Everybody loves a bargain, but it's always important to ask why a potential bargain is as cheap as it is. In the case of Hess (NYSE:HES), a diverse set of high-quality assets and a hefty weighting toward U.S. liquids and overseas natural gas would normally seem to be a very good thing. Management has seemed disturbingly lackadaisical about economic returns and capital allocation, though, and investors need to have a strong cause for believing that management can deliver growth in production and shareholder value before entering a position here.

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Good Assets Can Drive Value
On just the basis of its assets, Hess probably deserves a higher premium than the market is willing to give.

Hess has over 1.5 billion barrels of oil equivalent (BOE) of reserves, and more than 70% of that is oil and liquids. More than 30% of those oil reserves lie under U.S. soil, and Hess is both a major operator in the Bakken region and a significant acreage holder in the emerging Utica area, where other well-known players like Chesapeake Energy (NYSE:CHK) have been seeing strong initial results.

Hess also has relatively attractive natural gas assets from a geographical perspective. Although natural gas-heavy companies like Ultra Petroleum (NYSE:UPL) and Devon Energy (NYSE:DVN) are still very much out of favor because of the uneconomic price of natural gas in the U.S., that's not true around the world. Gas prices are higher in Europe and Asia, where Hess has nearly 25% and 60%, respectively, of its natural gas reserves.

SEE: What Determines Gas Prices?

Taking a step back, Hess has all-around solid geographic diversification. A little more than a quarter of reserves are in North America (which includes unconventional assets like Bakken and deepwater assets in the Gulf of Mexico). Less than 20% are in Africa - something of a good news/bad news proposition given the potential for political/operational turbulence (as seen in Libya and Angola). Africa is also home to strong discoveries made by companies like Chevron (NYSE:CVX) and Anadarko Petroleum (NYSE:APC). Europe is home to over one-third of Hess's reserves, while Asia makes up the rest (less than 20%). Hess is not a major player in Brazil or Russia at this point.

But Economics Matter
The biggest issue with Hess centers on the company's heavy capital expenditure budgets in recent years - budgets that have exceeded operating cash flow and pushed the company toward asset sales and debt financing. On a closely related note, there are legitimate questions as to whether the company has been too careless with drilling costs and total economic returns from its exploration and production (E&P) activities.

Hess spent over $3 billion in 2012 on its Bakken properties. While the Bakken has indeed proven to be a productive area for companies ranging from Whiting Petroleum (NYSE:WLL) to Exxon Mobil (NYSE:XOM), Hess's well costs exceeded $13 million at the start of the year. It's all but impossible to generate consistently good economic returns on wells that cost more than $10 million, so it's worth asking if the company was drilling away shareholder value.

Since then, the company has switched to pad drilling, and well costs have moved below $10 million (and below $8 million in some cases). All told, Hess guided Bakken spending down about 30% for 2013. Even so, this comes with a cost. Where Hess had once targeted 2013 Bakken production of 80M boe/per day back in 2011, guidance for 2013 was about 64M to 70M boepd.

All told, Hess guided its capex budget to $6.7 billion in 2013, with more than half of that to be spent in the U.S. and about 40% (in total) on unconventional projects. After spending 18% more in 2012, that's still a steep budget, but Hess is stuck in the same Catch-22 as many other oil and gas companies. The Street demands production growth, but it apparently expects these companies to do that without spending any money.

Speaking again of money, Hess has taken some reasonable steps to produce more of it. The company has chosen to divest its refinery operations, and has also decided to sell other E&P assets in Russia (a while ago), the Eagle Ford (more recently) and other areas. More divestitures could be on the way, either as a means of pacifying activist investors or recognizing the lack of operating leverage in particular geographic areas.

SEE: Oil And Gas Industry Primer

Recent Results Highlight Some Challenges
Hess's fourth quarter numbers highlight some of the good and bad points of this story. Production increased 8% on a year-over-year basis in the fourth quarter, with a 10% increase in liquids production. Compared to majors like Exxon and Chevron, that's excellent, and it also compares favorably with smaller producers like Anadarko.

What wasn't so impressive was the 18% decline in E&P segment earnings. All told, Hess is one of the least profitable (on a per-BOE basis) large E&P companies. So here again we have the familiar problem - Hess has a lot of oil and can produce it, but it can't do so especially profitably right now. Along similar lines, the company's finding and development costs have been above the peer group and rising, making the company even more vulnerable to oil prices.

Breaking up Is Hard to do and Arguably not Worthwhile
With Hess apparently trading below its assets' value, it is not altogether surprising that activist investors have shown up here. In particular, Elliott Management has taken a 4% stake, nominated a slate of five independent directors and pushed for the company to break itself up.

I'm skeptical that a break-up would produce the sort of value that Elliott management seeks. The company has certainly spent itself into a bad place, and I can fully understand a certain level of mistrust toward management. Likewise, I could see an argument for selling particular assets like the BP-operated (NYSE:BP) assets in Norway, the assets in Ghana and so on. Nevertheless, I think spinning out the Bakken assets would be tricky from the perspective of unlocking real long-term value, and I think management simply needs to exercise more capital discipline.

SEE: Evaluating A Company's Management

The Bottom Line
I believe investors can make a case that Hess could be worth upward of $90 per share under better circumstances. The key unknown for me is the extent to which Hess's spending decisions are fully voluntary. In other words, would Exxon face the same decisions (and costs) if it controlled the same acreage? As it is, though, I'm not inclined to give the company the benefit of the doubt, and $68 to $70 per share seems pretty fair to me in terms of valuation.

I would be careful shorting these shares, given what I think is solid inherent value. At the same time, it's hard to feel completely comfortable that management is looking toward maximizing long-term economic returns and will succeed in making the best of high-quality assets in places such as the Bakken, Utica and Ghana, among others.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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