You've seen the news headlines about global warming and how carbon-based fuels like oil are a huge piece of the problem. That's not hyperbole. That's scientific fact. If environmentalists had their way, we would stop using older energy sources today and rely entirely on renewables like solar and wind power. That's a great dream, but it's just that -- a pie-in-the-sky dream. Oil giant BP (BP -1.65%) recently explained the problem with that goal. Here's what you need to know to understand why oil giants like BP and ExxonMobil (XOM 0.12%) are still putting big money to work in a dirty, out-of-favor industry...and how you can benefit.
Global warming is real
The science behind global warming is incontrovertible. The process of burning carbon-based fuels like oil releases carbon dioxide that increases the impact of the greenhouse effect. Humans didn't cause the greenhouse effect; it's a natural process in which gasses in the Earth's atmosphere trap the sun's heat. In fact, without the greenhouse effect, the planet would be much colder and, perhaps, not quite as nice to live on.
The problem we face today is that human activity appears to be exacerbating the natural process, increasing the amount of heat trapped. Some projections for the future suggest that the Earth will heat up so much that it could cause a severe impact on the planet and all of the lifeforms that live on it. To be fair, making those projections requires a lot of estimates and educated guesses. It would be an understatement to say that it's very difficult to make these kinds of long-range predictions. This is largely why there's so much controversy around the issue. Still, the world has begun to adjust, with solar and wind power growing meaningfully as countries around the world look to reduce the use of carbon fuels.
Coal has been the most impacted, with electricity increasingly supported by cleaner-burning and lower-cost natural gas. That's a transition fuel, as the world continues to build out alternative energy like solar and wind. Electricity, meanwhile, is increasingly the power of choice, even for automobiles. Which means oil, which is used to make gasoline, is also facing major headwinds. So why on this green Earth would an investor want to buy an oil and natural gas stock like BP or Exxon?
There's a long way to go
It's a laudable goal to switch from carbon-based fuels to clean energy, but not one that can be achieved overnight. Fuels like oil and natural gas are too integral to our day-to-day lives to simply remove them. In fact, as BP's Bernard Looney, chief executive of the energy giant's upstream division, recently highlighted, "[I]n almost every scenario -- oil and gas together are forecast to represent greater than 40% of the energy mix in 2040." That's another two decades in which these two sources of energy remain vital contributors to world energy markets.
BP's latest projection calls for global oil demand to rise from around 100 million barrels of oil a day currently to roughly 110 million barrels of oil by 2040. This assumes a gradual transition toward cleaner energy sources like solar and wind. If this scenario plays out, there's no problem for oil companies. However, if the world gets more aggressive, BP's projection for demand is just 80 million barrels of oil per day. That would be a problem (though hardly the death knell for the industry), but it isn't the most likely outcome since it requires all countries to actually meet the targets set out in the Paris agreement. That hasn't been going so well, notably with the United States' pulling out of the deal.
This is all very interesting, but there's one more fact that investors need to keep in mind: Oil and natural gas are depleting assets. Once you pull a barrel of oil out of the ground, it is gone for good. So as you use oil and natural gas, you need to find new sources to replace the fuel you've used. This is no small issue. Using very conservative estimates, BP looked at what global production would look like if all oil and gas exploration were to be stopped right now. Using a roughly 3% annual decline rate, by 2040 oil production would be roughly 45 million barrels of oil a day. That's well below even the 80 million barrels a day needed in the most aggressive clean energy scenario.
Which is why the outlook for energy giants like BP and Exxon isn't as bad as you might think if you follow the media coverage of global warming. It also explains why BP recently paid $10.5 billion to acquire onshore U.S. energy assets from BHP Group. The 470,000 acres of land holds an estimated 4.6 billion barrels of oil. That's oil BP will need to replace the oil it's pulling out of the ground today. BP's capital spending plans call for investment of between $14 billion and $15 billion a year. It's still betting big on oil and natural gas, but as the demand and depletion dynamics show, that's just good business even as the world gets increasingly serious about global warming.
And BP isn't alone in this assessment or approach. For example, Exxon plans to spend as much as $30 billion a year developing onshore U.S. energy projects, offshore oil, and natural gas assets. The goal at Exxon is to push production higher after a multiyear period in which production had been dropping. But the big-picture reason for the investment is really the same: The world can't simply stop using oil and natural gas. Someone has to keep finding new supplies, and companies like BP and Exxon are taking up the challenge.
Meanwhile, investors can collect historically high dividend yields from both Exxon (around 4%) and BP (around 5.6%). It's worth noting that BP was forced to cut its dividend after the Deepwater Horizon disaster in 2010, so its dividend history isn't nearly as impressive as Exxon's streak of 36 consecutive years with a dividend hike. Conservative investors would likely prefer Exxon. But, in fairness, BP has changed greatly since that horrific event and is on much stronger financial ground today.
Don't ignore big oil
The headline risk from global warming is real. However, efforts to deal with that issue likely won't be as bad for big oil companies including BP and Exxon as investors think. And those willing to take a contrarian, and likely realistic, view of the energy industry can collect fat dividends while these two oil giants continue to do what's needed to supply the world with vital oil and natural gas -- oil and gas that will be needed even in the best-case scenario of a globally coordinated effort to reduce greenhouse gas emissions. If global warming has kept you out of the oil patch, you might want to reconsider that decision.