Oil isn't dead, and investors who avoid the sector completely are missing out on some great potential.

In this episode of Industry Focus: Energy, host Sarah Priestley talks with Motley Fool contributor Todd Campbell about why you should put upstream oil company Hess Corporation (HES 0.06%) on your watch list. Tune in to learn some of the most important things to consider when you're looking at an oil company; what catalysts have changed for Hess, and how they very well could turn the company's negative streak around; how activist investors have been pushing for change at Hess lately, and what that's meant for it; and more.

A full transcript follows the video.

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This video was recorded on March 29, 2018.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, the 29th of March, and we're going to be talking about an upstream oil stock that might be an opportunity. We haven't heard about any of those for a while. I'm your host, Sarah Priestley, and joining me in the studio is Motley Fool senior contributor, Todd Campbell. Todd, thank you very much for joining me on the show today!

Todd Campbell: I'm so excited to be here, Sarah! As listeners may know, I'm usually talking about healthcare stocks. But, as a generalist, it's always so much fun to join some of the other shows and talk about some of the other really interesting stocks that I'm coming across as I'm doing my own work.

Priestley: I was going to say, if anybody listens to all of the shows, they will most definitely recognize you from Kristine's show on Wednesday. But, yeah, thank you very much for joining us! I couldn't not have you on after I read your article, If I Had to Buy One Stock in March, It Would Be This One. And lo and behold, I was so surprised, it was an energy company. It's obviously very in vogue to be bearish on oil, as it has been for the past three or four years. 

The company that you chose was Hess Corporation, ticker is HES. Hess is now solely an upstream oil producer. It spun off its midstream business into Hess Midstream Partners last year. Upstream means they are an exploration and production company. I think we covered this in a previous episode, but it just means they go looking for oil and gas deposits, they drill the exploratory wells, all the good stuff that goes along with getting those wells online. And once it's up and running, they operate it. The stock has already had a little bit of a roller coaster start to the year, but it's up 4%. It's actually up 2% since you wrote your article, Todd. [laughs] 

Campbell: Yay! 

Priestley: Well done! How was Hess' 2017?

Campbell: I think it might help, Sarah, to talk really quickly about why I actually chose an energy stock, because you were kind of surprised when you clicked on it and saw it, and maybe a lot of other readers and listeners might be surprised to hear me talking about this stock, too. I typically tend to avoid industries that are in decline or beaten up or beaten down. However, I think there really are some very intriguing underpinnings here. And now, with so many years, since 2014, these things basically being in the doghouse, I think there's some opportunities for investors to go out there. I don't necessarily want to call them bargains yet, because on the valuation metrics they're not going to be bargains necessarily. But I think if you believe in the idea that inflation is going higher because of global economic expansion, and that's going to create additional demand for commodities, this might not be a bad time to start tucking some of these energy stocks into portfolios. And certainly, Hess Corp has been one of those names that hasn't been a great or stellar performer over the last decade. The stock was $130 a share back in '07, $100 back in 2014, now probably trading around $50. So, long-term investors haven't really benefited from that. But, I think there are some catalysts here that really make it intriguing.

Priestley: I agree with you, and I would say the biggest change that we've seen in the oil industry over the past five years is a real focus on bringing down that cost of production. So, trying to really bring down the cost per barrel to make it competitive, and to essentially enable them to make money in this low crude cost environment. I think there's a lot of opportunity, particularly with Hess. Having read your article, I did a little bit more research on it, and it all bolsters your view.

Campbell: You asked earlier, and I never quite got to it, what was last year like. And that's probably a really good starting point, because it builds into my thesis. I think one of the things you have to understand as an investor looking at this stock is, this is a stock that's going through a considerable period of change. You just said we're talking about driving costs out of production so that these companies can become more profitable. We see that in the past with different industries or different individual companies that run into tough times, they eliminate as many costs as they can, and that gives them more operating leverage once revenue starts to come back. 

If you look at Hess, they're restructuring their business away from all these other pieces of the energy market so that, like you said, they can be a pure play E&P company. As a result, they're divesting assets that are mature, that are high-cost, so that they can focus on these faster growing areas like -- places like the Bakken, places like offshore drilling, where they think they can generate a much better return on investment. 

