Activist investor to stake $1B on changing shale operations

Simon Casey and Rachel Adams-Heard February 26, 2020

HOUSTON (Bloomberg) --The energy-focused private equity firm Kimmeridge Energy Management is looking for a U.S. shale producer to target for an overhaul, saying the sector has become “uninvestable.”

The New York-based firm, which is focused entirely on U.S. oil and gas investments, is part of a growing chorus calling for radical action in the shale industry. Producers have bloated overhead costs, misaligned management incentives and are pursuing unsustainable expansion, the firm said in a white paper laying out its investment thesis, which was seen by Bloomberg.

Kimmeridge is seeking to raise $500 million to $1 billion, according to a person familiar with the matter, who asked not to be named because the information is private. Those funds would be used to take stakes in U.S. oil and gas producers and push for changes in the way they operate, the person said.

While the combination of hydraulic fracturing and horizontal drilling created a decade-long production boom that catapulted the U.S. to the top of global oil output, most of the companies responsible for the expansion have left investors with little to show for it. Energy has been one of the biggest laggards in the stock market in recent years, and has shrunk to account for less than 4% of the market value of the S&P 500 Index.

 “The U.S. E&P industry is in crisis,” Kimmeridge said in the paper. The firm argues that shale companies need to embrace a new business model focused in part on lower growth and costs while prioritizing the return of cash to investors. Executives and boards can’t be expected to make those changes on their own because they’re paid to maintain the “status quo,” Kimmeridge said. “Investors will need to drive this change.”

Despite a growing consensus on what oil companies must do to arrest the decline, the sector so far hasn’t attracted much attention from activist investors. Kimmeridge waged its own proxy battle last year against the incumbent board of Denver-based shale oil producer PDC Energy Inc., but saw those efforts fizzle. It also pushed for asset sales at Carrizo Oil & Gas Inc., folding its position to net a $90 million gain, a year before the company was sold to Callon Petroleum Co.

“It’s very hard to be an activist in this industry,” Ben Dell, a managing partner at Kimmeridge, said in an interview, citing the difficulties of convincing other investors such as index funds to vote against the re-election of directors. This time around, Kimmeridge has hired Mark Viviano, a former analyst at Wellington Management, to help lead its activist push.

Independent oil producers continue to tout internal rates of return of 100% for their wells. But their returns on average capital employed have come in around 4%, according to Kimmeridge -- “well below” the industry-weighted average cost of capital. The firm also said shale drillers’ focus on net asset values is misplaced, with executives building corporate strategies that drive a “perpetual deferral of free cash flow into the future.”

That’s particularly problematic today, Kimmeridge said, when “investors are increasingly concerned about the transition away from fossil fuels.”

Then there are overhead costs. For every $100 of cash flow generated by the sector, 15% to 20% was spent on selling, general and administrative expenses, or SG&A, according to Kimmeridge. The average CEO earned more than 100% of their target in 2018 “while delivering massive share price underperformance.”

In arguing that dramatic changes to the shale business are possible, Kimmeridge points to the tobacco industry as an example. Altria Group Inc. didn’t need excessive growth to bring investors back to a company “on the wrong side of social pressures,” Kimmeridge said in its white paper. “Rather it was the dramatic return of capital that forced investors to pay attention.”

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