A Modern Investment Paradigm: Executives Are More Powerful Than Shareholders

Includes: OIL, USO
by: Artyom Zakaryan, CFA


Management incentives are not aligned with shareholders.

Executives keep on drilling unprofitable wells at the expense of investors who are watching their money being thrown down the hole.

Where is investors' rage? Has impending bankruptcy become a norm for shale investors?

It is painfully obvious that the best way to make money in the 21st century is to be an executive rather than an owner. Nowhere it is more pronounced than in the oil industry. There have been several notable bankruptcies in the offshore drilling industry and among shale plays. Stockholders got wiped out, many bondholders lost significant amount of principal, however, in the overwhelming majority of these bankruptcy cases, the original management, which drove companies into the abyss remains at the helm of the reorganized company.

I follow offshore drilling industry very closely, Hercules Offshore and Vantage Drilling have reorganized themselves and burnt a significant amount of shareholder capital in the meantime. The reason both companies are bankrupt is because of enormous debt current management teams piled onto the balance sheet in pursuit of high profitability during good times. Once the cycle turned upside down the writing was on the wall and equity in both companies got wiped out.

The original management team is still there enjoying their high salaries and perks. The problem is in improper alignment of managements' interest. They are paid bonuses upon achieving certain profitability milestones and it makes all the sense in the world for them (management) to engage in riskiest possible behavior in the short-term disregarding long-term goals of sustainability. Knowing full well that there is no adverse outcome even if these risky strategies won't work, there is absolutely no incentive for management to exercise prudence. So, here's a question: why are owners putting up with this?

I come from a part of the world where there are very few public companies. Companies are privately owned and are managed under a scrupulous supervision of the largest shareholders. That is clearly not the case in the Western world, where executive management is much more powerful than shareholders and I only blame shareholders for finding themselves in such a predicament. The fragmented nature of shareholding for most publicly traded companies does not allow for efficient supervision of management teams and they get away with activity bordering on criminal abandonment of fiduciary duty. Moreover, there are all kinds of restrictive payouts written into labor contracts of top management that most of the time it is more costly to let them go than have them stay. Once again I blame shareholders for being weak, disorganized, and passive.

Lack of fiduciary responsibility has been especially visible in the shale oil industry over the past 12 months. Management of most US-based E&P producers have kept authorizing large capital expenditures knowing full well that they are unable to generate enough cash flow from the drilled wells to justify continued capex. They keep reporting outspend of two dollars per one dollar generated on the cash flow statements yet on the conference calls analysts applaud these so-called "efficiencies" and exaggerated IRRs in ever-decreasing commodity price environment. E&P management teams are flushing investor cash down the hole with no end in sight. Furthermore, it is mind-boggling that investor money is not drying up and banks still keep credit lines open to outfits that are absolutely guaranteed to go bankrupt in the near future. It's a vicious circle, because banks' lending department personnel also get paid on the nominal value of their loan portfolio and have no incentive to pull back credit lines. Screw the shareholders who will ultimately take losses, short-term bonuses of the management team is the only thing that matters.

Current US shale equity holders in over-leveraged names will get mostly wiped out as there is really no choice for many companies but to reorganize and shed enormous debt in the process in hopes of restarting with a clean slate. All of this could have been avoided if management teams were to simply stop drilling and completing money-losing wells over the past 12-15 months. Most small and mid-size companies were very well hedged and operating cash flows generated by hedges and existing production could have lowered debt burden to more rational levels in the absence of investing cash outflows. As a consequence of such a discipline, production would have slowed down and oil prices would have had a chance to remain in a high enough price range ($60-65 per barrel) helping current equity holders remain solvent.

Shareholders as a group should have taken a stance but modern investment system and culture precludes such a possibility. Most large shareholders are financial institutions which have absolutely no willingness in active supervision of management teams. As a result, current shareholders will be left holding a bag, new shareholders will replace them whereas old management teams will stay and continue to fleece new equity holders. Welcome to modern investing paradigm, where being an executive more than trumps being an owner.


Related stocks: Halcon Resources (NYSE:HK), Penn Virginia (NYSE:PVA), EP Energy (NYSE:EPE), Paragon Offshore (NYSE:PGN), Ocean Rig (NASDAQ:ORIG), Pacific Drilling (NYSE:PACD), Seadrill (NYSE:SDRL), Seadrill Partners (NYSE:SDLP), Midstates Petroleum (NYSE:MPO), Goodrich Petroleum (NYSE:GDP), Linn Energy (NASDAQ:LINE), Breitburn Energy (NASDAQ:BBEP), Triangle Petroleum (NYSEMKT:TPLM), Oasis Petroleum (NYSE:OAS), Whiting Petroleum (NYSE:WLL), Chesapeake Energy (NYSE:CHK), Sanchez Energy (NYSE:SN), EV Partners (NASDAQ:EVEP), Vanguard Natural Resources (NASDAQ:VNR)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.