“BP MUST BE SUBJECT TO A WINDFALL TAX!”. So was the almost universal clarion call from political commentators and politicians themselves when BP announced its annual results for 2021 earlier this week. Declaring a headline pre-tax profit of FIFTEEN point two BILLION dollars (as one newscaster emphasised the magnitude almost in disgust), it clearly allowed the inference that BP is akin to a latter-day Dick Turpin of the business world. Leading the charge for a windfall tax at 0715, only 15 minutes after the results were released, the BBC Radio 4 Today programme’s departing business presenter, Dharshini David, temporarily lost sight of objectively reporting the business news and in what almost became a rehearsed rant, virtually adopted the role of populist lobbyist in front of the show’s 7m listeners. Against the backdrop of the significant political hot potato of inflation surging as much as anything thanks to rising energy costs, calling for a tax surcharge on oil companies being seen to be making off like bandits while household incomes are under increasing pressure is a simple and seductive argument. 

Excess profit? Or just a big number 

When seeking an axe to grind, or an argument to defend, as often with complex companies’ profits, it’s a case of pick whatever number suits your purpose (whether it is the raw headline figure, or one based on adjustments for continuing operations, especially if there has been a reconstruction or major disposal; or, in the case of retailers, analysts are always keen to compare like-with-like progress, particularly if the company is in the habit of regularly opening new stores etc). But here for the sake of simplicity let us take BP’s consolidated group annual headline figures as reported by the company itself for the last 6 years: 

*Jupiter estimates
(a): Adjusted underlying replacement cost (RC) profit net of interest and taxes attributable to BP shareholders 

Is the argument for a windfall tax justified? Which profits should be sur-taxed? A figure based on the ongoing operations as in (a)? Or the warts-and-all pre-tax profit, which may reflect the ramifications of events which took place in previous reporting periods? Or pick another line from the Annual Report; there are plenty from which to choose.
A windfall tax is usually justified if companies are seen to be making egregious or ‘excess’ profits at someone else’s expense, particularly in the energy and utility sectors where genuine price differentiation is limited. It is undeniable that BP’s most recent result is significant: $15bn of declared pre-tax profit, or £11bn, is indeed a great deal of money; in context it is the equivalent of 3.7 new Queen Elizabeth class aircraft carriers, minus aeroplanes—they come as an optional extra; the accounting tax alone (rather than the actual tax paid in cash, as shown above) of £5bn charged on BP’s 2021 profit would buy 1.7 aircraft carriers. But there were no such calls in 2018 when the company reported a profit figure $1.5bn higher; different times, different circumstances, one assumes. And, bearing in mind the price of oil has been highly volatile while the costs of extracting, refining and delivering it have remained largely fixed, so too have the company’s pre-tax profits shown wild fluctuations. Indeed, the swing from a pre-tax profit of $8.2bn in 2019 to a loss of $24.9bn in 2020 is a total negative fluctuation of $33.1bn (£24.5bn), almost exactly the equivalent of the UK Department of Transport annual budget. If we look at the cumulative pre-tax profit over the six years, totalling $20bn, that’s an annual average of $3.33bn (£2.5bn), which suddenly does not look so very large at all; does that rank as egregious or excessive? And consider that the total amount of tax paid in cash by the company is $23.2bn — it is hardly as though the taxpayer has been short-changed by the company.

Nominal sums or investment returns? 

Integrated oil companies are big, capital-intensive businesses with long project pay-back periods. Their profits need to be seen in the context of returns to shareholders in relation to the companies’ capital employed (ROCE) in maintaining huge portfolios of long-term fixed assets and the need to reinvest in new projects in order to be sustainable businesses. Here the picture is less happy. Middle single-digit average returns (bearing in mind two years in our illustration are negative) not much greater than the company’s weighted average cost of capital indicate that the company is struggling to create economic value added; if a tax surcharge is levied, that reduces the amount available for reinvestment which in turn limits the likelihood of achieving more profitable returns; left to fester long enough, the debilitating effect creates a drag on both profitability and tax payments to the exchequer. You don’t rob Peter to pay Paul, you end up robbing both Peter and Paul.

