Can These Hedge Fund Oil and Gas Favorites Deliver on Expected Gains?

Activist hedge funds have been hard at work on SandRidge Energy, WPX Energy, and Chesapeake Energy, and other well known investors have taken notice. Can these oil and gas companies deliver the returns that the "smart" money expects?

Feb 11, 2014 at 9:39AM

There has been a lot of hedge fund activity in the oil and gas sector lately. Companies like SandRidge Energy (NYSE:SD), WPX Energy (NYSE:WPX), and Chesapeake Energy (NYSE:CHK) have all been activist fund targets with other big name financiers also taking positions. Can these energy producers deliver the meaningful share price gains that these influential investors expect?

Focusing onshore to boost shareholder value
A big believer in SandRidge Energy is billionaire investor Leon Cooperman, the founder of hedge fund Omega Advisors. He feels the company is greatly undervalued. Another hedge fund, TPG-Axon Capital Management, has a similar view and took aggressive steps to try to get the higher value recognized. TPG-Axon's activist pressure gained it a presence on the board and a change in top management.

As the executive suite shifted so did the company's direction. The recently announced sale of SandRidge's Gulf of Mexico operations is a major move. The oil explorer is now totally committed to its onshore U.S. fields, where the roughly $1 billion in proceeds from the Gulf properties sale will be reinvested. SandRidge hopes to grow this year's onshore production by about 35% with the funds.

That growth will be needed. The company's operating cash flow was down around 16% in the latest quarter compared to a year ago, and oil and gas revenues fell 6%, mainly due to a 13% decrease in total oil and gas production after prior asset divestitures. SandRidge will be relying on its core Mississippian oil and gas properties to make up the lost output. This region, lying across parts of Oklahoma and Kansas, saw recent quarterly production increase about 59% year over year, now delivering nearly 80% of the company's total yield.

The stock market appears unsure about the Mississippian's potential, however. Trading at an enterprise value (market value plus debt) of around 8 times expected operating cash flows, the company is valued noticeably lower than "hot" shale oil firms like Pioneer Natural Resources at around 14 times or Concho Resources at around 11 times cash flow. This suggests SandRidge could see a higher share price on any good news coming out of its onshore fields.

New venues to deliver growth
WPX Energy has caught the attention of David Einhorn. The noted investor, maybe best know for his prescient short position in Lehman Brothers before its collapse, has an approximate 2.5% position in the natural gas producer. Hedge fund Taconic Capital Advisors also views the company positively. After announcing its 6.39% stake, the activist firm conferred with WPX management on ways to increase shareholder value. Apparently, Taconic got its point across. In December, WPX announced its CEO would step down and that the hedge fund could fill a newly created board seat.

The company's most recent quarter didn't provide management with much defense -- it posted a loss of $114 million, compared to a $66 million loss a year earlier. Stagnating production and weak natural gas pricing were the main reasons for the poor performance. WPX does have some good prospects, however. Discoveries in the Niobrara shale are expected to stem gas production declines. Initial finds have been promising, and the Unconventional Oil & Gas Center ranks the firm's first two producing wells as the best in Niobrara.

WPX also has an opportunity to grow in oil. Oil revenues advanced 55% quarter over quarter in the most recent period, and production reached an all-time high. The gains are coming from fields in the Bakken shale, which saw deliveries up 46% year over year. Finds in New Mexico could further boost sales. The company's first nine wells in the San Juan Gallup play showed decent initial flow rates, and the reserve is estimated to have a potential 66 million barrels of oil equivalent.

WPX investors appear skeptical. With an enterprise value of around 8 times operating cash flow, the company appears to be trading at a significant discount to leading natural gas producers like Cabot Oil and Gas, whose enterprise value is closer to 17 times cash flow. A higher multiple might be expected once WPX proves its new locations can provide growth.

Expecting better returns from reduced costs
Chesapeake Energy appears to be a favorite of famed investor Carl Icahn. Initiating a 7.56% stake in mid-2012, since raised to 9.98%, Icahn went to work on unlocking shareholder value by gaining representation on the company's board. Changes began occurring at Chesapeake not long after. Its founder-CEO and six other top executives left during 2013.

The company's business tone has also changed. After spending exorbitant amounts on shale properties, Chesapeake has recently turned more cost conscious. The transformation looks to have helped results. Recent quarterly adjusted net income came in at $282 million, a jump from $35 million a year earlier. The focus on reducing costs looks likely to continue. The natural gas producer expects a 20% drop in capital spending and a 25% cut in per-production administrative expense for 2014.

It appears the market isn't giving Chesapeake much credit for its new financial prudence. At an enterprise value to operating cash flow multiple of around 6.5 times, the company looks modestly priced. A more generous valuation may be forthcoming as investors get comfortable with the "new" Chesapeake Energy.

Bottom line
Hedge funds have been shaking up the oil and gas sector. Investing in undervalued and under-performing firms, these financiers expect better results, and many will take active steps to make sure it occurs. While an energy producer's success will ultimately depend on its operational performance, hedge fund-influenced companies like SandRidge, WPX, or Chesapeake may now be positioned for meaningful share price gains as long as production growth targets are met.

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Bob Chandler has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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