness concerning a prolonged bear market building. Crude oil ( CL1:COM) began the year at $75 and is currently north of $100, having carried the major oil companies into significantly double digit returns YTD for most of them. There are never guarantees when it comes to the stock market, however, long-term I believe there is more value in some of these companies, in particular those who embrace the energy transition and consider themselves part of the change towards a greener energy mix globally.
This crude oil price development means that major oil stands to harvest massive returns short-term, but it also means they will have growing cash flows from operations that can be deployed into future investments. What this means, is that they can accelerate their transformational strategies based around more available cash, supported by tailwinds from a strong political agenda to move in that direction. This is combined with decades of operational experience in tough environments highlighting a path for oil majors to become massive in, for instance, offshore wind farms or other large engineering projects such as solar farms.
With the onset of the Russian-Ukrainian war, countries across Europe have lined up to issue statements concerning the need to rid themselves of dependency towards Russian fossil fuels, meaning that we can expect a higher prioritization of public funds allocated towards the green energy transformation as the mitigation of that dependency will require an alternative - wind, sun or even nuclear energy in most instances. On top, the leading international body for assessment of climate change, the IPCC, has clearly exercised its voice in 2022 upon having released its most recent report. The core message being, that the time of fossil fuels is over - the world needs to put fossil fuels in the rearview mirror. With the world at a 'now or never' crossroad scenario according to the leading experts, it's something we need to consider as investors as political sentiment will inevitably impact the industry and company valuations.
Oil majors are asset heavy, making it meaningful to gauge the investment environment by considering the price to book value of the above mentioned, and while some of them are moving outside of their long-term average, some of the major European operators still appear to be within reach, particularly Shell (SHEL), BP (BP) and TotalEnergies (TTE).
Having appeared to be in hiatus for a while, the Oracle From Omaha, Warren Buffett, has decided to bet big on oil in the later part of 2021 and early 2022, having accumulated massive positions in both Chevron (CVX) and Occidental Petroleum Corporation (OXY), making up more than $40 billion in total as of today, and more often than not, Mr. Buffett knows what he is doing as he continues his market beating streak. As will become evident later in this article, I don't perceive that Mr. Buffett has boarded the oil train to the tune of transformational tones with these picks, but big money is moving into oil, and I believe the long-term prospects are meaningful.
Standing at a crossroad in terms of going green or not, major oil executives are basically left with two options.
Those in favor of the first strategy will argue that value is lost if focus is shifted with management trying to ride two horses at the same time. That valuable assets will be offloaded for bargain prices in order to please the growing shareholder base and society focused on green energy - effectively becoming an unfocused company. An example of such an argument would be the situation of Shell selling their Permian basin assets for $9.5 billion to ConocoPhillips (COP) in an effort to maximize cash redistribution to shareholders, fueling the business plan with cash and swaying from maximizing production within the existing business to keep emissions in control. Again, people in favor of this angle may conclude, that management is losing sight of what the company is put on earth to do, extract fossils from underneath at the highest profit possible. Lastly, those in favor will also argue, that oil prices may rise over time, increasing value output from this strategy as more companies transition towards the second strategy and therefore reduce their operational scope within traditional fossil fuels, resulting in diminishing supply at a greater speed than demand will slow, resulting in surging income levels for these companies.
Those in opposition to that angle may construct the argument that a company pursuing the first strategy is slowly running out of options and opting out of being part of the future, slowly losing its place and relevance. Therefore, also arguing, that the second strategy is more rational with a need to balance short-term profit maximization with the purpose of securing the long-term viability of its business. That a new business opportunity is presenting itself particularly within offshore wind farms, where existing oil majors typically will have extensive experience operating under such harsh conditions, being able to construct a profitable business allowing the company to slowly diversify towards where future market value is while staying in touch with society from the logic that it's easier being part of the solution, than problem. Furthermore, those in favor of the second option, could also see the situation as one, where they don't want to be invested in companies that may not function long-term.
Personally, I support the perspectives anchored within the second approach, meaning I hold little interest in companies that have yet to go this direction. However, such an opinion is of course individual.
