Hess Anticipates a Third Guyana Development Online by Year-End

Director

Dave Meats

Hess' track record for efficiently allocating capital and generating value has been steadily improving. The company has deftly streamlined the portfolio, jettisoning less competitive and riskier positions in Equatorial Guinea, the Danish North Sea, and Libya, and shifting the focus to more lucrative oil and gas assets. Today the firm has two major growth assets, its 30% working interest in the Exxon-operated Stabroek block (offshore Guyana) and its acreage in the Bakken Shale play (U.S. onshore). Hess' ongoing investment in these regions is supported by cash flows from its legacy operations in the U.S. Gulf of Mexico and Southeast Asia.

The firm's Guyana assets will be an engine for rapid growth in the next few years, differentiating Hess from other independent upstream firms. Slow and steady expansion has become the industry norm, with excess cash being funneled back to shareholders instead of ploughed back into the ground. Hess still aims to distribute 75% of its free cash but that cash flow is reduced by heavy upfront spending in Guyana, which nonetheless makes sense given the region's exceptional economics and the size of the prize in the ground. The block's gross recoverable resources are a moving target while exploration continues, but the latest estimate is over 11 billion barrels of oil equivalent. For Hess, that translates to an array of large projects. Recent guidance indicates six phases of development all online by 2027, culminating in gross volumes over 1.2 mmb/d. This includes two phases that have already been sanctioned and two that are currently producing). Even that feels conservative, with over 30 discoveries to date. We model 10 phases.

Hess is also one of the largest producers in the Bakken Shale. This includes a large portion in the highly productive area near the Mountrail-McKenzie county line in North Dakota. Management intends to develop this asset with a four-rig program that will optimize the usage of its infrastructure and expects production to reach 200 mboe/d in 2025, then plateau near that level for almost a decade. Our well-by-well production model suggests that goal is realistic.

Business Strategy & Outlook

The ability to generate maintainable excess returns on invested capital is a hallmark of companies with economic moats. And Hess has failed to consistently do so over the past decade, because of historically poor capital allocation (which resulted in $10 billion of cumulative write-downs from 2010 to 2020). But more recently, management has found a winning formula. The firm’s asset portfolio has been comprehensively reshuffled. Most of the firm’s less competitive assets have now been sold, and the firm is now investing in two key regions: the North Dakota Williston Basin (home of the Bakken Shale play) and the Stabroek Block (offshore Guyana). On account of this transformation, we now expect durable excess returns on invested capital for at least the next 10 years, and accordingly assign a narrow moat rating.

A large portion of Hess' Bakken acreage is ideally located in the core of the play, supporting at least another decade of impressive well results. On average, the firm’s latest completion design is expected to yield 150 thousand barrels of oil in the first 180 days of production, putting the firm on equal footing with the best Bakken operators. These wells theoretically break even with WTI crude prices at around $40 per barrel. This field-level calculation excludes land costs, infrastructure, and other corporate costs. But even on a “soup-to-nuts” basis, the asset can generate substantial free cash flows over the next 10 years at midcycle prices ($55/bbl WTI).

In any case, the firm’s Guyana assets are now the undisputed crown jewel of the portfolio. Exxon operates the Stabroek Block, and Hess has a 30% non-operating stake. However, due to the relative scale of these companies the block is probably more impactful for Hess. Management believes discoveries like Liza can be developed profitably with Brent crude at or below $35/bbl. While we think that’s a stretch, our own modeling confirms that the basin offers similar returns to the most attractive shale projects. Such exceptional economics partly reflect the shallow depth of the reservoir and its very high productivity, but the timing of the initial development was a big help. The first discovery, Liza-1, was announced in May 2015, just after the steep crash in oil prices that began in late 2014. As a result, the partnership initially benefited from bottom-of-the-cycle prices from service providers. And due to learning curve effects and economies of scale, future developments are expected to be even more capital-efficient.

