Big Oil’s Great Paradox: Record Profits, Low Stock Valuations

Instead, they’ve been rewarded with rock-bottom ratings, especially in Europe. The biggest majors there, BP (ticker: BP ), Shell ( SHEL ) and TotalEnergies ( TTE ), are trading at between five and seven times projected 2023 earnings. That compares with about 11 times for Exxon Mobil ( XOM ) and Chevron (CVX).

Last year, energy was the only safe place to hide from an inflationary economy and free-falling market. This year, even with persistent inflation, oil stocks are a tougher bet.

The near-term problem is that oil prices are not expected to reach their 2022 highs again this year, and natural gas has already fallen below Ukraine’s pre-war levels. Therefore, revenue slows down. The long-term problem is that the energy companies of the future—what they will be today after they focus more on renewables—don’t have much of an investor base. Without an influx of new investors, the stock is unlikely to see the higher valuations it needs to repeat last year’s strong performance.

Companies say they can profitably invest in clean energy and fossil fuels at the same time, but many investors don’t believe it. This is especially true for the big European companies, which have committed to being greener. Until these companies show the profits they say they can make from clean energy, they are likely to face steep valuation discounts and trade at less than 10 times expected earnings.

BP made one of the most detailed cases last week for a dual mandate: drilling for crude today while building new businesses in biofuels, other renewables and electric vehicle chargers that will take off in a few years. In addition to increasing its dividend, the company says it will invest an additional $1 billion a year in both fossil fuel and energy transition companies through 2030, leading to higher oil production and more renewable energy . Instead of cutting production by 40% by 2030, it will cut it by 25%.

Investors liked what they heard. BP shares rose 14% from the company’s filing on Tuesday through the close of trading on Thursday. And analysts raised their medium-term expectations for the company, raising 2025 earnings estimates by 17%.

But the stock’s gains don’t necessarily mean investors outside BP’s traditional base are buying its story. The rally was likely sparked by the enthusiasm of that base, some energy fund managers say. Those investors liked BP’s higher payout and its claim that “we’re still going to be in oil and gas drilling and get very good returns,” says Rob Thummel, portfolio manager at asset manager TortoiseEcofin. Still, even after the recovery, the stock is trading at just six times expected 2023 earnings.

Oil companies are unlikely to be rewarded with higher valuations for green investments in the same way that renewable-focused utilities such as NextEra Energy

(NEE), have been in recent years. “I believe in the ‘green premium.’ I don’t think these companies will have it anytime soon,” says Michael Cerasoli, portfolio manager at Eagle Global Advisors.

BP expects its change in strategy to boost results considerably; has raised its core profit forecast to 2025 by 25%, partly based on an assumption of a more expensive petro. BP raised its oil price forecast to $70 from $60 by 2030 because it expects Russian output to fall over time and because U.S. shale output is growing slowly and the Organization of the Exporting Countries de Petroli is increasingly ready to intervene when prices fall. (Russia announced on Friday that it will cut output by 500,000 barrels a day, starting next month, in response to Western price caps on its crude.)

Even with the higher price assumption and an ongoing share buyback plan, BP’s earnings per share are expected to fall every year through 2026.

However, BP’s Looney says so barron’s that there is still a strong case for your company. BP is positioned to supply a global energy system that still needs hydrocarbons, while building a greener future. BP’s Global Energy Outlook, released last week, argues that oil use has already leveled off and is likely to fall faster than expected due to the shock of Russia’s invasion of Ukraine.

But even President Joe Biden said in his State of the Union address that the world would need oil for at least another decade. To replace oil and natural gas, BP is investing in products such as biofuels. Last year, it paid $3.3 billion for a Houston company called Archaea Energy that produces biogas from landfills. “We’re going to transform this business,” adds Looney. “They have 80 sites. It would probably take them four years to build it because they had capital constraints. We’ll probably build it in two years.”