As no one is able to peer into the future, we don't know what will be the most value creating strategy, but as investors we need to consider what avenue we find more attractive, as some organizations are aggressively pursuing one or the other.
At the end of the day however, we've seen that ESG aspects matter especially within "dirty" industries, and other commodity industries are also embracing the adaptation. It is likely, that the importance of ESG will only rise over time and start to assert its power over the market cap of companies who in particular are at a crossroad moment, such as fossil fuel companies.
I've been tracking the companies in terms of pursuing either of the avenues in recent years and it has been one where it's possible to carve a chasm separating pursuers of either avenue by the Atlantic Ocean. So, a situation where European oil majors are divesting existing fossil fuel assets, ploughing billions into renewables and planning drastically lower emissions over the coming decades. Meanwhile, the two American giants, Chevron and Exxon (XOM) have been doubling down and effectively only been allocating pocket change towards green energy initiatives.
Companies resisting are receiving continuously growing amounts of flak and pressure from its shareholder base to the point where we can't say that they aren't allocating at least some funds aimed at clean energy initiatives. However, as recent as half a year ago, Exxon CEO Darren Woods dismissed the notion that climate change was a serious risk for the industry and that the company is viable, also long-term pursuing its current strategy. One statement from Mr. Woods I do agree with, is that there will still be a need for Exxon's products for a very long time, but that doesn't mean there aren't risks tied to navigating climate change for a company standing its ground. However, that one particular fact, that the products will remain in place for decades, is also why it's not without reason, that some steer the direction of the strategic option focused on sticking to their guns. A relevant question to ask here, is whether such a strategy will be recognized by the market allowing the market cap to climb in order to reward shareholders.
Of the two, Chevron is the more ambitious in embracing the need to consider clean energy initiatives, recently having communicated a $3 billion pledge in the direction of a new business unit focused on low-emissions solutions while also having implemented a number of 2030-2050 targets. However, seen from my chair, it's more out of necessity than genuine prioritized strategy that these initiatives are launched. At least at this point, it's difficult to argue that Exxon and Chevron are front runners or even slow followers embracing clean energy ambitions and targets. This is probably most evident by that fact, that there are no net-zero targets in place, not even by 2050, as is the case for the remaining companies in scope for this article.
A research study conducted in a collaboration by representatives of two Japanese universities studied eight years of data from 2010-2018 to identify how BP, Shell, Chevron and Exxon approached the renewable energy space, and while the data can be argued to be slightly outdated, it does illustrate how the companies have been approaching the topic, as can be seen by CAPEX allocation and MW of renewable energy produced during the previous decade leading up to 2018. The study concluded that "European majors have more consistently acknowledged climate science, participated earlier in industry climate-change frameworks, adopted internal carbon pricing, spent and pledged more on clean energy, and recently set net-zero transition and energy product decarbonization goals. Trailing far behind, the American majors continuously exhibit defensive attitudes to renewables investment and the need to shift from fossil fuels, explicitly stating ambitions to grow rather than reduce hydrocarbon production"
For better or for worse, being the second mover carries the advantage of letting one's competitors carry the risk of potentially betting on wrong technologies, having to handle technological hurdles or overpaying for infrastructure in a marketplace where the real value of the future cash flows is uncertain. As we will see, a company like Shell is also appearing to be treading water, even four years after the study referenced above.
I believe the more ambitious companies deserve mention, with BP being the first company I'd like to highlight. I've previously covered BP, who I find to be amongst the most ambitious oil majors when it comes to the green energy transformation. Some of the highlights taken from their strategic roadmap includes
What really solidifies BP's ambition is their defined purpose of "reimagining energy" in order to become a net zero company by no later than 2050 and preferably sooner. The ambition has been captured is BP's 2030 goals.