The other advantage for Hess is the massive scale of the Stabroek Block’s potential resources. There have been over 30 discoveries announced so far. Development is ongoing: the first phase, targeting the Liza discovery, was brought online in late 2019, and the partnership had two phases in service at the end of 2022 (with two more already sanctioned and a third pending final approval). The current plan calls for six total phases of development by 2027, with a cumulative capacity of around 1 mmboe/d. Hess’ share would account for about 40% of firmwide volumes, which makes this a genuine game changer. And there’s further upside: we agree with management’s view that the block could eventually support as many as 10 phases. However, in contrast to shale, these projects come with daunting up-front capital requirements (the first development phase alone costs about $1 billion net to Hess). As a result, the resulting cash flows are very long-dated and the asset won’t be truly self-funding until the mid-2020s.

Of course, like all E&P firms, Hess is exposed to a range of potential environmental, social, and governance issues that could hurt its ability to generate strong returns. The most significant ESG exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills). Of these, the greenhouse gas emissions are the biggest threat, and there’s no way for oil producers to avoid this completely. Firms can clean up their operations in the field as much as possible by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to reduce CO2 volumes being released into the atmosphere during the extraction process. Hess aims to reach net zero for emissions related to its own operations by 2050, but it does not have a goal for eliminating downstream emissions (at the refinery and beyond). Yet these account for the vast majority of total oil and gas emissions.

Recognizing this, management has pledged to spend at least $750 million on REDD+ carbon credits sold by the Government of Guyana between 2022 and 2032. Essentially, these credits discourage deforestation by compensating governments for not cutting down trees that act as carbon sinks, which prevents this carbon from being released into the atmosphere. Hess is paying $15/ton for these credits, and based on its emissions intensity that translates to well under $1/boe--a fairly trivial cost it is incorporating voluntarily. The REDD+ scheme was created by the UN Conference of the Parties, giving it a high level of credibility, but it remains to be seen whether investors or energy consumers will be convinced that curbing deforestation really offsets carbon emitted by the use of petroleum products. 

Since there's no practical way to eliminate all carbon emissions from the oil and gas value chains, it's likely that consumer aversion to fossil fuels will grow. That increases the reputational risk for producers and encourages substitution, when possible. It also makes value-destructive regulatory intervention more likely (think fracking restrictions or carbon taxes).

Likewise, spills are a concern for oil firms operating offshore, like Hess. Though the probability is very remote, a devastating accident like the BP Macondo disaster in 2010 could have a material adverse impact on the firm (which could be forced to cover cleanup costs and perhaps face other legal repercussions). Spills also occur from time to time during long-haul transit over land, and Hess has limited exposure here through its midstream subsidiary. Still, there is very little chance that the firm would be on the hook for an event like the Kalamazoo River (Michigan) spill, which also occurred in 2010.

These ESG-related threats are not likely enough to be included in our base-case forecasts, but because the impact would be material, it does affect the firm’s moat potential. In this case though, we believe there is a sufficient margin between our projected ROICs and the firm’s WACC to support a narrow moat anyway. Further, we note that Hess’ geographic diversification could mitigate regulatory risk in the U.S., at least. If legislation is passed that significantly hampers U.S. producers, Hess could end up being a net beneficiary as the negative impact on U.S. supply would probably push up oil prices enough that the increase in value of Hess’ Guyana assets offsets the reduced value of its Bakken assets.

Narrow

Economic Moat

Hess

Hess Corp is an exploration and production company, which engages in exploration, development, production, transportation, purchase & sale of crude oil, natural gas liquids and natural gas with production operations. It operates through the following segments: Exploration and Production and Midstream. The Exploration and Production segment explores for, develops, produces, purchases and sells crude oil, natural gas liquids and natural gas. The Midstream segment provides fee-based services including crude oil and natural gas gathering, processing of natural gas and the fractionation of natural gas liquids, transportation of crude oil by rail car, terminaling and loading crude oil and natural gas liquids, and the storage and terminaling of propane, primarily in the Bakken shale play of North Dakota. The company was founded by Leon Hess in 1920 and is headquartered in New York, NY.

Earnings data Q2 2023

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Hess Midstream offers investors a mix of safety and income, with a strong balance sheet profile and downside-protected contracts. The company has a free cash flow yield of about 10% based on 2023 projections and pays out a dividend yield of around 8.4%. HESM is expected to see solid growth as its parent re-ramps activity in the Bakken.

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