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By John Kemp
LONDON, Jan 30 (Reuters) - The arrival of a swarm ofactivist hedge funds and investors in the oil and gas sector maybe good news for corporate governance, and possibly forshareholders. But it risks killing off the innovation andrisk-taking which has revolutionised U.S. petroleum productionover the last decade and transformed the global energy outlook.
Activist Carl Icahn has finally pushed Chief ExecutiveAubrey McClendon out from the Chesapeake, the firm hefounded in 1989, and grew into the country's second-largestproducer inside two decades.
Hedge funds TPG-Axon and Mount Kellett Capital are hoping toemulate 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 Argentinathrough the U.S. court system over its defaulted debts, andarresting a sail-training ship owned by the Argentine navy inGhana before an international tribunal ordered it to bereleased.
The activist hedge fund has promised to boost shareholdervalue at Hess by installing a more independent and experiencedboard, refocus Hess's portfolio by spinning off its Bakkenacreage and overseas assets, improve cost control and instilgreater capital discipline.
The question is whether the arrival of activists with theiremphasis on capital discipline, and the removal of thebuccaneering entrepreneurs, will reduce the rate of innovationand harm the long-term outlook for U.S. oil and gas production.
The positive perspective is that the leadership changes markthe maturing of the shale industry from its early pioneering,Wild West phase into a steadier and more stable state. Thecontrast is between the pioneering Henry Ford in the early 20thcentury and legendary manager Alfred Sloan at General Motorsfrom the 1930s to 1950s.
The less positive perspective is that the activists willbring a short-term boost to shareholder value but at the cost oflong-term stagnation and decline.
HYDRA-HEADED HESS
It was inevitable the U.S. oil and gas sector wouldeventually draw the unwelcome attentions of activist fundstrying to pick off the weaker members of the herd.
Oil and gas is the fastest growing industry in the UnitedStates. No industry has seen a bigger transformation over thelast decade. But the general upswing helped conceal veryvariable management performance. Now the industry has become thevictim of its own success. As gas and oil output has soared andprices have fallen, the focus has shifted to cost control andexecution.
Hess has not helped its own case. The company cannot decidewhether it wants to be a major international oil and gascompany, or a mid-sized independent oil and gas prospector inthe United States.
The company's proxy statement lists a bizarre mix ofcompanies in its self-selected comparator group: Anadarko,Apache, Devon and EOG, but also BP, Chevron, Shell, Total andStatoil, with Conoco, Marathon, Murphy, Occidental and Talismanthrown in for good measure.
With great respect to Hess, it is not Shell, Exxon orStatoil.
The one company it is not compared to is ContinentalResources, which it most resembles with its Bakkenposition, according to Elliott Management's pitch-book, whichhas been filed with the U.S. Securities and Exchange Commissionas part of its bid to install five new independent directors.
Investment analysts are unsure whether to classify Hess as alarge-cap international oil company or a small U.S. focusedindependent. Only two of the sell-side analysts coveringinternational oil companies including Hess also coverindependent U.S. companies operating in the Bakken, according toElliott. Hess is a composite which does not score well in anyvaluation category.
FINANCIAL DEALINGS
Elliott has criticised what it sees as the overly cosyrelationship between the chief executive and the rest of theboard of directors, and the resulting lack of accountability forpoor performance.
In the case of Chesapeake and SandRidge, activists have gonemuch further, and complained about the propriety of complicatedfinancial dealings between the companies and their chiefexecutives, including special compensation programmes thatallowed the chief executive to invest alongside the company innew wells.
Lawyers will spend many happy hours arguing whether thesecomplaints have any legal merit. But shareholders have no moralor practical reason to complain. The risks of buying into afamily-owned firm, or a company with a founding or otherwisedominant chief executive, are well known.
In the case of McClendon, the chief executive can claim tobe an entrepreneur as well as a manager, who created enormousamounts of value for shareholders initially.
Unlike the bland bureaucrats and accountants who run manylarge corporations, McClendon and Ward see themselves, with somejustification, as risk-takers and value creators who builtsuccessful businesses. They are co-owners as well as managers, astatus which has been recognised by the boards of theircompanies in their unusual compensation programmes.
Compensation programmes for all chief executives are alwaysa little unusual -- quis custodet ipsos custodies? The specialprogrammes created to reward McClendon and Ward are more unusualthan most, but did at least align the incentives of the chiefexecutive with those of stockholders in the explorationprogramme.
McClendon and Ward have been felled by the declining priceof gas, condensates and more recently oil, rather thangovernance failures. If the price of gas was still $6 or $8 permillion British thermal units, no one would worry about thespecial compensation programmes at Chesapeake and SandRidge orunderperformance at Hess.
In that sense, the fracking revolution has started to devourits own children. By transforming not only the technology butthe cost structure of the industry, the fracking initiallycreated fabulous profits which then evaporated as competitionintensified and output surged.
INNOVATION AT RISK
From an industry perspective, the most worrying thing aboutthe arrival of the hedge fund activists is whether they willkill off innovation.
Activists preach shareholder value, cost control and capitaldiscipline. Elliott quotes approvingly from a July 2012Citigroup research report that calls for Hess to cut explorationspending 50 percent. "The company should return more cash backto shareholders instead of attempting to grow at all," Citigroupwrote.
However, small and midsized exploration and productioncompanies like Chesapeake, Continental and Mitchell/DevonEnergy, all with larger than life leaders, a willingness toinnovate and take risks, have been entirely responsible for thesurge in U.S. oil and gas output. Majors like Exxon, BP andShell played no part in the shale revolution. They were too busyfocusing on capital discipline and shareholder value.
McClendon has been pilloried for his role at Chesapeake. Butto shift the focus for a moment, did Apple Computer have acorporate governance problem when Steve Jobs was in charge?Transformational change is often associated with individualswith outsized personalities and an unconventional approach tomanagement. Henry Ford is another example.
Some innovations generate huge payoffs; most fail. Norational capital-disciplined investor would have pursued theunproven and highly risky approach to horizontal drilling andhydraulic fracturing under the city of Forth Worth in Texas.That is why it fell to George Mitchell at Mitchell Energy andDevelopment.
Like the railway barons of the nineteenth century, the oiland gas prospectors have over-expanded their industry based onfaulty projections and a failure to understand the collectiveaction problem (rapid growth is rational for one firm but notfor the entire industry). Now they are paying the price.
