BP has elaborated on its strategy to deliver net zero – cutting oil and gas production by “at least” 40% by 2030.
Investors are ever more focused on what climate change means for both the emissions and the valuation of their portfolio. We have long argued that an oil company which gives greater certainty about cutting production to fit within a Paris aligned budget would increase confidence on both of those fronts. On the day of BP’s announcement, its share price is up 7% – the market has clearly shown that it agrees.
The question now is, as investors have clearly shown what they want, who else will follow BP’s leadership?
A clean cut
On a planet that has finite limits, solving the climate challenge requires absolute reductions in emissions. This in turn means absolute reductions in the sources of those emissions – the use of, and production of fossil fuels.
While European oil and gas companies have been queuing up to announce emissions targets over the past year or so, they have framed them to allow increases in production for the next decade or so. North American producers remain undaunted in their assumption of full steam ahead for fossil fuels.
This causes two problems. Firstly, without absolute reductions in fossil fuel production/use, it is hard to see how international climate commitments can be achieved. Secondly, if a company plans to grow production while the rest of the world lowers its use of fossil fuels, it leaves open the financial risk of asset stranding.
There have been vague hints of production cuts by an unspecified degree at some unknown date in the future; Eni had come closest to giving numbers by pointing to an oil production peak in 2025 before a “flexible” profile. But until now, no companies have really managed to bring themselves to properly confront this reality.
BP puts flesh on the bones
That has now changed. In setting out its 2050 net zero target earlier this year, BP noted that it would give more detail in September. We agreed this was needed – it’s easy to set targets that are a long way in the future but don’t drive much change now, or are reliant on overoptimistic assumptions on technologies like carbon capture to square the circle.
BP’s announcement notes that it expects oil and gas production to fall by at least 40% by 2030, and related emissions from that production (including from end use) to fall by 35-40%.
The carbon intensity of BP’s operations will fall by 30-35%; as oil and gas fields mature, their carbon intensity will tend to increase on a per barrel basis (for example, as oil reservoirs are depleted they will increasingly deliver less hydrocarbons and more water, therefore requiring more energy per barrel of oil), so it is to be expected that operational emissions will fall slightly more slowly than production.
Further, BP expects its refinery throughput to fall by nearly 30%, calming any concerns that it may have wanted to just move down the value chain.
The targets, however, don’t cover all of BP’s economic interests. For example, they exclude its stake in Rosneft and it’s trading business. Nevertheless, the scale and detail of this intent clearly differentiate it from the rest of the pack.
Investors get a chance to vote with their feet
As investors have grappled with the issue of climate change, a tension has risen – how to allocate capital in a way that furthers the financial interests of beneficiaries, while realising that some of the fossil fuel companies in their investment universe have to get smaller?
Whereas a constant pursuit of growth may once have been a positive, the maths has changed. Over the last decade, the industry has shown a propensity to over invest in the pursuit of increased volume. For example, Exxon’s acquisition of XTO Energy and persistence with oil sands and other capital-intensive projects has left a hangover from the $100/bbl years, with years of falling return on capital employed. The shale treadmill has delivered volume growth but capital destruction. Exploration has delivered poor value for money, and for years it has been the norm that the majors have failed to replace their reserves organically, making up the gap with acquisitions.
At the same time, investors have recognised the megatrend of the energy transition towards a lower carbon economy. Furthermore, their clients and the beneficiaries of the capital that they steward are increasingly looking for “Paris alignment”, given that they will have to live with the planet that their investments create. And yet, despite repeating the mantra of value over volume, virtually all oil and gas companies have continued to pursue plans for near term production growth. Furthermore, they’ve tended to shoot for production growth in excess of even business as usual demand growth, let alone the declines required by climate goals.
The result: woefully underperforming stock prices. The industry puzzled as it delivered record cashflows in 2018 and 2019, yet share prices remained weak. Some observers even noted that the majors seemed to be trading at a discount to the value of their proven and probable reserves. If investors think that future projects might get stranded, they can’t put much of a price on them.
In a recent blog, we pondered whether greater commitment to a portfolio that stayed within the Paris limits, hence giving better certainty on avoiding future destruction and a more appealing story to the more environmentally-minded, would be rewarded by the market. We didn’t have to wait long. The results are in – following today’s announcement, BP’s stock price is up around 7% at the time of writing despite cutting its dividend in half.
Oil and gas executives have previously argued that reducing investments in fossil fuels would not benefit their shareholders, and might even be a breach of their fiduciary duties as directors. The huge outperformance of Ørsted since leaving the oil and gas business suggested that such concerns might be misplaced – its shares are up around 215% since selling its oil and gas portfolio in 2017 and moving into offshore wind, while the S&P Exploration & Production index is down around 65% in the same period. BP’s share price is now down 40%, with today’s gains a step to reversing the trend.
But, while that was a complete divestment of fossil fuel assets from a relatively smaller player, the market has lacked an opportunity to show its view on a larger company making the call to progressively wind down its fossil fuel production. The results show that executives can rest easy. With this debate out of the way, which other companies will embrace the new world and follow suit?