BP is also investing heavily in wind power with Norwegian partner Equinor ( EQNR ), including installing enough offshore turbines along the US East Coast to power two million homes. Americans, whose opinion of BP may be linked to the 2010 Deepwater Horizon explosion in the Gulf of Mexico, will get clean energy from the company later this decade.

However, BP is unlikely to get credit for these investments from the environmental community for years to come. Mark van Baal, founder of the climate-focused activist shareholder group Follow This, gave BP better marks than other oil majors in addressing climate change last year. But he said his plan to increase drilling means he has “backtracked”. It plans to file a shareholder resolution to challenge the move. Looney considers these criticisms unfair, because while BP will continue to drill, it has “accelerated and advanced” its clean energy spending.

Within the environmental movement, there is a wider distrust of BP because of its troubled history in green energy. The company had even adopted the moniker Beyond Petroleum in 2003, before scrapping the idea. And like other oil majors, BP’s transition businesses remain a work in progress, with uncertain climate benefits.

BP puts gas stations that have convenience stores in its “transitional growth engine” bucket, for example. Looney says this is justified because most of the stations’ earnings come from ancillary services such as selling food to riders. Owning gas stations also allows BP to control how quickly it installs electric vehicle chargers; plans to install more than 100,000 charging points by 2030.

The goals of some of the investors BP needs to attract overlap with those of environmentalists, but not exactly. They have to believe in the returns of the new companies, as well as in their green bona fides. Wind power, in particular, has been a financial albatross of late, with project developers complaining that they signed contracts to install turbines when the prices to build them were much lower. Recently, an East Coast developer tried to back out of a major contract in Massachusetts.

BP says it can get 6% to 8% returns from wind, below the 15% it expects to earn from biofuels and the 20% plus it can get from oil today. Looney says BP can use the wind energy it produces for high-value purposes, such as making clean hydrogen or powering electric vehicle chargers.

“Offshore wind is the fastest growing energy source in the world,” says BP CEO. “It’s the only way for countries like the UK and Germany to really decarbonize. We think we’re distinctive, because we’re not just a company that’s going to generate the electron, we’re going to do something with the electron.”

BP could eventually turn cheap almonds into valuable almond joys, but it will take years for investors to see the proof. Meanwhile, fund manager Cerasoli expects low valuations in the energy sector to persist. Finally, BP and its rivals could look to another strategy. It could take years, but once they build big enough divisions, he says, “I wouldn’t be surprised if these big guys end up spinning off their organic businesses.” In fact, spin-offs could eventually be the cleanest route to this green premium.

Investors are optimistic after the

S&P 500 Index

A 7% recovery to start the year. Maybe a little too optimistic. Contrarians have declined to their lowest level since November 2021, according to a weekly survey by the American Association of Individual Investors, a contrarian indicator. If investors get too happy, there’s a good chance the market is about to crash.

This notice makes me think of a line SeinfeldGeorge Costanza, who wins a life-changing business contract and then discovers a discoloration on his lip that he believes is fatal. “God would never want me to succeed,” he says. “He would kill me first. He would never let me be happy.” His therapist reminds him that he doesn’t believe in God. “I do for the bad things,” he replies.

George’s wisdom is a good antidote to the hopeless dreams that drive the stock market up, led by its riskiest assets. The market hasn’t earned that kind of happiness, or at least Wall Street’s definition of happiness. At 18.3 times expected earnings, the S&P 500 is approaching unreal levels. The market has held valuations above 18 times only twice in the last 30 years: in the tech bubble and during the peak of the pandemic, notes Keith Lerner, co-chief investment officer at Truist Advisory Services. Meanwhile, full-year earnings estimates for the S&P 500 have fallen since last May, from $250 a share to $223.

To give the market an even higher valuation, investors would have to believe that “earnings are going to be much stronger than the consensus” or they should overlook the 2023 numbers, Lerner says. “From our point of view, this is just a tough argument.” His advice: maintain a healthy cash position.

Write to Avi Salzman at avi.salzman@barrons.com