Rogue Investors And Opportunity With Hess
The world oil market is hardly free and frictionless, with supply responding seamlessly to high price signals. U.S. oil production gains from shale are just a tiny part of the global oil market. Evidence mounts that the per-barrel marginal cost of oil is higher than advertised. Inefficient government-run oil companies and high oil taxes are one big problem; paper currencies, deficits, and other demand-boosting factors are another problem.
Production disappointments in Russia, Nigeria, and Venezuela cannot be ignored.
It seems Russian oil millionaires ‘n billionaires need their tax breaks to spur lagging Russian oil production, and even Putin himself has a hard time getting his tax reform proposals to turn things around. Ouch, this according to Bloomberg:
“The impact of the production and mineral-extraction taxes when crude is selling for $100 a barrel means that, after paying pipeline fees, producers in Russia are left with about $22 a barrel to lease rigs, pay workers, rent equipment and service debt before recording any profit, said Wolcott… The production tax is the larger of the two, accounting for about $50 of the per-barrel levy when crude trades for $100. That would remain unchanged under Putin’s proposal.”
Focusing on Africa, Nigerian crude production is back at 2009 lows thanks to pipeline sabotage. According Bloomberg:
“Nigeria’s oil thieves are back in action, sabotaging pipelines to rob Africa’s biggest crude producer of more than a 10th of its daily production. In the first two months of this year alone, Royal Dutch Shell Plc (RDSA) and other oil companies have declared three force majeures, a legal clause that allows them to miss contracted deliveries due to circumstances beyond their control.”
As for Venezuela? For now let’s the dust settle with the aftermath of Hugo Chavez. But it’s safe to say that there’s plenty of uncertainty for the oil producer’s future.
Today, with uncertainty filling the streets in foreign oil-producing nations, I’ll update you on a drama playing out at an asset-rich, American oil company. Let’s take a look at where two parties compete to unlock hidden value…
Investor Drama At Hess (Share Price Rises!)
No matter the state of the broad stock market, you can find value-enhancing or value-destroying events underway at specific companies. On Feb 1st, I wrote to you about an event unlocking value at a stodgy oil company with great assets: Hess Corp. (HES).
To recap: activist hedge fund Elliott Management acquired a 4% ownership position in HES. It announced proposals to change Hess’s unfocused strategy, and unlock billions in shareholder value in the process. Elliott argues that Hess should spin off its Bakken shale acreage into a separate company. This acreage is an attractive, but poor focus and execution had led to high production costs.
A month has passed, and Elliott Management is already getting results. HES stock was up this week on news that it plans to sell unattractive, noncore assets, replace some board members, and increase the annual dividend to $1 per share. CEO John Hess calls these initiatives “the culmination” of his multi-year transformation process.
In a letter to shareholders, the CEO attacks Elliott’s proposals: Elliott “ignores credit implications”; “ignores tax consequences”; and “uses flawed valuation benchmarks.” He quotes a handful of Wall Street analysts arguing that the cash-producing offshore assets should be used to fund growth in the cash-consuming Bakken.
This, however, has been the situation for years. The result: HES trades at a “conglomerate discount.” A conglomerate discount is when the market values a sprawling, unfocused company at a discount to the sum of its parts.
Here’s my question, which reflects why I agree with Elliott management’s thesis: Why would portfolio managers want to own two poorly managed exploration and production companies when they can simply buy the best-of-breed companies in each category: no-growth cash cow and high-growth resource play? Management, in my view, hasn’t adequately answered this question.
Hess’s actions are a step in the right direction, but fall “dramatically short of what is needed,” Elliott believes. In a written response, Elliott makes two strong points in the conflict over breaking up the company:
- “Hess’s conventional portfolio did not fund the development of the Bakken, rather it funded $4.5 billion of exploration failure and over $4 billion of acquisitions of conventional assets and downstream investments. Hess mismanagement resulted in the company issuing more debt, issuing similar amounts of equity, and selling more assets than Bakken pure-play Continental to achieve similar production growth in their build out of the Bakken.”
- “Pure-play Bakken operators all have ready access to credit markets. Continental has similar Bakken production to Hess and has $2.9 billion of bonds that yield less than 4.0%.”
In other words, the proposed spin-off of Hess’s Bakken assets into a new company would hardly be starved of capital, especially in an era of low corporate bond yields and high oil prices.
Hess will hold its annual meeting on May 16. Regardless of which party wins its slate of board nominees, it’s refreshing to see an undisciplined, asset-rich oil company getting leaner and more focused.
HES stock is a good-looking play on oil prices, with upside into the $100s.
Dan Amoss, CFA
Original article posted on Daily Resource Hunter