BP Sustainability Strategy (BP Investors Centre, Sustainability)
BP Sustainability Strategy (BP Investors Centre, Sustainability)
Such an ambition also carries a significant consequence for capital allocation. Therefore, BP is aiming towards more than 40% of its CAPEX budget allocated towards low carbon initiatives by 2030. Naturally, it carries risks as some technology platforms are not yet fully developed, or the leading technology not yet identified. Should BP have opted for the wrong route, it will come with a consequence as it would mean having allocated vast amounts of capital into low return segments. Another thing evident from BP's financial outcomes, is a lower expected return on average capital employed from its investments in low carbon electricity compared to its existing portfolio of fossils while its value-added services under the name of convenience and mobility is expected to exceed current ROACE levels. Of the companies in scope, BP is the most transparent in estimating the financial outcome.
BP Sustainability Financial Roadmap (BP Investors Centre, Sustainability)
BP Sustainability Financial Roadmap (BP Investors Centre, Sustainability)
The second company I'd like to highlight is Equinor (EQNR), formerly Statoil, since rebranded back in 2018 and most likely the least known of the bunch, also being the smallest measured on total assets with $147 billion in comparison to slightly below $300 billion for both BP and Total, while Shell has total assets slightly above $400 billion. Equinor is based out of Norway.
Just like BP, Equinor targets being net-zero by 2050 having recently accelerated its strategy aiming to allocate 50% of its CAPEX budget to low emission projects by 2030, as such, even more ambitious than BP. One of the reasons most likely being, that Equinor has the Norwegian state as its majority shareholder, holding 67% of the shares. In many ways, Equinor has a similar outlook to that of BP despite being significantly smaller in size, including.
The other major part of Equinor's strategy consists of efforts focusing on carbon capture technologies, carrying experience from existing CC solutions already harvested by the company, which is supposed to act as a lever in driving an efficient portfolio.
Equinor 2030 Renewable Portfolio (Equinor Investor Centre, Energy Transition Plan)
Equinor 2030 Renewable Portfolio (Equinor Investor Centre, Energy Transition Plan)
Equinor has identified a number of different technology routes where carbon capture can play a role while considering the effort required to succeed.
Equinor Decarbonising Roadmap (Equinor Investor Centre, Energy Transition Plan)
Equinor Decarbonising Roadmap (Equinor Investor Centre, Energy Transition Plan)
Having a majority shareholder such as the Norwegian state, also shows itself in the embedded vision of changing with society. Such a majority shareholder is something prospective investors need to consider, as they may insist on accelerating the change even sooner, in an effort to compensate for global lethargy while striving to be a beacon of leadership. What that means is, that profitability could be squeezed for a period to ensure maximum focus on the energy transformation, and here I'd prefer maintaining a balanced approach as the world will rely on fossils for a very long time to come. As main street investors, we need that balance so the company can continue to focus on its core purpose, driving value for its owners, but what that 67% owner considers value, may differ from the average Joe as there may be a political angle yet to be seen in full. The carbon capture aspect of the roadmap will also be interesting to follow as it banks on technologies not yet readily available or profitable, coming back to my previous perspectives related to risks in being a first mover.
TotalEnergies is a stand-alone case amongst the European oil majors, as the company is pursuing not only the offshore wind market, but also wants a strong presence in solar energy. Total has opted to allocate 50% of its CAPEX between 2022-2025 towards renewables and LNG, again striving towards being net-zero by 2050 just as is the case for BP and Equinor.
Total is betting on India being a key market, having partnered with Adani Green Energy Limited, before acquiring a 20% stake in the company for $510 million which was communicated early 2021. Total is ranking the creation of solar farms as one of its top priorities, therefore offering an alternative to Equinor & BP who appear more focused on the wind energy segment, with a particular focus on offshore, which is also expected to grow the fastest of the two. However, Total is also focusing on both onshore and offshore wind.
Total Renewables Strategy Roadmap (Total Investors Centre, Strategy Roadmap)
Total Renewables Strategy Roadmap (Total Investors Centre, Strategy Roadmap)
Total also recognizes that short-term pain must be accepted to achieve the long-term benefits. Billions will have to be invested in lower returns areas than traditional fossils, but this also results in obtaining the preferred infrastructure due to the first mover advantage. The current decade is expected to be one of major change for Total as oil output is expected to be 30% lower than today, while LNG output is expected to double only to be overshadowed by renewables which is expected to triple, albeit from a lower numerical starting point.
