North Dakota

Hess successfully shrinks itself to grow

December 4, 2013: 10:52 AM ET

Amid pressure from investors who argued the company had stretched itself too thin, Hess has shed assets and is moving forward as a streamlined company.

By Craig Giammona

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FORTUNE -- Leon Hess formed the energy company that bears his name in 1933 with a used 615-gallon tanker truck that made residential oil deliveries in his hometown of Asbury Park, N.J.. Over the years, Hess has grown into a diversified global company with revenues of $37.7 billion in 2012.

Hess' (HES) revenues are projected to close this year at less than one third of 2012 levels. At the same time, the company's stock price has surged, increasing more than 50% as Hess pursues a shrink-to-grow strategy that has seen the company slim down and focus on its oil and gas acreage in North Dakota's Bakken formation.

Pushed by investors who launched a contentious proxy fight early in 2013, Hess has sold upwards of $7 billion in assets (a $1.3 billion sale of oil and gas assets in Indonesia was announced this week) as it reconstitutes itself as a streamlined exploration and production outfit. Morgan Stanley said in a recent research note that Bakken acreage will constitute 40% of Hess' net asset value once the proposed sale of holdings in Thailand is complete. Hess has also dumped its marketing, refining, and energy trading businesses this year and is trying to unload its more than 1,300 gas stations.

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For Hess, which also owns acreage in the Utica formation, future earnings are pegged squarely to the domestic shale boom that has reversed decades of declining production and pushed the U.S. ahead of Russia and Saudi Arabia as the world's top energy producer. Some larger oil companies, like Exxon (XOM) and Shell (RDSA), have struggled to generate profits on U.S. shale, but analysts say Hess' holdings in North Dakota should help drive the company's profits higher as production increases.

"It's certainly one of the key growth drivers for the company," says Pavel Molchanov, an equity analyst with Raymond James. "It's becoming even more important as the shrink part of [Hess'] shrink-to- grow [strategy] tapers off."

Hess estimates that its overall oil production could grow as much as 8% through 2017. Going forward, Hess will generate cash from remaining oil and gas assets in Norway, Malaysia, Africa, and the Gulf of Mexico, but the company is betting that it can nearly double production in the Bakken, where it's the third-largest acreage holder. In the third quarter, Hess produced an average of 71,000 barrels of oil per day in the Bakken, a 14% jump over the same period last year, while also cutting well costs by 18%, an important step as the company looks to generate more profit after big capital expenses. The company has estimated that 2016 Bakken production will reach 120,000 barrels a day.

"Now, it's really about execution and hoping the commodity price works for them," says John Williams, an investment analyst at T.Rowe Price, which owns more than 15 million shares of Hess, or about 4.4% of the company.

In July 2012, Hess announced plans to exit the refining business and refocus on production in the Bakken. But investor pressure earlier this year brought added urgency to the process. Hess' stock was trading below $50 when activist investors started accumulating shares in late 2012. Elliott Management, which now owns about 5% of Hess, went public in January with a push to split the company's onshore shale assets in the U.S. from the rest of the company and to transform Hess' board of directors. Elliott received support from Relational Investors, a San Diego fund with $6 billion in assets.

So far, investors have responded well to Hess' transformation. The company is buying back shares and paying down debt with the cash from asset sales, and Hess stock now trades at over $80. Since the proxy fight was settled in May, Hess is up 19%, compared to 8.8% for the S&P 500 (SPX) during that same period.

"I think we're very close to the optimal fighting weight for this company," says Fadel Gheit, an energy analyst at Oppenheimer. "You have to credit (Elliot founder and CEO) Paul Singer. He cracked the whip and they ran, and they ran fast."

Hess went public in 1963 and has remained a family company, with Leon's son John taking over as CEO and chairman in 1995. During the proxy fight, John Hess vacated the chairman's seat, and Hess added nine new board members, including three nominated by Elliott. While transforming its board and speeding up asset sales, Hess has resisted calls to split off its U.S. shale assets from the rest of the company. But some investors are still clamoring for that move, which they argue would boost the company's stock price.

T. Rowe Price's Williams thinks Hess stock is worth more than $100, if not $110. Other analysts agree that Hess shares are "cheap," which is partly why some investors think the company needs to continue selling assets to unlock more value from Bakken.

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"The primary issue going forward is, do the U.S. assets need to be separated from the rest of the company to get a proper valuation?" says David Batchelder, a co-founder of Relational.

Hess has said it will be cash flow positive by 2015. In the third quarter of 2012, the company generated $2.8 billion in cash from operations, but capital expenditures were nearly $4 billion. That margin dropped by 87% in the third quarter of this year, coming in at $153 million on revenues of $1.25 billion. With its balance sheet improving, the smaller Hess also appears more competitive relative to its peers, with an EBIDTA margin of 35% in the third quarter, compared to an 18% percent average for the energy sector.

"Without a doubt, they're incrementally growing profit better than pretty much anybody else," says Craig Sterling, head of global equity research at EVA Dimensions. "Those other companies are kind of just waiting for higher oil prices and better margins."

Hess too would like higher oil prices. Barring that, analysts and investors will be watching closely to see if the company can ramp up Bakken (and Utica) production and ride the U.S. shale boom to higher profits.

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