If you look at 2017, the company produced 295,000 barrels of oil equivalent per day. If you just took a look at that and then look at first quarter numbers and second quarter numbers, you're probably going to look and say, "Todd, what are you even talking about? Why would you recommend this?" Because production is going to decline right now. And that's because they've sold some of these assets in the North Sea and elsewhere. And that's reducing their average production. But at the same time, they're making these other investments, Sarah, and I think those are going to pay off. And as you get to the end of the year, your exit rate and production is going to be much higher than it is here at the beginning of the year.

Priestley: Yeah, absolutely. And it's funny that you mentioned, they've sold their assets in the Permian Basin. A couple of years ago, nobody could get enough of the Permian. It's interesting that you're seeing this shift. But, you're absolutely right, it's focusing on these kinds of high-growth, high-yield projects in the North Sea and Permian, as you mentioned. The two most notable are the Bakken and Guyana. Am I saying that correctly?

Campbell: Yeah, I think that's absolutely fine. Sure, right? I mean, I'm used to covering healthcare stocks, where pronouncing the names is a guessing game at best.

Priestley: Oh, yeah, that's true. Probably the most interesting one for me, being interested in shale, is the Bakken, where they have 1,300 wells. I think they have over half a million net acres of leasehold. And a lot of the region that they have is actually these tier-one, very profitable wells.

Campbell: Yes. And the production there, you've talked about this on the show in the past, you had a great show on March 8th -- I'll give you a shout out, if any listeners want to go back and check that out -- talking about the difference between shale production and production in other areas, some of the advances that are coming and allowing these operators to get more and more oil out of the ground and the shale. I think you're seeing those innovations, and they're benefiting all players within the Bakken, including Hess. Hess, as you mentioned, has over 550,000 acres there. They have four rigs operating right now. And by the end of the year, they're going to have six rigs operating. So, I think you're going to see production in the Bakken really start to ramp over the course of the tail end of the year. And that's pretty high. We alluded to this. Those are pretty good metrics for production in that play. So, I think that could definitely help the company financially.

Priestley: Absolutely. And one thing to make a note of here is, when we talk about shale, we're often talking about a lot shorter life spans of these projects than you would normally get for offshore and conventional drilling. But, management has pegged the lifespan about 10 years at the core portion of this development, and the firm's entire inventory in this region could last twice that. So, we're not talking 50 years out, which we like to as long-term investors. But, still, this is very much a long-term project for them.

Campbell: And what's interesting, too, is if you look at last year's production and what the replacement was, I think they replaced 350% of their production, part of that came from the fact that they actually increased their proven reserves for the Bakken to I think two billion barrels, something like that, from 1.7 previously. So, obviously, as they're getting better about getting that oil out of the ground, that's becoming a much more valuable piece of the puzzle for them. And now, with doing all those asset sales, I think they raised $3.4 billion last year in asset sales alone. That gives them tons of financial flexibility to fuel their development efforts in the Bakken, and also go out and basically pre-fund their expenses that are going to be associated with Guyana.

Priestley: Absolutely. And this is kind of the model that we have for E&P firms, their bread and butter is finding new deposits, and this is the way that they fund it, they get these cash cows going up and running and then they use the cash that they generate from those to invest in more exploration.

And the one last interesting thing I think about the Bakken is, as we've always talked about with shale, it's such low production rates. I think management is pegging the internal rates of return between 40-50% on crude prices of $50 a barrel. And you're seeing a lot of the oil companies pegging a lot of their production around this $50 a barrel, which, estimates for two years out are pretty safe.

Campbell: Just to piggyback on that, that was very interesting there, think about this -- the Bakken production for Hess was averaged about 105,000-110,000 barrels per day in 2017. By 2021, they think they can be producing 175,000 barrels of oil equivalent per day. So, you're talking about significant ramp up with really high rates of return.

Priestley: Exactly. Investors should be very happy about that. Then, Guyana, which you've mentioned, there seems to be a huge amount of investor optimism pegged on, and a lot of the turnaround is pegged on the success of this new project, which is a joint venture with ExxonMobil.