Total Renewables Strategy Roadmap (Total Investors Centre, Strategy Roadmap)
Total Renewables Strategy Roadmap (Total Investors Centre, Strategy Roadmap)
Lastly, we have Shell, who is somewhat of a laggard compared to the previous three, but ahead of the US majors Chevron and Exxon. Despite having a lengthy and information filled transition strategy publicly available, there isn't the same level of specificity as for the more progressive peers.
Shell is allocating roughly $3 billion in 2022 CAPEX towards renewables, out of a total CAPEX budget between $23-27 billion, as such corresponding to less than 10%. Combining that with the lack of clear-cut targets in the roadmap, it's a bit difficult to understand Shell's intention and vision. Unfortunately, it's possible to get the sensation that it's more talk than action at this point.
Shell Capital Allocation (Shell Investors Centre, Q4-21 Results)
Shell Capital Allocation (Shell Investors Centre, Q4-21 Results)
Management has shared some 2030 milestones, but they are from my perspective most characterized by being unspecific or inferior to for instance Equinor who is much more aggressive on carbon capture, or renewables in general where it's very unspecific at this point for Shell.
Shell Renewables Transition Strategy (Shell Investors Centre, Renewable Strategy)
Shell Renewables Transition Strategy (Shell Investors Centre, Renewable Strategy)
Summarizing and BP and Total stand out amongst the bunch. Equinor is also very interesting, but the Norwegian state being the majority shareholder puts me off a bit, as a state may carry political agendas to a degree that is difficult to understand as it may change according to the political landscape in a given time period. Further, that they have the chance to pass decisions despite opposition due to the majority share ownership. BP and Total offer slightly different routes, but both hold hefty 2025 and 2030 targets, having committed themselves to the point where there is no turning back - management really does believe they can construct a profitable business going in this direction, while cutting back on their legacy fossil business along the way even though it should be mentioned they still expect to carry a fossil footprint long into the future.
I prefer a company who doesn't get nervous once a direction is set, and therefore I also perceive it as a problem that Shell has yet to define its route despite being such a massive company with more than $400 billion in total assets. It doesn't impress when the management team is unable to set the course.
As already laid out, arguments can be made for either route as an investor, and glancing at for instance operating margins, there is no clear indication that either route is superior at this point in time - most of these companies are only just beginning allocating substantial amounts of their CAPEX budget, and out of a balance sheet covering hundreds of billions, it's not quite visible yet. However, for reference it's insightful to have a look at the current global leader in offshore wind farms, Ørsted A/S (OTCPK:DNNGY) carrying an operating margin fitting the existing levels of oil majors, suggesting a reasonable business can be carved from transition to for instance offshore wind. This is also in line with the financial targets published by a few of the companies, while not all are able to gauge what the future will look like just yet.
It appears, that transitioning in accordance with what I previously labelled the second option, carries the greatest risk, but also suggests the companies being more viable long-term.
Given the high oil prices, all of the companies are expected to deliver very strong EBITDA levels for FY2022. Considering the priorities of the individual companies, it could be expected that Chevron and Exxon will prioritize a higher direct distribution of capital to its shareholders, while the other companies to some extent should be expected to allocate part of the excess income towards their investment plans, in order to accelerate and get ahead of the green transformation curve. This could in particular be the case for BP, who has stated they see their net-zero 2050 target as one they would like to achieve sooner rather than later.
Valuations for these traditional fossil fuel companies have long been suppressed, not least because these companies don't fit into the agenda surrounding global energy in the 21st century. Similarly, legacy car manufacturers have long since been left in the dust, valuation wise, in comparison to Tesla who is pioneering the transformation. Similarly, it's difficult to envision a future where the companies betting on the legacy business will command a premium valuation.
However, I believe the companies able to make the leap, perhaps spearheading the transition, stand a chance of elevating the valuation awarded by the market. However, given that a significant amount of assets will have to be shed over time, while new ones are added to the balance, it is a long-term prospect.
