Energy Companies and the Rise of Shareholder Activism

Recently, the oil and gas industry has found itself the unsuspecting target of an unusual degree of shareholder activism. Large activist shareholders, mostly hedge funds, set their sights on at least half a dozen major energy companies last year, calling for dividend increases, board shakeups, and even the ouster of chief executives.

Some of these activists have been praised for instilling much-needed fiscal discipline at companies where managements allegedly ran amok with shareholder dollars. Some have even been hailed as shareholders' best friends, sticking up for the little guys whose voices are so often drowned out in the cavernous voids of corporate boardrooms.

Yet just a few decades ago, these activists would probably have been painted in a very different light. Instead of being called protectors of the average shareholder, they might have been deemed corporate raiders -- so-called barbarians at the gate who would barely hesitate before stripping a company of its assets and firing countless workers just to make a quick buck.

Why has this new generation of activists suddenly re-emerged, and why are they so determined to target the oil and gas industry? And are they true advocates of generating shareholder value, or are they just looking to exploit company weaknesses for their own short-term gains?

Why oil and gas companies have been activist targets
As Ed Crooks of the Financial Times recently noted, there are three key reasons the energy industry has found itself the target of increasing shareholder activism.

The first and most obvious is that the industry deals with real assets, which can be sold to unlock value for shareholders. This feature is perhaps most evident in the ongoing debate at Hess (HES 0.65%), where Elliot Management, a hedge fund led by Paul Singer, is prompting the company to separate its Bakken acreage from its international assets and also to sell off its refining and marketing business. Elliot believes doing so could improve the company's depressed share price, which has fallen sharply over the past couple of years.

The second feature of the oil and gas industry that makes it especially vulnerable to shareholder militancy is the nature of its investment returns. Many projects are characterized by large initial capital investments that may not pay off for several years into the future, if at all. Yet immediate value can be unlocked by divesting existing assets, which can propel a company's share price higher, though often at the expense of creating sustainable value over the long haul.

At Transocean (RIG -2.29%), for instance, investor Carl Icahn is putting pressure on the company to raise its dividend to $4 per share, which he believes will improve capital allocation and provide a boost to its stock price. But Transocean's board suggests that Icahn's recommendation, though it may boost short-term returns, could potentially jeopardize the company's long-term returns and viability. 

The third feature Crooks highlights is the industry's entrepreneurial nature, which has often led to dominant chief executives who command an unhealthy influence over their companies' boards. Nowhere is this more evident than at Chesapeake Energy (CHKA.Q), where a risk-taking oil and gas entrepreneur -- Aubrey McClendon -- built a fledgling natural gas start-up into one of the leading energy producers in the country.

Yet poor corporate governance and an unhealthy addiction to debt-fueled expansion, overseen by a timid and relenting board, proved to be Chesapeake's -- and McClendon's -- undoing. After more than two decades at the company, McClendon departed as CEO on April 1, reportedly forced out by the company's largest shareholders.

An eerily similar situation is playing out at SandRidge Energy (NYSE: SD), which, interestingly, is captained by a Chesapeake co-founder, Tom Ward. As with Chesapeake, activist investors have pointed the blame at SandRidge's CEO, as well as the rest of its management team and its board of directors, whose recklessness, they argue, has kept the company's share price far below where it would be were a more disciplined management team to be installed.

Late last year, activist hedge funds TPG-Axon Capital Management and Mount Kellett Capital Management took aim at SandRidge, highlighting numerous management- and board-related missteps in separate scathing letters.

TPG-Axon argued that SandRidge's board failed to rein in the company's excesses, allowing Ward to rake in tens of millions in annual compensation, while the company's stock price plummeted roughly 80% since its IPO. The hedge fund's argument has convinced many. SandRidge has since agreed to add four new directors nominated by TPG-Axon to its board, and Ward is expected to depart as CEO.

Shareholder activism: good or bad?
In many of these cases, shareholder activism that led to change was probably a good thing for company shareholders. After all, nobody invests in a company to let reckless CEOs squander their money, while using shady private dealings to amass vast fortunes for themselves. But the phenomenal rise of large activist shareholders may also have a downside.

Most importantly, it could stifle the innovation and dynamism that has characterized the American oil and gas industry. As John Kemp at Reuters has noted, it was companies like Chesapeake Energy -- with risk-taking entrepreneurs at the helm -- that pioneered the push into shale oil and gas plays. Had they instead focused on capital discipline and cost reduction, perhaps our domestic energy picture would have remained bleak.