British oil giant BP PLC (BP, Financial)(LSE:BP., Financial) is in the process of implementing a bold strategy to transition itself into a renewable energy company. Since the world will eventually need to transition to clean energy, this company is not planning on letting itself enter a long-term decline. Instead, it is investing in its transition while cash flows from its fossil fuel operations are still strong.
On Monday, the company announced the latest step in its energy transition plan: the acquisition of Archaea Energy Inc. (LFG, Financial), an American biogas company operating 50 renewable natural gas and landfill-gas-to-energy facilities across the U.S.
Shares of Archaea jumped more than 53% following the news, but BP shares showed little change because Archaea is still unprofitable. However, the current lack of market enthusiasm for Archaea only increases BP’s long-term value proposition.
The terms of the deal
BP will be acquiring Archaea for a value of $4.1 billion, consisting of $3.3 billion in cash (or $26 per share) and the assumption of $800 million in debt. This represents a 38% premium to Archaea’s volume-weighted average share price for the 30 days ending Oct. 14.
The deal is still pending regulatory and shareholder approval, though there is very little concern that regulators will decide to step in. With shares of Archaea trading at $25.90 as of this writing, the market has already closed the arbitrage opportunity, indicating a high degree of certainty that the deal will be completed. Once past these hurdles, the companies plan to complete the merger by the end of this year, after which Archaea will operate as a subsidiary of BP.
Archaea has not been a public company for very long at all, having just hit the markets following a merger with special purpose acquisition company Rice Acquisition Corp. on Sept. 15, so there is very little reliable information available on the company’s financials. However, we do know Archaea is currently unprofitable, having recorded a loss per share of 9 cents in full-year 2021 and a loss per share of 18 cents in the quarter ended June 2022.
Despite Archaea not being profitable yet, BP promises investors that this acquisition will not have any impact on the company’s dividend or buyback plans. Since BP has a market cap of $96 billion, this acquisition should be easily digestible. The company offers investors a dividend yield of 4.1% and has a three-year share buyback ratio of 0.6%.
In its press release regarding the acquisition agreement, BP claimed Archaea will realize distinctive value due to its trading capabilities and global customer relationships.
RNG outlook
Archaea is currently still a small company in the grand scheme of things, but it is one of the largest RNG producers in the U.S. It currently produces around the equivalent of 6,000 barrels of oil per day in RNG. Upon closing, this will provide a 50% boost to BP’s existing biogas supply volumes, which come from joint ventures with Aria Energy and Clean Energy Fuels Corp. (CLNE, Financial).
Biogas is considered a clean, environmentally-friendly energy source for two main reasons. For one, biogas is produced from the decaying organic matter in landfills, so it helps reduce landfill emissions. Additionally, biogas is cleaner burning than oil. Since it is produced from decaying organic matter that fixed carbon from atmospheric CO2, it is considered carbon neutral.
Given that biogas is a way to capture clean and renewable fuel while reducing the impact of landfills on the environment, it would make sense to produce it wherever there are landfills.
However, the biogas industry’s growth is hampered by the expensive and inefficient production process, which would make biogas production unprofitable if it were not subsidized. This makes it difficult to deploy on a broader scale.
Also, in markets such as the U.K., where biogas production is already full scaled, issues have emerged where the incentive structure encourages some edible food to be diverted down the food waste hierarchy for biogas production. Even if technological advancements could make biogas production profitable, it might not be a good thing because diverting food for fuel purposes would make the overall negative impact of biogas on the environment about as bad as burning oil (if not worse).
Nevertheless, biogas is still the best available solution for reducing landfill methane emissions at scale. There are more environmentally-friendly solutions to deal with waste that can be deployed locally, such as aerobic composting, but while some cities have used this solution effectively for sewage sludge treatment, it is just not currently feasible to compost landfills.
According to the American Biogas Council, the U.S. has over 2,200 sites producing biogas. In comparison, Europe has over 10,000 operating digesters while having a population that is a little over twice the population of the U.S. This means the total addressable market for the biogas industry in the U.S. is huge. The American Biogas Council estimates there are 14,958 potential sites for biogas projects in the U.S.
Overall, Archaea Energy still has significant room to scale up and reach subsidized profitability in the U.S., even if it is ultimately an imperfect solution that will continue to exist mainly as a better alternative to letting landfills produce methane unchecked.
Takeaway
BP’s plan to acquire Archaea is another step in the right direction for its renewable energy transition. While the size of the biogas industry in the U.S. should ultimately be restricted to building capacity on existing methane-generating waste sites, there is still plenty of room to grow here as the U.S. biogas market is not yet built out like Europe’s. The fact that BP continues to make value-accretive acquisitions while retaining its dividend and share buybacks is an encouraging sign that its long-term transition plan is going well.
