In the oil patch, the age of the hunter-gatherer is drawing to a close. Will the farmers take over?
Aubrey McClendon's coming departure from Chesapeake Energy symbolizes important changes being forced on the exploration and production sector. Mr. McClendon co-founded Chesapeake and led it to become the second-largest producer of natural gas in the U.S. by output.
Chesapeake bought land in virtually every big American shale prospect. But as natural-gas prices sank—in part because Chesapeake and its peers were so good at producing the stuff—financing the empire became ever harder. As the stock fell, activist shareholders weighed in, ultimately prompting Mr. McClendon's departure.
Chesapeake isn't alone. Both Hess and SandRidge Energy are also under siege from activist hedge funds. As with Chesapeake, they face criticism for perceived governance lapses, a lack of focus and high spending. During the boom years, investors were often prepared to overlook lax governance and rising leverage. But weak gas prices and a lack of momentum in oil prices have helped change attitudes.
Looking at a sample of all exploration and production companies with a market capitalization of $500 million or more, the deterioration in the sector's finances is clear.
In the year ended in September 2003, for every dollar of cash flow per share, 80 cents went to capital expenditures, according to S&P Capital IQ. In other words, they spent well within their means. Consequently, net debt to cash flow fell from 1.61 times in September 2003 to less than 0.67 times three years later.
As energy prices rose, and the shale land grab picked up, so did spending.
This need not necessarily be a bad thing: The sector habitually recycles cash flow and raises capital to develop the next big thing. But it went too far.
Having peaked at more than $8 in the year ended in September 2008, cash flow per share for the sample has hovered at about $5 since then. But capital expenditures per share have picked up, hitting $7.20 a share, or 1.5 times cash flow, in the 12 months ended in September 2012.
Consequently, net debt is back up to 1.44 times cash flow. The industry's need for funding has also led to its share count more than doubling over the past decade as it has raised new money. So besides a higher debt burden, shareholders have also suffered dilution.
Little wonder, then, that the expansionist old guard such as Mr. McClendon is being shown the door. What comes next? Consolidation. This means, in part, fixing finances by selling assets and curbing spending. But it also means mergers and acquisitions. Even if all that hunting and gathering has left companies short of money, they do own a lot of potential resources that could be farmed by someone with more financial firepower.
Fourth-quarter results from the major integrated oil companies suggest that, if they haven't already retained the services of an investment banker, they soon will. Exxon Mobil and Royal Dutch Shell, in particular, are paying investors with dividends and buybacks to hold their stock in lieu of big growth. Buying a large exploration and production company offers one way of addressing this deficit while giving investors in the sector a chance to pick up takeover premiums.
Despite Mr. McClendon's departure, Chesapeake seems like an unlikely target given its complex edifice of financing arrangements and joint ventures. Like Hess, it may be worth more if sold in pieces. But there are other targets. Sanford C. Bernstein identifies Range Resources, whose liquids-rich reserves are tailor-made for the revival in U.S. petrochemicals manufacturing.
Meanwhile, Anadarko Petroleum, while large with a market capitalization of $42 billion, offers a mix of U.S. reserves as well as foreign projects such as Mozambique liquefied natural gas, which have traditionally been the preserve of the majors. Exploration and production empire building may no longer be in fashion. But that needn't stop investors from enjoying the fruits of conquest.