Ovintiv: Inactivity Fuels the Activism Fire
By: Gabrielle Gregg
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
With an oil price crash and a sharp economic downturn brought on by the COVID-19 pandemic, 2020 marked a difficult year for the oil and gas industry. One clear victim was Ovintiv, a North American exploration and production (E&P) company that operates a broad portfolio of assets in Canadian and U.S. basins. Already facing pressure to meet the challenge of transitioning to renewable energy, Ovintiv now also faces a reduction in its credit rating to below investment grade, making future expansions fuelled by debt more expensive. These concerns, coupled with the company’s elevated debt levels, have resulted in a depressed valuation of 5.2x based on Enterprise Value to EBITDA—about half the multiple it commanded just 4 years ago.
Ovintiv: A Rich History
Ovintiv originated from Canadian Pacific Railway’s first push into Western Canada in the 1880s. The company continually improved its core assets over the next century and merged with the Alberta Energy Corporation to form Encana in 2002. Encana succeeded in its early years by concentrating on strong core operations, selling underperforming assets, and prudently managing debt. Over the following seven years, investors remained confident in Encana’s strategic plan and ability to outperform market expectations. By 2008, it was Canada’s largest energy company by both market capitalization and production volume.
However, confidence in the company faded seemingly overnight when a pipeline burst in Northeast British Columbia in November 2009. This news was exacerbated by claims that Encana failed to follow its safety-response plan during the crisis. Encana also faced broader market issues caused by the worldwide financial crisis and plunging natural gas prices due to the shale revolution. In hopes of recovering from the pipeline accident and low energy prices, a new strategic plan was introduced in 2013, in which the company shifted focus away from its core operations toward multi-basin expansion. Efforts to drive margin growth and diversify product lines were not enough to revive Encana from the confidence crisis that had begun years earlier. After years of net losses and increasing debt, Encana rebranded yet again in 2019 to become Ovintiv. Once a company that had revolutionized Canada’s energy market, Ovintiv’s headquarters departed Canada in search of U.S. investor capital. The departure of Canada’s most historic energy company was striking for the industry, with leading experts claiming that the energy industry in Canada was “no longer associated with innovation.”
Kimmeridge: The Activist Investor
Despite maintaining a portfolio of industry-leading assets, Ovintiv has consistently generated below-industry returns for shareholders. Ovintiv’s shares have fallen 84.4 percent since June 2013 while peers have fallen comparatively less—just 11.1 percent over the last 8 years. This gap between potential and achieved performance has attracted activist investor Kimmeridge Energy Management to seek change within Ovintiv via a proxy fight for three board seats. Kimmeridge is a powerful fund that strives to be a thought leader in the industry and has raised $3.0 billion of LP commitments since 2012. Through several white papers directed to shareholders, it has highlighted supposedly fatal flaws in Ovintiv’s current operations. Key areas of concern include poor environmental stewardship, capital allocation, and corporate governance. While Ovintiv has recently agreed to elect one board member from Kimmeridge, its hostile attitude towards the activist fund leaves room for improvement.
Drilling Down to the Root Causes
Despite the recent change in board members, problems have persisted within Ovintiv. Poor capital allocation, government concerns, and lack of environmental stewardship all need to be addressed to ensure a successful turnaround.
Ineffective Capital Allocation
Management has allocated capital poorly, demonstrated clearly by its underperforming acquisitions and inefficient operations. Net debt has increased 53 percent since 2013 from $4.6 billion to $7.1 billion, mostly funding several poorly timed acquisitions. Both Athlon Energy, acquired in 2014 for a 25 percent premium, and Newfield Exploration, acquired in 2018 at a 35 percent premium, were costly relative to industry valuations at the time. These acquisitions forced management to shift focus from innovation on existing assets to prioritizing cost savings to meet synergy goals.
The company currently holds assets in three core basins as well as four non-core areas. Over the last few years, Ovintiv has deployed upwards of three-quarters of its capital to each of the core basins without a strategic focus on any particular basin or commodity. The key challenge in capital allocation is that each basin offers exposure to a unique commodity: the Montney provides condensate and natural gas exposure in Canada, the Permian provides U.S. oil exposure, and the American Anadarko contains both gas and liquids. This diversified approach directly contrasts with the company’s successful strategy in the late 2000s. In that era, Ovintiv sold international assets in Ecuador and Brazil, divested storage and midstream assets, and even spun-off its oil sands business. Alongside its prudent management of debt levels, this directional clarity gave investors comfort in knowing what company they were purchasing today and years into the future.
Governance Concerns
The second concern is an inappropriate governance structure. There is a lack of alignment between compensation and performance, with repeated increases in executive pay while Ovintiv’s share price and performance metrics underperform its peers. Even with the introduction of a long-term incentive equity plan, the company lacks significant ownership by key insiders. This has led to a lack of accountability and misaligned management incentives.
