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Baron Energy and Resources Fund (BENFX) 4Q16 Letter: Energy Recession Is Over

Baron Energy and Resources Fund 4Q16 Letter

4Q16 / 2016 Performance and Review:

  • Our view that in 2016, saw the bottom of the energy recession that began in 2014 as well as the beginning of a potential multi-year cyclical recovery
    • Oil and equity prices bottomed in Feb 2016 and oilfield activity, investment, and earnings bottomed in the middle of the year; saw price bottoms in industrial and precious metals and a variety of other commodities during 2016
    • Coupled with the recovery in oil and natural gas prices, led to robust stock performance across much of the energy and resource-related landscape in 2016
  • In 2016, Fund value increased in value by 28.31%; enthusiasm is tempered by its underperformance relative to benchmark (S&P North American Natural Resources Index) by 256 bps for the year and 126 bps for 4Q16
    • Energy-related investments posted a net contribution of 32.23% but generated relative underperformance in industrials, consumer discretionary, alternative energy, and in materials
    • Were underweight materials all year which hurt when mining & metals soared in the first half and once again when construction materials stocks got a big boost after the election
  • Entered 2016 with a substantial cash position of approximately 15% which was a help early in the year as prices were bottoming
    • Established new positions in companies such as Rice Energy, Encana, US Silica, and Targa, all of which were among the top 10 contributors to performance for the year
    • 3 of top 5 positions throughout the year were core investments in high quality E&P companies with a focus on the Permian: these 3 were among the most significant contributors in 2016
  • Interest in the Permian Basin revolves around our view that despite being a leading source of US oil production for the past 70 years, the shift toward unconventional drilling and completion technology is still nascent and the resource has a lot of room for growth; number of economic formations and the recovery rate from each formation combined with above average expected growth rates in production over the next several years should result in more value creation

2017 Outlook:

  • After a difficult start, 2016 proved to be a very good year to be invested in the energy sector; believe this is just the beginning of a new upcycle
  • Macro setup for energy is pretty good
    • Oil market has returned to balance and OPEC is intent on accelerating a rebalancing such that inventories return to normal
    • Oil demand has posted stronger-than-trend growth for several years despite disappointing economic growth
    • Recent rise in interest rates seem to signal a move from a deflationary environment to an inflationary environment
  • 3 key messages investors should think about over the next 2-3 years:
    • The worst energy recession in a generation is over
    • US energy renaissance is alive and well
    • Equity investors remain significantly underweight in their exposures to the energy sector and to a lesser extent, resource-related businesses
  • Energy recession is over:
    • More risk to the upside than the downside
    • Encouraged by the fact that supply/demand balance has flipped from surplus to deficit since the middle of 2016, as seen in declining global inventories, and the prospects for a more rapid decline in inventories following the agreements by OPEC and key non-OPEC producers
    • Significant restructuring has taken place across the industry in recent years and industry has cut costs, closed excess manufacturing plants, pared non-core assets, reduced debt, been proactive in adapting new technologies
    • Expected to lead to improved operating efficiencies, higher normalized margins, and stronger growth for those companies that lead in the recovery
  • US Energy renaissance is alive and well:
    • Continue to believe that the best opportunities to profit from the recovery lie with US-based E&P companies that have leading positions in shale plays where oil is the dominant commodity being sought and produced, such as those in the Permian and Anadarko basins
      • Companies in these plays should post leading production and CF growth over the next several years and also see increases in NAV
      • Has been significant M&A activity in the domestic oil market in the past year that have improved the competitive positions of many of the companies in the Fund
    • Improved fortunes of US shale oil and natural gas producers in 2017 will also have positive knock-on effects for those companies that benefit from growth in E&P capital investment
      • Increased activities in the OFS and increased throughput volumes in midstream sector
  • Energy investors remain significantly underweight in their exposures to the energy sector and to a lesser extent, resource-related businesses:
    • Surveys continue to show that while investors are less skeptical about the outlook for energy and resource-related stocks and are less underweight than last year, they are still cautiously positioned toward these areas and remain underweight relative to historical norms
    • There is still significant amount of capital remaining on the sidelines that could be put to work
    • It is possible that index weightings will get revised upward over time
    • Energy sector has been one of the least correlated of the major sub-sectors of the S&P 500 Index to the overall performance of the S&P 500 over the past five years
      • Allocation to a dedicated energy and resource fund may provide a differentiated return and diversification for investors