Given the information available today, I find that Total and BP are further in their journey's towards becoming the energy companies of tomorrow, and I believe the market needs to see proper execution in the coming years, while we ultimately may observe the leaders being recognized for their efforts and heightened relevance and longevity in comparison to those who don't embark on the journey.
As such, it's no immediate payoff for shareholders, but companies becoming part of tomorrow's energy and providing a clear vision and roadmap could stand to benefit down the road. The alternative could be a similar situation such as the one IBM has experienced for a decade, where no matter what management does, the market simply doesn't recognize it as the company as perceived to have been left by more progressive peers. Similarly, those who are late to embark on the journey could well be paying hefty dividends for many years, but see their market cap slowly erode.
Global Energy Mix By Consumption (ourworldindata.org/energy)
Global Energy Mix By Consumption (ourworldindata.org/energy)
Considering the current energy mix in combination with the global agenda of transitioning, as quickly as possible, towards clean energy, it's easy to understand where future value and market recognition can be expected to lie. Fossils will stay relevant for decades, but surplus cash flow should be invested in the transition, and I don't expect the market to reward those who don't, which underlines the importance of providing the market with a clear and trustworthy roadmap.
I believe the answer lies mostly with quality of strategy and overall company commitment towards the strategy. Based upon those parameters, I believe BP, Total and Equinor stand out amongst the rest, with Equinor not making the cut due to its shareholder base.
Being in the early innings of the transition, it's difficult to find metrics that may allow assessment of managements decisions. However, a number of historic measures can be applied, such as each company's historic return on invested capital (ROIC). ROIC allows to benchmark the two, but it should be noted that the measurement makes use of 'net operating profit after tax' as part of the fraction, which is relevant as it's a financial value extracted after depreciation, where depreciation policy can matter greatly for such asset heavy companies.
Basically, ROIC tells us something about managements efficiency at allocating the capital under its control. The transition requires management to allocate billions and billions of dollars towards somewhat unknown territory. Capital can only be used once, and shareholders will want the maximum return as those assets will drive new sources of free cash flow to be reinvested, creating a positive cycle. Furthermore, capital can only be allocated once, and with such massive amounts expected to be allocated, it matters greatly for the long-term value creation how management prioritizes. Observing the two companies over a ten-year period, Total appears to have secured better allocation of available capital.
Given the uncertainty build into a metric such as ROIC, it's also of interest to consider the companies from a cash flow point of view. Coming back to the uncertainty tied to the strategic execution I prefer a company creating a lot of free cash flow, as it's the cash available to the company after cash outflows supporting its operations and therefore available towards for instance new endeavors.
Total creating a higher numerical free cash flow is not in itself meaningful as Total's FY2021 revenue is almost $30 billion higher than that of BP coming in at $184.6 billion. At the end of the day however, Total consistently creates a higher free cash flow. An interesting metric to consider, in order to mitigate the drawbacks from metrics containing input from the financial statement such as price to earnings, is free cash flow yield. However, here both companies carry a similar valuation, thus not providing a gap suggesting a preferable candidate.
Summarizing, Total appears to have the more diverse clean energy strategy being at the center of solar power while also focusing on the other steppingstones as BP, such as wind power. Combining this with the stronger historical returns on assets and superior free cash flow generation, Total edges ahead of BP despite the fact that I believe there is much positive to be said regarding BP's own voyage.
The market has for long remained skeptical of traditional oil majors tied to fluctuating oil prices, but also because these companies don't "fit" into the energy mix of tomorrow as characterized by majority of the global political scene. Some of the legacy companies have designed detailed strategies elevating them from the oil pit striving to ensure their relevance decades from today. Management teams in some of these companies have begun putting their money where their mouth is, and Total and BP stand out amongst their peers when measured on this parameter. If these companies are to continue driving value for their shareholders long-term, I believe they must exercise a progressive approach when it comes to adopting clean energy. Total has the more diverse approach and very aggressive 2030 targets while creating a very strong free cash flow allowing it to cater to its shareholders both short- and long-term. I believe Total will be a winner amongst its traditional oil peers when we consider the long-term prospects.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of SHEL either through stock ownership, options, or other derivatives. 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.