British oil and gas major BP PLC (LSE:BP., Financial)(BP, Financial) has not been doing particularly well this year. While the broader energy sector is up an incredible 18.78% year to date, represented by the iShares U.S. Energy ETF (IYE, Financial), BP’s shares have only gained about 4.24%.
This underperformance has everything to do with BP’s all-in bid to rapidly transition from oil and gas to renewable energy. The company is hard at work investing billions in clean energy and selling off parts of its oil and gas operations.
While oil and gas might still be profitable for now, in the long term, it is destined for permanent decline. BP’s strategy thus seems to be a wise choice; by becoming an early mover, it has the potential to be churning out profits in a couple of decades while peers that just stick with oil and gas enter a downward spiral.
However, the big question for investors is, can the company truly pull this off? If it can, when can investors expect the stock to take a turn for the better? Let’s take a look at where BP is right now and what it will take for the renewable energy transition to bear fruit.
BP’s transition plan
BP is putting into motion an ambitious plan to reach net zero by 2050. That may seem like a long timeframe, but the reality is that it will take time to build out enough renewable energy infrastructure to support the world’s energy needs.
By 2025, BP plans for approximately 40% of the capital it invests to go toward five energy transition growth businesses: bioenergy, convenience, electric vehicle charging, renewables and hydrogen. In other words, investors do not need to worry that BP is trying to transition too fast since 60% of BP’s capital investments will still be in non-renewable energy assets at that time.
The continued investments in oil and gas are essential because without that cash flow, BP would not be able to fund its transition. The company is not expecting its clean energy segment to be profitable at all by the time 2025 rolls around. Even as it sells off parts of its oil and gas business to fund renewable projects, it will still need to maintain and continue investing in hydrocarbon extraction projects.
The latest step in BP’s transition is the acquisition of a massive 40.5% stake in Australia’s Asian Renewable Energy Hub. According to BP, which will become the operator of this project, it has “the potential to be one of the largest renewables and green hydrogen hubs in the world.” The idea of the hub is to provide solar and wind energy to local customers and export green hydrogen energy internationally.
We can likely expect more announcements of this nature from BP in the future, along with further divestments of oil and gas operations.
Profitability timeline
When BP’s CEO Bernard Looney took office in February 2020, he set goals to reduce BP's oil and gas output by 40% (an amount equal to the U.K.'s daily output in 2019) while boosting its renewable energy capacity 20-fold (equal to the power produced by 50 U.S. nuclear plants).
To achieve these goals, Looney planned to sell $25 billion worth of fossil fuel assets by 2025, which was equal to 13% of the company’s total fixed assets at the time. Meanwhile, the company has acknowledged that the renewable energy business will not be profitable until 2025 at the earliest.
The company’s fossil fuel divestments were sped up by the decision to exit its investments in Russian petroleum major Rosneft (MIC:ROSN, Financial) in the first quarter of 2021 in light of Russia’s war on Ukraine. BP took a $24 billion pre-tax charge on the sale, and while this was not exactly a profitable divestment, the company was still able to reduce its net debt to $27.5 billion and announce $2.5 billion in planned buybacks in the first quarter.
As of BP’s first-quarter 2022 results, the company aims to bring in Ebitda between $9 billion and $10 billion from its “transition growth business” (i.e., EV charging, convenience, bioenergy, renewables and hydrogen) in 2030. For 2025, it still marks this part of its business as being in a growth stage, so it seems the company is guiding for its renewable operations to become profitable on a pre-tax basis sometime between 2025 and 2030.
Valuation
Considering the company does not expect its renewable energy business to be profitable in 2025, the planned divestment of fossil fuel assets would imply that in 2025, BP shares will be worth 13% less than when Looney became CEO. This has already been more than priced in, even if we completely ignore the long-term growth potential of the renewable energy business and take into account the loss on the Rosneft investment, as the stock price has declined 25% since Looney became CEO.
According to the GuruFocus free cash flow-based reverse discounted cash flow calculator, the company would need to see its free cash flow actually decline by 6.42% per year for the next decade in order to be fairly valued at its current price.
Based on the DCF model, it would appear BP has quite a bit of wiggle room thanks to its margin of safety. Even if the return on investments in renewable energy fails to keep up with the loss from fossil fuel divestments, the difference would need to exceed 6% for the next decade in order for the stock to be overvalued today.
Takeaway
BP is pursuing a bold strategy by attempting to transition to renewable energy at a faster pace than its peers. It will not be an easy task, and the share price will likely suffer in the short term as investors balk at the sale of oil and gas assets to invest in operations that will not be profitable until some nebulous time in the next three to seven years.
However, for investors focused on the long term, this is one of the few oil giants that has not resigned itself to a slow but steady decline. BP truly plans to be part of the world’s energy future in 30 years’ time, not just as a fossil but as an industry leader. It appears to have the financial firepower to pull this off, especially since it is beginning to divest oil and gas assets while they are still commanding high prices. Even if shares still have farther left to fall, the stock is likely undervalued compared to its long-term potential right now, though investors might still be able to wait for a better entry point.