Further (relevant) read: [GMO] An Investment Only A Mother Could Love

Top Contributors:

  • RSP Permian:
    • Shares rose in the fourth quarter after the company raised its production guidance, delivered strong quarterly results, and acquired Silver Hill Energy Partners in the Delaware sub-basin in the Permian
    • Shares will benefit from improvements in operating results and prudent cost management as the company generates production growth and integrates Silver Hill properties
  • Encana:
    • Stock rose in the fourth quarter after it reported production guidance that beat expectations, a solid multi-year growth outlook, and lower cash costs
    • Has strong positions in two of the more attractive oil plays in the Permian and Eagle Ford and two of the lowest cost gas basins in Western Canada
    • One of the most attractively valued E&P companies with strong long-term growth and returns potential
  • Halliburton:
    • Shares increased in the fourth quarter as company reported strong earnings on lower costs and margins in NA that beat expectations; also rallied after OPEC’s decision to cut output
    • Market-leading position in NA unconventional plays and is the best positioned company to benefit from the ongoing recovery in onshore well completion activity
  • Valero Energy:
    • Rose on solid third quarter results driven by lower operating costs and reduced capital budget guidance; also rallied on post-election sentiment that positive regulatory changes will help with rising RIN costs
    • Produced strong FCF and returned cash to shareholders through dividends and share repurchases that we believe will result in a potentially higher share price over the next several years
  • Targa Resources:
    • Shares rose during the fourth quarter on recovering commodity prices after OPEC signed a deal to cut production; believe this deal will translate into better visibility, volumes, and operating leverage for Targa, allowing it to stabilize its dividend and improve its coverage ratio, and explore avenues for growth through better utilization and footprint expansion

Top Detractors:

  • Flotek Industries:
    • Shares fell in the fourth quarter following a short seller’s assertion that independent consultant studies commissioned by Flotek were based on incomplete data and failed to consider key variables
    • After incorporation additional data, consultant confirmed its conclusion that CnF improves well productivity; expect shares to rebound as demand for CnF remains solid
  • Rice Energy:
    • Shares declined in the fourth quarter due to a weakening gas outlook and higher exposure to in-basin pricing following acquisition of Vantage
    • Believe Rice offers exposure to some of the best acreage and production growth; also think market underappreciates the value of midstream holdings
  • Newfield Exploration:
    • Shares fell after the company reported quarterly results that fell short of expectations despite raised production guidance and increased activity in its highest return assets in OK
    • Like shares at these prices and believe there is more upside to resource potential and opportunities to sell non-core assets to accelerate development of higher return assets
  • SolarEdge Technologies:
    • Leading provider of DC optimizers and inverters for residential and commercial solar systems
    • Share price fell on investor concerns around sluggish residential market growth as a result of changing purchase behavior and slowing growth of the largest installers
    • New competitors are looking to penetrate the market in 2017, suggesting amplified pricing pressure above market expectations and potentially lost market share (exited position)

Portfolio Structure and Activity:

