Investor activism threatening oil industry amid shale worries

HOUSTON — Well-heeled investors who control a growing block of money behind the North American energy surge have stepped up their bid to wring profits from oil companies, steering capital away from projects and toward dividends.

Tired of waiting for emerging shale reservoirs to become lucrative, the financiers got pushy last year. They booted executives and pressed more than a dozen large firms to cut spending, sell international assets and spin off businesses into shareholder-friendly corporate structures. And they are not expected to back down this year.

But as shareholder activism spreads across the industry, it’s raising questions about whether American oil companies can maintain their position if they abandon plans to explore for hydrocarbons abroad and develop more resources. It also could strain executives’ ability to reach long-term operational goals, diverting too much attention to short-term volatility in stock prices.

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“Its’ a hard thing to build your business around; it’s very consuming,” said Maynard Holt, co-president and head of the upstream investment banking business at Tudor, Pickering, Holt & Co.

“It means you’re cutting the search for opportunities that play out many years from now,” Holt said. “You can underinvest and wake up one day and wish you had more inventory.”

The investor aggression comes just as oil companies feel sharp pressure from the rising cost of steel, labor and specialized equipment designed to puncture shale rock. Energy companies’ costs are expected to rise 4 percent to 5 percent globally this year, and slightly more in North America, according to the information firm IHS. That’s faster than inflation.

Also, moving from over-drilled natural gas fields to more lucrative oil patches has taken time and billions of dollars since 2011, compressing margins despite what is often characterized as a U.S. energy renaissance.

Some view it as an opportunity. Over the past three years, returns on energy investments have underperformed other global markets by 27 percent — making the field ripe for adjustments, said Poppy Allonby, an energy investment manager at BlackRock, the largest money manager in the world with more than $4 trillion in assets.

“I think the sector is cheap versus its own history and the broader market. As an investor, I ask myself, ‘Can that change?’” Allonby said, noting an increase in dialogue about capital allocation and investment returns. “A lot of the companies are starting to address some of the market’s key concerns, and that’s a positive.”

Last year, investors shook up top management at Chesapeake Energy, Occidental Petroleum and SandRidge Energy, and they urged Apache Corp., Devon Energy, QEP Resources and Hess Corp. to sell billions in foreign and nonessential U.S. assets and put more muscle behind key plays in North American.

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Gretchen French, vice president and senior credit officer for Moody’s Investors Service, counts 15 cases of major shareholder activism in the energy industry last year, dwarfing the two such instances the year before.

And French said she expects more this year from investors impatient with smaller, independent oil producers’ high capital spending — they typically outspend their cash flow by billions of dollars — while share prices lag and distributions to shareholders are few.

Investment returns have hovered between 10 percent and 15 percent for the past four years, sinking from 25 percent to 30 percent returns in the previous decade, according to IHS.

Shareholders have had difficulty understanding that the five-year rush for North American shale oil and gas land has forced producers to take the long view on profits, said Stephen Trauber, global head of energy investment banking at Citigroup.

“These are pieces of acreage, so they don’t return anything right away,” Trauber said. “You can deploy the capital, but it takes three to four years before they can start generating cash flow.”

Trauber said more than 170 new activist investor funds — ones that invest in companies with the intent of changing them — have emerged in the past two years, encouraged by the success of forceful tactics that led to the spinoff of several pipeline and refinery businesses.

The trend is starting to change behavior even at companies that haven’t been targeted by aggressive shareholders. Some oil producers have worked to get a jump on the pressure, forming tax-advantaged master limited partnerships and stock buyback plans unprompted.

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And as costs overrun projects, oil companies have become a lot more cautious about taking on complex new ventures: Investors often see them as too risky, even if they help build the oil and gas reserves that are crucial to energy company balance sheets, saidPritesh Patel, a senior director and researcher of capital costs at IHS.

Rising costs and high spending have eaten into production margins before without igniting shareholder revolts. But because oil prices have been relatively stagnant in recent years, higher production can’t always cover the costs, Patel said.
That’s made companies reluctant to start new projects, Patel said.

Roger Diwan, vice president of financial services at IHS, said that can be short-sighted. “They’re getting out of projects where returns aren’t so good,” he said. “But five years down the road, what does your business look like when you cut, cut, cut?”

Occidental Petroleum, to cite one example, recently announced it is spinning off its California business and moving the rest to Houston. But it will have to find a way to offset lost cash flow from the spun off unit and from other assets it plans to sell.

Still, other companies — including Hess and Apache — have seen several performance measures improve since investors pushed them to cut assets, reduce debt and repurchase shares, Diwan said.

And in other cases, activists have instilled better checks and balances on corporate leadership at oil companies, as in the management shakeups at Chesapeake and SandRidge last year, said French of Moody’s Investors Service.

“They were demanding greater accountability, and in our view, that was positive,” French said.

Spending cuts: Investor push to cut spending hindering M&A markets

But as militant billionaire investors like Carl Icahn and Barry Rosenstein reach deeper into the industry, some stakeholders are worried that spending cuts will force producers to drill fewer wells and deploy fewer rigs, said Michelle Foss, chief energy economist at the Center for Energy Economics at the University of Texas.

“The only way to bring up production in tight rock plays is to spend more,” Foss said. “If you spend more, you risk losing your margin, and everyone has. If you don’t spend enough, you blow your economics,” as there is not enough production to cover costs and provide a return.

A lot of producers jumped into shale plays and projects “not well prepared for the realities,” aiming only to drill enough to prove a play’s worth and then flip it, she said. After some initial success, “things fizzled and investors and management teams that didn’t think they would be operating ended up doing just that.”

Yet money keeps pouring into exploration and production firms.

“I think it’s largely because people just don’t understand these plays,” Foss said. “If they did, they’d be a lot more nervous.”


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