8 Min Read
By John Kemp
LONDON, Jan 30 (Reuters) - The arrival of a swarm of activist hedge funds and investors in the oil and gas sector may be good news for corporate governance, and possibly for shareholders. But it risks killing off the innovation and risk-taking which has revolutionised U.S. petroleum production over the last decade and transformed the global energy outlook.
Activist Carl Icahn has finally pushed Chief Executive Aubrey McClendon out from the Chesapeake, the firm he founded in 1989, and grew into the country's second-largest producer inside two decades.
Hedge funds TPG-Axon and Mount Kellett Capital are hoping to emulate that success by ousting McClendon's disciple, Tom Ward, from the top position at SandRidge.
Now Elliott Management is targeting the venerable John Hess, son of founder Leon Hess, at the eponymous corporation by trying to stack the board with its own handpicked nominees.
Elliott is best known for stalking the Republic of Argentina through the U.S. court system over its defaulted debts, and arresting a sail-training ship owned by the Argentine navy in Ghana before an international tribunal ordered it to be released.
The activist hedge fund has promised to boost shareholder value at Hess by installing a more independent and experienced board, refocus Hess's portfolio by spinning off its Bakken acreage and overseas assets, improve cost control and instil greater capital discipline.
The question is whether the arrival of activists with their emphasis on capital discipline, and the removal of the buccaneering entrepreneurs, will reduce the rate of innovation and harm the long-term outlook for U.S. oil and gas production.
The positive perspective is that the leadership changes mark the maturing of the shale industry from its early pioneering, Wild West phase into a steadier and more stable state. The contrast is between the pioneering Henry Ford in the early 20th century and legendary manager Alfred Sloan at General Motors from the 1930s to 1950s.
The less positive perspective is that the activists will bring a short-term boost to shareholder value but at the cost of long-term stagnation and decline.
It was inevitable the U.S. oil and gas sector would eventually draw the unwelcome attentions of activist funds trying to pick off the weaker members of the herd.
Oil and gas is the fastest growing industry in the United States. No industry has seen a bigger transformation over the last decade. But the general upswing helped conceal very variable management performance. Now the industry has become the victim of its own success. As gas and oil output has soared and prices have fallen, the focus has shifted to cost control and execution.
Hess has not helped its own case. The company cannot decide whether it wants to be a major international oil and gas company, or a mid-sized independent oil and gas prospector in the United States.
The company's proxy statement lists a bizarre mix of companies in its self-selected comparator group: Anadarko, Apache, Devon and EOG, but also BP, Chevron, Shell, Total and Statoil, with Conoco, Marathon, Murphy, Occidental and Talisman thrown in for good measure.
With great respect to Hess, it is not Shell, Exxon or Statoil.
The one company it is not compared to is Continental Resources, which it most resembles with its Bakken position, according to Elliott Management's pitch-book, which has been filed with the U.S. Securities and Exchange Commission as part of its bid to install five new independent directors.
Investment analysts are unsure whether to classify Hess as a large-cap international oil company or a small U.S. focused independent. Only two of the sell-side analysts covering international oil companies including Hess also cover independent U.S. companies operating in the Bakken, according to Elliott. Hess is a composite which does not score well in any valuation category.
Elliott has criticised what it sees as the overly cosy relationship between the chief executive and the rest of the board of directors, and the resulting lack of accountability for poor performance.
In the case of Chesapeake and SandRidge, activists have gone much further, and complained about the propriety of complicated financial dealings between the companies and their chief executives, including special compensation programmes that allowed the chief executive to invest alongside the company in new wells.
Lawyers will spend many happy hours arguing whether these complaints have any legal merit. But shareholders have no moral or practical reason to complain. The risks of buying into a family-owned firm, or a company with a founding or otherwise dominant chief executive, are well known.
In the case of McClendon, the chief executive can claim to be an entrepreneur as well as a manager, who created enormous amounts of value for shareholders initially.
Unlike the bland bureaucrats and accountants who run many large corporations, McClendon and Ward see themselves, with some justification, as risk-takers and value creators who built successful businesses. They are co-owners as well as managers, a status which has been recognised by the boards of their companies in their unusual compensation programmes.
Compensation programmes for all chief executives are always a little unusual -- quis custodet ipsos custodies? The special programmes created to reward McClendon and Ward are more unusual than most, but did at least align the incentives of the chief executive with those of stockholders in the exploration programme.
McClendon and Ward have been felled by the declining price of gas, condensates and more recently oil, rather than governance failures. If the price of gas was still $6 or $8 per million British thermal units, no one would worry about the special compensation programmes at Chesapeake and SandRidge or underperformance at Hess.
In that sense, the fracking revolution has started to devour its own children. By transforming not only the technology but the cost structure of the industry, the fracking initially created fabulous profits which then evaporated as competition intensified and output surged.
From an industry perspective, the most worrying thing about the arrival of the hedge fund activists is whether they will kill off innovation.
Activists preach shareholder value, cost control and capital discipline. Elliott quotes approvingly from a July 2012 Citigroup research report that calls for Hess to cut exploration spending 50 percent. "The company should return more cash back to shareholders instead of attempting to grow at all," Citigroup wrote.
However, small and midsized exploration and production companies like Chesapeake, Continental and Mitchell/Devon Energy, all with larger than life leaders, a willingness to innovate and take risks, have been entirely responsible for the surge in U.S. oil and gas output. Majors like Exxon, BP and Shell played no part in the shale revolution. They were too busy focusing on capital discipline and shareholder value.
McClendon has been pilloried for his role at Chesapeake. But to shift the focus for a moment, did Apple Computer have a corporate governance problem when Steve Jobs was in charge? Transformational change is often associated with individuals with outsized personalities and an unconventional approach to management. Henry Ford is another example.
Some innovations generate huge payoffs; most fail. No rational capital-disciplined investor would have pursued the unproven and highly risky approach to horizontal drilling and hydraulic fracturing under the city of Forth Worth in Texas. That is why it fell to George Mitchell at Mitchell Energy and Development.
Like the railway barons of the nineteenth century, the oil and gas prospectors have over-expanded their industry based on faulty projections and a failure to understand the collective action problem (rapid growth is rational for one firm but not for the entire industry). Now they are paying the price.