By John Kemp
LONDON Jan 30 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
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
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
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
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
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
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
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.
INNOVATION AT RISK
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
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
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.