Major oil companies are in the early stages of one of the biggest transformations in any industry in decades. Nearly all of them are starting to make investments in low-carbon businesses, investing in wind, solar, and hydrogen power.
Investors clearly have mixed opinions about this shift. Big pension funds and other institutional investors are demanding that oil companies make this change, but as the companies invest in renewables, their stock prices tend to fall.
BP (BP) is one example. The company announced plans this year to produce net zero carbon emissions by 2050, and increased its spending on renewable projects — goals that are in line with investor demands. But its stock has continued to fall. It’s now down 48% this year, worse than its Big Oil competitors.
RBC Capital Markets analyst Biraj Borkhataria published a note on Tuesday analyzing this shift, and considering which companies might be able to best navigate it.
The key problem is this: Renewable energy companies are often valued on their expected future earnings. Solar development firms, for instance, often report annual losses but receive lofty valuations from investors because of expectations that their current investments will pay off in the future.
Oil companies, however, are valued on their ability to pay their dividends in the near term. Their cash flows this year and next are of paramount importance to investors. Growth isn’t really part of the calculus. Oil companies aren’t expected to grow much in the years ahead, because even the most bullish analysts doubt that oil demand will rise more than a total of 10% in the next decade from 2019 levels.
Renewables are capital-intensive businesses — similar to oil and gas — meaning that they demand high upfront investments. So oil-and-gas companies that spend on renewables today will cut into their ability to pay out strong dividends or buy back stock. And they won’t get the financial benefits of those investments for years to come.
As a result, oil-and-gas companies are stuck in a bind — their near-term investments won’t help them with investors because they’ll reduce cash flow. And Wall Street won’t value their renewables segments like they value stand-alone renewables companies, because oil-and-gas companies still have their legacy businesses dragging down their valuations.
One option to get around this issue might be to spin off the renewables businesses once they achieve scale, Borkhataria suggests.
“If the valuation disconnects continue, clearly the majors may look to spin out low-carbon segments in order to crystallize some of the ‘value’ created,” he wrote. “We think this is a possibility in the coming years.”
Oil-and-gas companies with large renewables portfolios could use spinoffs to realize that value. “After risking assets, we estimate that Equinor, Galp [Energia], and Total have the most material low-carbon businesses, and these could represent 17%, 15% and 10% of current enterprise values, respectively, if valued in isolation,” he wrote. “We think this represents significant optionality in the current share prices.”
Borkhataria also upgraded BP and Chevron (CVX) to Sector Perform from Underperform because both now have more-reasonable valuations and good prospects for shareholder returns.
His top picks in the industry are Royal Dutch Shell (RDS.A), Total (TOT), and Equinor (EQNR).
“Our preference is for those with the best free cash flow generation potential, healthier balance sheets, but also those that have started to build a track record in low carbon,” he wrote.
Write to Avi Salzman at email@example.com