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Hess Shares: Less Appealing Than They Look

Oil outfit Hess has improved its operations, but not enough to offset drop in prices from shale production.

Hess has undergone a massive overhaul in the past five years. That’s made it more efficient and, in some investors’ eyes, undervalued. But those who bet on its shares are likely to be disappointed.

After a spate of production misses and cost overruns early this decade, Hess went on a diet, shedding its gas stations and slimming its midstream operations. It also refocused on exploration and production, an effort that is starting to bear fruit, thanks to key operations in the Bakken shale formation and promising fields in Asia, the Gulf of Mexico, and off the coast of Guyana.

Analysts, on average, believe the stock (ticker: HES), recently $51.30, is worth $65. CEO John Hess told investors last week that the company’s “decade or more of visible production growth [will] deliver improving returns and value.” The stock yields 2%.

Yet even as oil has rebounded—thanks partly to a production cut by the Organization of Petroleum Exporting Countries—the best days for Hess may be behind it. Blame the U.S. shale boom, which will swamp any rally in oil prices and in Hess shares. In fact, some canny observers believe the stock could fall at least 10%.

West Texas Intermediate, the benchmark U.S. oil, recently fetched $53.36 a barrel; a number of analysts believe it could rise as high as $70 this year. In theory, that should benefit Hess, which has proven reserves of 1.1 billion barrels and plans to produce 300,000 to 310,000 barrels a day this year, one-third of it from the Bakken formation, which stretches across parts of North Dakota, Montana, and southern Canada. Yet the risk is that oil peaks this year. Global demand for petroleum trails economic growth, thanks to new technology, renewables, and the developing world’s transition from manufacturing to services. Then there’s the shale boom. Some observers believe oil will fall below $50 by January and dip under $40 next year, partly since U.S. output could ramp up quickly.

Last year, Hess lost $6.2 billion, or $19.92 a share, on $4.8 billion in revenue, including $3.7 billion in noncash charges, based on generally accepted accounting principles. More years of losses lie ahead.

NONE OF THIS IS GOOD NEWS for Hess shareholders. Bakken producers are said to be viable whenever WTI oil fetches $55 to $60 a barrel. Yet even with prices below that level, drilling is under way in the Bakken and elsewhere, aggravating an oversupply that OPEC was hoping to address. As of mid-January, U.S. oil producers had pumped an extra 500,000 barrels a day in the previous three months, more than the volume Saudi Arabia had committed to stop producing. Earlier this year, major shale drillers reported budget increases exceeding 50%. Hess boosted its budget by 18%, even though it is increasing production by only 10%.

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In the Bakken, Hess is increasing its rigs this year to six from two and aims to drill 80 wells. Management says that two-thirds of its wells in the Bakken provide a 15% internal rate of return—a level analysts say is viable—when WTI is $60, and 49% when oil is at $50. Every $1 move in the price of oil changes after-tax cash flow by $70 million. That would be good news if oil prices move in the right direction. But long term, that’s unlikely.

Technology has helped Hess drive extraction costs 10% lower than they were last year and 66% below their level in 2012, just before activist Elliott Management launched a proxy battle, took seats on the board, and forced the company to slim down. Yet supply costs—for fracking materials, wages, and the like—are jumping.

Meanwhile, other areas are more profitable than the Bakken. Production in the Permian Basin, located mainly in West Texas, is viable at $50 a barrel, and that’s attracted producers such as EOG Resources (EOG) and Pioneer Natural Resources (PXD). Output also is rising in the so-called Stack and Scoop shale formations in Oklahoma, where companies such as Devon Energy (DVN) operate. “Market sentiment is decidedly pro-Permian, Stack and Scoop,” Barclays analyst Paul Cheng wrote in January.

Says another analyst, who asked not to be named, “The issue is whether the Bakken will ever be needed when Permian breaks even at $50 and is closer to the markets.”

Hess also has pushed offshore for oil. This year, it will sell oil from the North Malay Basin in the Gulf of Thailand. Next year, the first oil is expected to come out of its Stampede development in the Gulf of Mexico. It also has a 30% interest in a world-class field off Guyana, operated by Exxon Mobil (XOM). It contains an estimated 800 million to 1.4 billion barrels but won’t come online until 2020, at the earliest.

John Hess is bullish on the company that his father Leon, a former owner of the New York Jets, founded in 1933. The nearly 50% shrinkage in global E&P spending since 2014 will lift oil prices, he maintains, and continued strong demand will offset U.S. shale production. Aside from new production offshore, there are other catalysts for the stock, including the planned initial public offering of Hess’ midstream master limited partnership. A war, of course, could send prices sharply higher.

For the current year, analysts expect Hess to lose $943 million, or $3.02 a share, on $5.8 billion in revenue. They see the per-share losses decreasing to $2.15 next year and 66 cents in 2019. Says Morningstar’s Dave Meats: “Hess is not expected to earn its cost of capital for several years.” The company should be able to handle the losses. It has $2.7 billion in cash and total liquidity of $7.3 billion following a recent refinancing. Its total debt is $6.8 billion, which Fitch recently downgraded to BBB-, one notch above junk, citing Hess’ “loss in size and diversification.”

Using an average price of $59 a barrel this year and $45 in 2018, Meats values Hess’ stock at $47, or 8.5 times enterprise value to earnings before interest, taxes, depreciation, and amortization this year and 13 times next year—around 10% below last week’s price. “I’m not saying oil prices can’t go any higher,” he adds. “But $55 is the long-term level for WTI that makes sense.”

On the other side of the world, Luan Nguyen, a proprietary trader at Vietnam’s Viet Capital Securities, has shared his view of Hess on the buy-side Website SumZero. “Return on invested capital is still far below the cost of capital,” he contends. “I just don’t see any upside.” If oil averages $51 a barrel this year, Nguyen says the stock is worth $45.

Best steer clear.