  • Portfolio:
    • Ended the year with 0.6% cash
    • Fund remains concentrated with the top 10 holdings representing 46.5% of the Fund
    • Oil & Gas E&P:
      • Represents 47.5% of the Fund
      • Focused on NA producers operating in Permian, Anadarko, Appalachian, and Western Canadian basins – names include RSP Permian, Parsley, Concho, Encana, and Newfield
    • Oil & Gas Storage & Transportation:
      • 8% of the Fund’s assets
      • Continued to see improving conditions in this sector, particularly for storage and transmission related companies
      • Many companies have undergone restructurings and more positive outlook for commodity prices has eased investor concerns about dividend growth
    • Oil & Gas Equipment & Services & Drilling:
      • 5% of the Fund
      • Outlook for a recovery in oilfield drilling and completion activity in NA is brightening as a result of increase in oil prices and even at this early stage of recovery, beginning to see the green shoots of pricing improvement that along with activity growth should lead to accelerating earnings gains over the course of next several years
      • Continue to harbor concerns about valuation and normalized earnings power in this sub-industry but are more comfortable that the restructuring of the past two years could result in a more positive earnings recovery
    • Renewable Energy:
      • 8% of the Fund
      • Ongoing investment in Tesla and new purchase of Infraestructura Energetica Nova S.A.B. de C.V. were positive contributors while TerraForm Power and TerraForm Global were modest detractors
    • Materials:
      • 9% of the Fund
      • Exited gold positions following the election and redeployed that capital into other areas
      • Performance negatively impacted by Flotek and Kraton
    • Oil & Gas Refining & Marketing:
      • 9% of the Fund
      • Trimmed exposure amid concerns about margins and tax policy following the outcome of US election
      • Cautious in the near term that rising prices will hurt refiner input costs and that the net effect of potential regulatory and tax policy changes will be a net negative for the sub-industry overall
    • Activity:
      • With the exception of Nabors Industries where we added to the purchases made in Q3, all of our top purchase activity in the quarter were the result of initiating new positions
      • Largest new position was in WPX:
        • Primarily focused on growing production in Bakken and Delaware
        • Assessment of early well results indicates that WPX’s position in the Delaware is one of the best in the industry and has the potential for multiple development zones and higher-than-average rates of recovery that will lead to faster growth and higher returns than Street expectation
        • Also been impressed with progress and success of management team
      • Jones Energy:
        • View Jones in a similar vein as WPX in that the investment thesis revolves around the potential for a successful transition into a new play that could result in accelerating production, growth and NAV creation
        • Last year, bought into an acreage position in South Central Oklahoma, “Merge”; initial data on well productivity that has been released by offset well operators indicate that it could be an attractive and economic area for future development
        • Think that Jones offers one of the highest reward opportunities even in a flat oil price environment; due to smaller market cap, somewhat more leveraged balance sheet, and more exploratory nature of its asset base, have sized the position to reflect both the upside opportunity and the higher risks
      • Sanchez Production Partners:
        • Company has been expanding its logistics footprint through a combination of acquisitions and organic capex investment in G&P, and transportation infrastructure to serve the growing production profile of its parent co better
        • Believe that the combination of recent acquisitions and ongoing investments will enable the company to grow its DCF and distributions to shareholders at a 6-10% rate over the next 3 years and a recent acquisition by Sanchez in the Eagle Ford could result in higher production growth rates
        • Current valuation does not reflect any future growth in distributions and even looks inexpensive if the company maintains its current rate of distributions ($1.70/share annualized is almost 15%)
        • Portion of this valuation discrepancy can be attributed to SPP having higher risks and lower long-term visibility than some peer companies that are related to larger more diversified E&P companies
        • Think the current discount and the visibility on capital returns over the next several years significantly mitigates these risks and creates an opportunity for significant upside
      • Infraestructura Energetica Nova S.A.B. de C.V.:
        • Company will continue to benefit from privatization efforts in Mexico’s energy sector
        • Originally Sempra Energy’s Mexican unit, was one of the first private companies to build and acquire nat gas pipelines
        • Business is built upon a diverse set of assets with long-term, take-or-pay and primarily dollar-denominated contracts providing stable and predictable cash flow
        • Company can double its asset base and CF over the next several years based on its current portfolio of contracts and sanctioned development projects
        • Longer term, opportunities to expand by acquiring rights to build pipelines, power gen and distribution assets, and storage infrastructure
      • Largest net sale in the quarter was Rice Energy
        • Decided to take profits and reduce the size of the position because the rapid appreciation in the shares this year brought the stock much closer to target price
      • Exited Marathon Petroleum due to growing fundamental concerns about the net effect of changes in the regulatory/policy environment post-election (left money on the table as Marathon subsequently became target of Elliott’s activism)
      • Net sale of Parsley Energy as the Fund experienced a redemption in mid-December to about 7% of AUM
Image Source: Baron Energy and Resources Fund Quarterly Letter

 

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