 

Memories are short. Following the collapse in global oil prices in 2014 as the effect of a slowing Chinese economy disturbed the supply/demand equilibrium for oil, for most of the remainder of the decade up until 2019 prices were barely allowing the industry to achieve cash break-even. It was an industry running on fumes. Rigs and platforms were being mothballed; new, high-cost exploration projects were being shelved; capital expenditure beyond what was already committed was binned. Despite the long-term climate change pressures stretching out over the next three decades, there is ample evidence that the industry has much catching up to do in the meantime just to maintain pace with current demand to keep us moving. 

The dividend cash machine 

BP has historically been one of the UK’s biggest dividend payers alongside Royal Dutch Shell. In 2021 in cash terms BP paid out $4.3bn (£3.2bn—that’s one complete aircraft carrier with a couple of bells and whistles, albeit still with no aeroplanes), most of which ends up being distributed to its biggest shareholders who are typically pension funds and life companies (in 2021 BP and Shell between them will have paid out close to $10bn or £7.5bn in cash dividends, excluding any returns to shareholders via share buy-backs etc). But as we go through significant societal change, accelerated by the knock-on effects of the pandemic, and shareholders drop steadily down the list of priorities for many companies’ boards at the expense of other ‘stakeholders’, it seems a moot point that such a direct benefit is potentially jeopardised too by higher taxes, despite it being those shareholders whose capital is at risk (and most of us are beneficiaries of those pension funds). 

Hating Big Oil: the modern equivalent of legalised bearbaiting 

Almost everybody loves to hate oil companies and not just the likes of Greenpeace and Extinction Rebellion; even if not hating them, central bankers and pension regulators would have dropped them from the Christmas card list some while ago. And yet, almost literally, they keep the world moving. We depend on them to a significant degree for our energy and fuel needs. Under the Paris Climate Accord the world will transition from a hydrocarbon-based economy and society to one which depends on alternative sources of energy, whether renewables, hydrogen or nuclear, possibly even other forms, such as nuclear fusion, which are yet but a twinkle in their inventor’s eye. The transition will not be a cliff-edge event; it will be gradual, and we see the big integrated energy companies as being an essential part of the transition process, not only continuing to meet the short and medium-term demand for oil, but also re-investing significant sums in new, alternative fuel sources. They are an important part of the long-term energy solution, not merely the encapsulation and embodiment of the climate change problem. In which light, they present an investment opportunity as much as posing a risk.

 

Many energy analysts estimate that peak oil demand is yet to be reached, probably around the end of this decade beyond which there is likely to be a slow but steady decline. Pre-pandemic demand for oil stood at around 100m barrels per day; having dipped during the recession it is now recovering towards that figure once more. There are many widely differing estimates for global oil demand by the middle of the century, but a consensus seems to be forming that depending on how quickly combustion engine vehicles are replaced by those powered by alternatives, it is quite possible that in 2040 global oil demand may still be around 75-85m barrels per day. As existing fields gradually expire, new ones will need to be drilled to meet the demand (indeed just this week the UK government issued licences for three new North Sea fields to be opened up). 

If they are part of the solution, why risk making them uninvestable? 

Simultaneously, and being well aware of the long-term existential threat to their businesses (and not all will survive, only the leanest, most innovative), they need also to invest in alternatives to remain literally sustainable businesses. All of which requires investment backed by access to affordable capital: if on top of all the obvious challenges the companies’ ability to generate their own capital is compromised by punitive taxes, so the onus is increasingly to find outside capital to do the job. But third-party investors weigh up the risks against the potential returns: the greater the risk, whether commercial, economic, competitive, social, environmental or political, the higher the required return. If the barrier or hurdle rate is too high, particularly if pushed that way artificially by government action, investors take their money elsewhere, capital dries up, the businesses wither and die. In the case of the energy industry none of which helps society achieve the ultimate aim of reducing global emissions.

 

For those thinking of joining the queue attacking the oil companies with punitive taxes, they should ask themselves what it is they are trying to achieve. It might be popular and populist and make good short-term headlines; but making such companies uninvestable by inflicting death by a thousand cuts is no way to keep the lights on. Or indeed allow Western democracies to survive.

 

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions. 

The value of active minds – independent thinking

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.

Fund specific risks

The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth. 

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