Campbell: Yes, they have 30% stake in it, ExxonMobil is the operator, and they couldn't ask for a better partner when it comes to this type of project. ExxonMobil is arguably best in breed at this kind of thing. They have a history of coming in under budget on time. Guyana is a truly massive potential opportunity, 6.6 million acres, and they're finding new areas to develop seemingly every quarter, they're reporting another new area that they might be able to explore and get oil out of.

Priestley: Yeah. They've had several confirmed discoveries. Liza is the first for development, and they think that's going to come online in 2020, although they're starting, I think this year they're going to begin development drilling. And that's requiring quite the investment from Hess' perspective. I think it's $950 million initial investment, and then total investment is looking to be more like $4 billion.

Campbell: Yeah. But, again, they have plenty of money now, because they sold all these assets. Their balance sheet is fine. And we'll get into this in a second, I'm sure, when we start talking about activism and the role that's playing in this stock, too. But, you're talking about these coming online in 2020. You look at Hess' share, that's about 40,000 barrels of oil equivalent a day. 40,000 barrels, that's pretty darn good, considering there in the 200s now, right? And 2022, when the second phase is up and running, their share should climb to 66,000 barrels of oil equivalent a day. And they just came out recently, and they're saying that with the third phase, Exxon is going to be cranking out about 500,000. That's 150,000 barrels of oil equivalent today to Hess. Which, based on what they're producing now, again, is a huge increase over the next seven or eight years.

Priestley: Yes, definitely. And the key thing to note, too, is that economically, this could be on par with their Bakken. They're expecting about $35 break even, which would be phenomenal for offshore drilling. It's something we haven't been able to see before, but because of the way that has all been set up in a low-cost environment, it's really helped. And the big thing with this is the timing of their sanctioning of Liza. I'm sure someone's going to correct me on how I'm saying that. That was a big help, because it was negotiated in such a low oil price environment. So, the exceptional economics, shallow depth of the reservoir, means it's going to be a really high productivity region, and it's arguably the most attractive exploration and production project in the industry right now, so Hess has been incredibly wise to get involved in this from the start.

Campbell: Right. And an investor might say, why don't I just buy Exxon? But the reality is, yes, Exxon is the operator there, but Hess is going to be more of the pure play, because it's going to represent a much larger share of Hess' future production.

Priestley: Yes, you're exactly right. As Todd mentioned, we're going to go on to talk about some of the trials and tribulations that Hess has had last year with activists. Todd, I think a company CEO's worst nightmare is an adversarial activist investor, and that's exactly what Hess has been contending with since I think 2013, is that right?

Campbell: Five years now. [laughs] I imagine John Hess is probably at the point now where he's like, "Come on, give me a break! I'm doing all these things you're asking me to do!"

Priestley: I'm sure he's aged a lot in those five years. [laughs] 

Campbell: Yeah. Hess Corp, if you look back at the 70s and 80s and the oil companies, they diversified themselves all over the place to try to smooth out the peaks and the valleys. And while that provided some insulation, it also took away a lot of the opportunity for upside from investors. And I think that got the attention of Elliott Management in 2013. Elliott Management has been around since '77, it's Paul Singer's hedge fund. They've been basically pounding the table for change to get this company leaner, to get rid of all of these old, mature assets, and start giving some more money back to investors. And that's exactly what we've seen over the last few years.

Priestley: Absolutely. Hess essentially headed off a proxy fight with the hedge fund when they announced their plans for extending their buyback. They tripled their buyback, is that right?

Campbell: Yeah, in March. They've done a few different things. They sold off all these assets, that gave them all sorts of money. They're pre-funding the Guyana project. They have all this money kicking around that they can handle the Bakken, and now, basically, the activists are saying, "Look, you have all this money. Let's start returning some of that back to investors." 

And yes, Hess pays a small dividend, but really, Elliot has been saying, "More buybacks, more buybacks, more buybacks." They announced a $500 million one at the end of last year. They announced an additional $1 billion to go on top of the $500 million in March. And $500 million of that buyback is an accelerated program, where they're just going to go out to an investment broker and say, "I want all those shares now." And the rest of it they plan on spending throughout the course of the year, assuming that there's no major crisis in the oil markets.