Weak Environmental Stewardship
Increased demand for decarbonization and calls for reduced emissions have been strong headwinds for the traditional oil and gas sector. As a result, curbing crude production emissions has been a major focus for E&Ps, primarily through drilling innovation that reduces emissions per barrel.
Ovintiv’s elevated intensity of CO2 emissions and CDP climate change score of “D” place it among the worst in its U.S. peer group for environmental stewardship. Inadequate transparency around target setting has resulted in a perception that the company is failing to comply with enhanced ESG requirements. With a greater focus on ESG standards across the industry, a company’s ESG profile is critically important to its ability to access and deploy capital, in addition to overall investor confidence.
Ultimately, Ovintiv must address these problems with strategic precision as the implications for inaction include further erosion of returns, efficiency, and competitive positioning. It is imperative that Ovintiv views its relationship with Kimmeridge as a strategic partnership in the midst of its current shortcomings, in contrast to its currently hostile approach to managing relationships with activist investors.
Migrating South
To recover from decades of poor performance and weak investor confidence, Ovintiv should focus resources on a revised board of directors, improved capital allocation, and a U.S. core asset base. By doing so, Ovintiv can create a new strategic direction that focuses solely on the American oil and gas industry.
Welcome with Open Arms
First, Ovintiv should willingly accept the remaining two Kimmeridge nominees to the board. By supporting the individuals recommended by Kimmeridge, it will be well-equipped to navigate the U.S. energy industry with an emphasis on ESG. The Kimmeridge nominees bring knowledge of U.S. shale technology and ESG reporting critical to the energy transition. With sufficient support from Ovintiv, Kimmeridge can employ its historically successful playbook to improve financial returns and make the company competitive on a national scale once again.
Capital Allocation
Following the appointment of the three Kimmeridge board nominees, a revised strategy should prioritize disciplined capital allocation to specific high-returning assets. The cyclicality of the energy industry has shown that a generalist, diversified E&P company does not warrant increased investor appetite. However, by following the Encana playbook of the late 2000s, Ovintiv can drive higher returns and regain investor confidence. With a renewed focus on core assets, it will have the scale to increase ESG stewardship, pay down debt, and improve production efficiencies for these core operations. The implementation of this strategy will bring innovation back to the forefront of decision-making at Ovintiv.
Shift Towards Core Assets
To meet debt reduction and asset simplification goals, Ovintiv should sell off its Montney assets. Providing around 40 percent of the company’s total production volume, the Montney comprises a significant portion of its asset base. When Encana rebranded itself as Ovintiv, its primary objective was to grow its U.S. operations. To prove commitment to this directional shift, Ovintiv should divest its Canadian operations and dedicate resources towards the Permian, a region where Ovintiv has a strong track record of success in cost reduction and technical innovation.
Given that the Montney basin provides commodity mix optionality and insulation from pricing volatility, there is substantial demand for assets in the region. For example, a recently-announced $8.1 billion merger between Arc Resources and Seven Generations is expected to create the largest pure-play producer in the Montney basin, producing 340 thousand barrels of oil equivalent per day by 2021. Since the announcement, both companies’ share prices have appreciated 15 percent, indicating high investor confidence in high-quality natural gas assets in the Montney. With LNG coming online in the next few years to the Canadian West Coast, the demand for assets in these Western Canadian basins will only increase. Transactions like this in the Montney provide economies of scale and operational flexibility, driving up asset valuations. Now is the ideal time for Ovintiv to sell its assets in the Montney at a high price to other upstream players consolidating assets in the basin.
Following the recent disposition of Duvernay assets for $263 million, Ovintiv is close to reaching its debt reduction target of 1.5x Net Debt-to-EBITDA. A disposition of Montney assets will allow the company to pay down debt and increase focus to core areas in the U.S. Using conservative estimates based on the Seven Generations and Arc Resources merger, the company can reduce debt well below its target. With high-value condensate production of over 80 thousand barrels per day and more than ten years of inventory, other E&Ps looking to further consolidate in the basin would benefit greatly from acquiring Ovintiv’s assets. Focused U.S. operations will create the opportunity for improved technological innovation, transparent ESG standards, and management accountability.
Creating a Well-Oiled Machine
Leveraging the expertise of the three Kimmeridge nominees will allow Ovintiv to redefine its strategy and competitive positioning. Within months, the new strategy would allow for prudent capital allocation, increased ESG stewardship, and production efficiencies. To capitalize on high valuations in the Montney, Ovintiv should sell its Montney assets quickly and use proceeds to focus on core operations in the U.S. If it follows this strategic plan, it will be well-positioned to reemerge as the darling North American E&P leader it once was.
