An interview with Mark Viviano, managing partner and lead portfolio manager on the public investment team with Kimmeridge Energy Engagement Partners.

How do you create investment opportunities at Kimmeridge?

We start by focusing on a very narrow section of the investment universe, which is the public North American energy companies. Then, we have a relatively simple formula. We look for high quality assets trading at a dislocated valuation, then we identify catalysts to drive a potential re-rating. Finally, we look for vulnerabilities to activism to maximize the potential impact of our engagement. The first two steps are exactly what I spent the first 15 years of my career trying to do at Wellington Management. It was extremely frustrating to have to rely on management teams to do the right thing, so joining Kimmeridge and incorporating shareholder activism into the strategy allows us to accelerate that value recognition.

As one of your campaigns, in 2022, Kimmeridge declared a position in California Resources holding talks with the oil and gas producer on ways to boost value, including by monetizing some of its land. Were you satisfied with the outcome of that engagement?

It is still an active engagement. I’d say we’re pleased with that engagement to date as the management team has been very receptive to our input. The stock has outperformed as the market begins to recognize the potential value of their real estate and carbon capture business. I’d say the primary catalyst for this was the strategic realignment the company announced earlier this year, where they laid out what they were going to do to facilitate the future separation of their oil and gas business from their carbon capture business and then pursue the monetization of their Huntington Beach real estate by commencing the entitlement process. They also announced lower investment levels into the upstream business and then a cost cutting program to improve profitability.

Are there any more recent campaigns that you’re in a position to speak about?

One of the active investments we have today is Chesapeake Energy, where we had been quite vocal about the need for the company to monetize its oil assets to focus on being a pure play gas company. They just announced back in August the final sales process for their Haynesville and Marcellus oil assets. That’s expected to close before the end of the year, so I would say that investment is also on track relative to our expectations.

DMI data show the number of energy companies globally subjected to activist demands in the first 10 months of this year has held relatively steady with 44 so far this year, compared to 47 in the same period in 2022. Do you feel we are likely to see a return to higher levels of activism in this space?

Honestly, it’s hard to tell. On the one hand, the valuation dislocation, relative to the broader market, should attract greater interest, but so many investors got burned by the sector in the past. A lot of traditional activists ultimately abandoned oil and gas. I do think that speaks to our competitive advantage as a sector specialist. Activists tend to screen for cheap and out of favor stocks, but the cheapest energy stocks usually have lower quality assets, by definition.

We always say you can change a lot about a company, whether it’s the capital allocation, the strategy or the management team, but you can’t change the rocks. You need to get the geology and the quality of the remaining drilling inventory right. Kimmeridge is an upstream operator. We have a full technical team of geologists and engineers in Denver that helps us with the underwriting of our public investments, as well. I think that competitive advantage has allowed us to continue to invest in a sector that many have abandoned.

In early 2022, your firm argued that U.S. energy companies should not fall into the trap of repurchasing shares to satisfy shareholders during high commodity prices but prioritize reinvestments and debt repayment so that they reduce the cyclicality of the business. What advice would you give to energy companies on how to best respond to today’s commodity prices?

We’ve been critical of the procyclical behavior of the industry. Historically, the issue was companies chasing production growth. They would increase drilling activity as prices rose and we all know how that story ends. Companies have certainly been more disciplined over the past few years, but they were overly aggressive in buying back stock with the excess free cash flow they generated last year when oil prices were above 90 and gas prices were above six.

Obviously, the issue is when commodity prices are high, share prices are usually high, and buying back stock is not always the best lever for value creation. While there is a need to be prescriptive on what percentage of that excess cash flow should be returned to shareholders, we don’t think companies should be prescriptive about the mechanism for doing so. In a cyclical industry, timing matters, and we think companies should keep their options open by employing all of the above to debt paydown ordinary dividends, special dividends or share buybacks. If you use excess free cash flow to pay down debt at the top, you do increase the likelihood of being able to buy back stock at the bottom, which is the best way to create value in a highly cyclical industry.

What are your expectations around M&A activity in the sector?

We published a report over the summer called “I Still Haven’t Found What I’m Looking For” and we criticized the lack of public-to-public M&A. To date, we think consolidation is the last piece of the puzzle in rationalizing the industry. There are simply too many public companies in a sector that doesn’t have a lot of investor interest, and that has too many business models that increasingly look similar and commoditized. At the same time, the rationale for public consolidation has probably never been greater. Scale is a maturing resource, so scale and operating efficiencies are going to be the key differentiator, while the valuation spread between large- and small-cap companies has never been wider.

Since that report, we’ve seen two high profile deals, with Exxon Mobil acquiring Pioneer and Chevron acquiring Hess. While I’d like to say that that is going to kick off a wave of M&A, I also caution other investors that those were the easier deals to do. The CEO of Pioneer, Scott Sheffield, had already announced his retirement at the end of this year and John Hess was turning 70 next year. That’s always been the pattern in this industry. Deals are driven by which companies are for sale rather than finding the best acquisition targets. Nobody wants to go hostile. They simply give up when their offer is rebuffed. The main message from the report that we published is that companies shouldn’t be afraid to take unsolicited offers public and give a voice to the shareholders on which deals are the right ones for them.

In a paper on compensation, Kimmeridge stated that the fate of the industry hinges on whether boards can successfully align executive compensation with the new E&P business model. Can you expand on this?

I don’t think shale executives have found religion. I think they’ve maintained discipline because it was being rewarded by the market. Historically the largest component of executive compensation in the sector was relative total shareholder return (TSR). CEOs are constantly looking around at what others are doing and what drives short-term outperformance, but that’s also why investors are so paranoid that companies will evolve their messaging to accommodate the changes in investor preferences. The management teams are just too reluctant to separate from the pack because of this focus on relative TSR.

We’ve argued that the industry needs to move more towards absolute TSR, so that you’re rewarded for prudently managing a business through the cycle and reducing that downside volatility that scares away so many investors from the sector.

Looking ahead to 2024, what opportunities are you hoping to explore?

One of the things we’re starting to think about is potential activist opportunities that may be emerging in the clean energy sector. We see a lot of similarities to the shale industry a decade ago, where these unrealistic growth ambitions intersected with a massive wave of capital coming into the sector. We’re starting to see cracks emerge as projects fall short of expectations and rising interest rates threaten what were already slim profit margins.

As we learned with shale, when the music stops, and investors peer behind the curtain, they start to notice those failures of governance and a lack of shareholder alignment. So, we think about what our next activist vehicle may look like, and there’s a high probability we’ll look to expand the opportunity set beyond traditional energy to take advantage of some of those dislocations on the clean energy side.