Priestley: And I think all of this announcement came the day before their deadline to nominate new directors. And I think they were seeking removal for the second time of John Hess, the CEO. So, it's kind of by the wire there.

Campbell: Back in 2013 or 2014, when Elliot first started advocating, they basically wanted to shake up the board tremendously. They did not feel like the board was shareholder-friendly at all. As a result, Hess separated himself from the chairman role, remained CEO and spun out of the chairman role. And they replaced a bunch of different directors. Again, you're looking at the same thing, they're saying, "Let's get more change, more change, work faster, work faster, work faster." And in some respects, I guess, Sarah, that goes against the long-term thinking that's associated with the oil business in trying to explore and line up production that can replace the production you have today tomorrow.

Priestley: In this instance ... normally, I feel like activists are pushing for short-term change, and it's not necessarily always in the interest of long-term investors. In this instance, Big Oil had it so good for so long, I do feel that it's necessary to push for a cultural shift with a lot of these boards. And Hess, I probably don't know enough about the company to know if that's right, but it seems like it's yielded some good results for them.

Campbell: Yeah, I would agree with you, too. I think any investor who was around in the 2000s, when oil was at similar prices and Hess was actually producing a profit is looking at it today and saying, "Why is the company losing money?" Obviously, there's some bloat there, or some things that need to change.

Priestley: Yes. And, I always try to look at this from an employee perspective, so I spend a lot of my time, as I'm sure you do, looking at Glassdoor approval ratings and things like that. And John Hess has pretty good approval ratings from employees, but one thing that I did see consistently was, they're cutting some fat. I think they announced a 15% headcount reduction earlier this year. They're trimming some fat, but a lot of this is not coming from the senior management level. I think they cut 30% costs in the Bakken production, so on the ground, they've cut 30%. And head office has cut 25%. And that's leading a lot of employees to ask questions. Which isn't necessarily something to base a thesis on, but it's something that we always think is interesting.

Campbell: Yeah, absolutely. It's tough, too, when you have, basically, John Hess, his last name is Hess, his name is on the business.

Priestley: Yeah, that's always difficult. 

Campbell: So, you're a little bit stubborn in that respect because you don't necessarily want to sell yourself outright, and theoretically you want to have this company around for decades. But, yeah, I agree with you. I think some change is needed to happen here. Those changes are now happening. And that's kind of what makes now not a bad time to be adding this stock to portfolios, in my view.

Priestley: I completely agree with you. Elliot's response to all of their recent announcements was, they said, "We are pleased that Hess is initiating a comprehensive operating review with the goal of becoming the best in class operator in the Bakken." They also congratulated the tripling of the buyback authorization, of course, because presumably that's going to bode very well for them. But, overall, they're happy now, so that's not really something that, hopefully, they're going to have to contend with for the next 12 months or so. But, you touched on something earlier that I want to revisit, and that's talking about the company's balance sheet, which is much healthier than it has been for a very long time.

Campbell: Yeah. All these companies have debt, right? They're in a business that's kind of expensive to run. So, it's kind of hard sometimes to find very low-debt companies. But, this company has a debt to equity ratio that's maybe a little higher than some, maybe it's higher than Exxon, but it's lower than others. It's lower than Anadarko's. I think it has $4.8 billion in cash exiting December, and about $6 billion in debt on the books. That's absolutely, totally manageable. The company said that it wants to eliminate about $500 million of that debt through the money it has on hand. And it's still able to do that with all the other things it's doing, pre-funding Guyana, looking at the Bakken, the work that they're doing there. 

Now, I think Elliot could come back and say, "Listen, we want you to get rid of some of these other assets like the Malaysian assets to raise even more money." Hess seems to be drawing a line in the sand on that, because he wants the cash flow from that to be able to have that cash flow continue to flow in to be able to fund some of these other projects. He doesn't want to necessarily get rid of all of that production, including his Gulf of Mexico production.

