by Aaron Levitt | January 30, 2013 9:54 am
The integrated model of owning upstream, midstream and downstream energy assets — the preferred corporate structure for numerous names in the energy sector — looks to be no longer working for many firms. The refining business has been difficult to gauge over the last few years, so many former integrated giants have begun spinning off or splitting up their exploration and downstream assets.
ConocoPhillips (NYSE:COP) and Marathon Oil (NYSE:MRO) were the first to do so (with great success) and are now strictly production firms. The move certainly unlocked shareholder value as both the E&P operations and the newly minted refining firms have produced great returns for investors.
Now, smaller integrated firm Hess (NSE:HES) is looking to do some value unlocking of its own. On Monday, the energy company announced plans to sell its oil storage terminal network and exit the oil refining business to focus strictly on production operations.
Despite the fact that the downstream sector has been resurgent over the last year, Hess’s refineries haven’t been so great due to the fact that they are predominantly located in the Northeast. Like former refining staple Sunoco, Hess’s facilities don’t generally have access to cheaper WTI Bakken-based crude oil and have thus seen margins vanish. The firm’s Port Reading refinery has actually incurred losses in two of the past three years.
With those losses firmly in place, Hess has begun to shift away from the refining industry. Last year, it closed its HOVENSA facility and this week announced that it’s looking to sell its twenty oil storage terminals and close the money-losing Port Reading refinery. The bulk of these storage terminals are located in the critical East Coast and have a combined storage capacity of 28 million barrels, while the refinery is capable of churning out 70,000 barrels per day.
The moves will save Hess roughly $1 billion pera year in expenses and complete its transformation from a lumbering integrated giant into a slick, fast-moving E&P firm. Hess owns plenty of acreage in low-risk, high-return assets like the Bakken and Eagle Ford shales.
That’s only part of the story, though. Activist hedge fund Elliott Management has some other ideas that could produce similar results for investors.
The firm, which now owns about 4% of Hess, believes the energy company should follow Conoco’s or Murphy Oil’s (NYSE:MUR) footsteps and do a more traditional spin-off rather than just a sale. Elliott would like Hess to spin off its Bakken and production assets into a separate firm called Hess Resources.
Secondly, it thinks Hess should then place its storage terminals, pipelines and other midstream assets into a tax-efficient master limited partnership (MLP) subsidiary. MLPs have become all the rage with energy firms and investors as they seek to defer rising taxes and future liabilities.
Finally, Hess could spin off or sell its retail operations and refining assets. Hess operates one of the largest networks of gas stations in the country. Likewise, if the refineries couldn’t be sold, they could always be placed into the MLP.
According to Elliott Managements calculations, breaking up Hess in this fashion could have a total equity value of $126 per share, with the biggest gain coming from the newly independent Hess Resources. Hess is currently trading for around $70.
In order to facilitate its plans, Elliott is looking for board seats and has nominated five of its own picks. These include a smattering of former senior oil and gas executives who will perform a “strategic review” of Hess.
While it could be a drawn-out fight, the implementation of either proposal could make the real winners Hess shareholders.
The company’s downstream segment is the biggest problem, as it’s trapped using more expensive Brent crude as its feedstock. While new rail terminals and pipelines are being considered for the East Coast from the Bakken, they’ll take some time to complete. As such, its facilities there will continue to be drag on earnings.
The problem, though, is that Hess isn’t as large of an integrated firm as Exxon (NYSE:XOM), so its production operations can’t carry money-losing facilities for that long. By becoming a strictly E&P focused firm, Hess should be able to trade at a higher multiple and produce better earnings going forward, which will certainly make investors some coin.
I’m inclined to lean towards Elliott Management’s proposal since it includes an MLP option for the firm’s midstream assets. These are still quality pipelines and storage assets that will be able to generate decent incentive distribution rights for Hess and shareholders. I’m not sure selling them outright is the best decision.
Shares of the firm are up big over the last two days as Hess and Elliott have made their announcements. Given the longer term potential of either proposal, though, the recent gains may just be the beginning — especially, if there is publicly traded MLP to be had.
As of this writing, Alyssa Oursler did not own a position in any of the aforementioned securities.
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