Priestley: Which makes sense, because you cannot rest on your laurels in that industry. It's unlikely that you find deposits that are going to last for years and years. And even if you do, the rates of return start to deplete fairly quickly. So, yes, it's absolutely important that they're taking on this debt to invest in exploring new options for the company. 

One thing I thought was interesting about all of this is, they're returning value to shareholders, they increased their dividend. And this plays into this broader trend of oil companies focusing on returning value to shareholders. One company you just mentioned, Anadarko, they move very quickly and aggressively to respond to this demand from investors, and their shares are up 37% in the past six months. So, it's obviously paying off, its investors are getting tired of the low returns.

Campbell: And because these stocks have been abandoned, and aren't very widely owned now, you figure any marginal improvements that reattract people to it can generate outsized returns. So, I think you're right, you're seeing, broadly, these companies coming to the realization that they can't run these bloated cost structures any longer. They need to get lean if they want to be able to generate earnings growth, which as we know from all areas of investing, stocks do follow earnings over time. You need to be able to continue to find new production and translate that production into profitability for your investors.

Priestley: Absolutely. ConocoPhillips also, just in case anybody's wondering, increased their dividend and upped their stock buyback to $2 billion. It's a trend in the industry, it's something I think we should be keeping our eye on. I think a lot of these oil companies, as we've talked about, they like to have this cash flow available so they can invest in new opportunities. They're probably doing this a little begrudgingly, because it's nice to have that available soft cushioning of cash for them. But, it's interesting to see, from the investor standpoint. Overall, Todd, you've kind of convinced me on Hess, to be honest with you. I'm definitely going to be reviewing it for my personal portfolio.

Campbell: I think it makes sense, especially with the market the way it's been lately, it could make sense to diversify yourself away from some of these names that have been hot performers over the course of the last year or two in other areas and pick up a couple of energy stocks. I think this one should be on your radar. If they can deliver on their production growth targets of 10% compounded annually through 2023, and if they can deliver on their cash flow projection for cash flow growth compounded growth of 20% over that same period, it's very hard for me to think that you're not going to see that result in an increase in this company's share price, especially if Elliot is still out there rattling the saber.

Priestley: And I think a lot of short-term headwinds are going to start to subside this year, or, hopefully start to subside this year. I agree with you, there's just a lot of great things going on. I like the debt reduction, I like the buybacks, the pivoting of their business toward these new projects, these low-cost profitable projects, is definitely the right way to go. Is there anything that you think we've missed that you think a prospective buyer might want to know?

Campbell: I think the only other thing I would leave listeners with is, this is probably a back end of 2018 into 2019 story where investors will really start to warm up more broadly to this stock. The first couple of quarters of this year, you are going to have a headline decline in year over year production because of those asset sales. So, take a little, stick it away, diversify yourself, and I think you'll end up being rewarded once Guyana comes online in 2020.

Priestley: And the very last question I have for you: are you excited that it's the first day of the baseball season?

Campbell: I am! I'm a Boston Red Sox fan, I'm up here in New England, and I plan on listening on the radio.

Priestley: I know our man behind the glass, Austin Morgan, is very excited. I was trying to win brownie points with him for just remembering that today was the day. [laughs] But, Todd, thank you so much for being on the show! Hopefully we can get you back again to flex those energy muscles.

Campbell: Thanks, Sarah! I really appreciate being on.

Priestley: The market is closed tomorrow, so there unfortunately won't be the usual Friday Tech show. But, don't worry. If you need to hear Dylan Lewis' dulcet tones, there will be a bonus episode available on Saturday. It's about the crew's time in Austin for South by Southwest. I haven't heard it yet. Dylan has only given me a few details, but it's about the team exploring the ancillary industries around South by Southwest, specifically food trucks. Apparently, it promises to be very entertaining. I can't wait! Make sure you check it out.

That's it from us today. If you would like to get in touch, please feel free to email us at [email protected], or tweet us on Twitter @MFIndustryFocus. As always, people on the program my own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thank you to Austin Morgan for producing the show. For Todd, I'm Sarah Priestley. Thanks for listening and Fool on!