Baron Energy and Resources 1Q17 Letter: Investors Selectively Focusing on the Negative


Baron Energy and Resources 1Q17 Letter


  • While overall stock market got off to a fast start with S&P 500 rising 6.1% in 1Q17, energy stocks lagged behind as S&P 500 Energy Index fell 6.68% and S&P North American Natural Resources Sector Index dropped 4.3%
  • Baron Energy and Resources Fund had a small decline of 0.44% during the quarter
  • Pleased with the start of the year and believe that the portfolio is set up well to benefit from the key trends that are in place in our areas of focus over the next several years
  • No doubt that weakness in oil and gas prices was a major contributor but the behavior of both commodities and stocks in the quarter was quite unusual
    • Investors were either overly focused on negative data points or were even interpreting positive data points negatively
    • Saw a significant unrelenting rise in the US rig count along with anecdotes of rising prices for service and supplies as the OFS recovers from one of the harshest recessions
    • E&P continued to demonstrate efficiency gains
  • Earnings and cash flow estimates for both the service and supply companies and the production companies have generally moved higher this year and yet both groups of stocks experienced sharp declines in the quarter
  • Instead of rising rig count or improving efficiencies being seen as positives in terms of future profitability, investors have instead focused on the negative that these trends may result in too much new oil supply out of the US
    • Think these concerns are premature and also continue to ignore the combination of ongoing production declines among many of the non-OPEC producers and a continued robustness in global oil demand
  • Another area of selective focus was on oil inventories and OPEC cut compliance
    • Despite high levels of OPEC compliance relative to past history, has been surprising to see how little impact the production cuts have had on the market this year
  • Unusually high degree of focus on high frequency data such as the weekly inventory data that is published by DOE while other lower frequency data or normal seasonal behavior in the oil market has seemingly been ignored
    • One of the drivers of lower oil prices in 1Q was the rise in US oil inventories which added about 56 million barrels or about 630k bbls/d
    • Oil inventories in US and throughout the OECD always build in 1Q
    • Timing of when OPEC cuts would impact physical markets and heavier than normal seasonal refinery maintenance experienced in 1Q made the build somewhat higher
    • However, investors seemed to ignore greater than normal declines in refined product inventories in the US, Caribbean, South Africa, and the Middle East


  • Believe that the long and deep energy recession has ended and that the business is returning to a more balanced and healthy footing
  • Lower flows combined with lower product inventories and healthy refining margins should drive refining activity higher and push crude inventories lower
  • Believe that as balance is restored to the global oil market and as the early stages of the industry recovery give way to better earnings and cash flow growth, the performance of energy stocks and Fund will improve
  • Even though oil inventories continue to be bloated around the world, supply/demand balance for oil has moved into a supply deficit position in the past year as inventories began declining in August of last year
  • Given that prices are still below levels that most OPEC countries need to balance budgets and fund social programs, think there is reasonable chance that current agreements be extended to second half of this year
  • See a long-term need for US production growth as part of the balancing mechanism in oil markets over the next several years as we get toward the end of the decade and negative ramifications from the sharp curtailment in global oil and gas investment levels for the past two years begin to manifest in rising reservoir depletion rates
  • Historically, oil prices have normalized around levels that enable industry to earn a reasonable return on capital employed and for major producing countries to remain solvent
    • Despite improvements in cost structures, analysis indicates that current oil price level and the levels experienced in the past 2 years are still below this normalized level for both international oil majors and national oil companies
    • As long as this persists, it will pressure investment in long-term future supplies
  • Return to growth and revival in capital investment for US E&P also brings new opportunities for organic growth for the midstream industry and services industry
  • Pullback in share prices in 1Q along with upward revisions in forward earnings and cash flow estimates have resulted in more favorable valuations across energy spectrum
  • Institutional investors are still underweight relative to historical norms – still significant capital remaining on the sidelines that could be put to work in energy and resource-related stocks

Portfolio Review

  • Fund remains concentrated with Top 10 holdings representing 48.7% of Fund; E&P represented 44.2%; Midstream represented 20.3%; OFS represented 18.6%; Renewable represented 7.8%; Refiners represented 2.9%; small position in Basic Materials via Flotek and Westlake Chemical Partners
  • Flotek, Tesla, Noble Midstream, Golar LNG, and Sanchez Production Partners were top contributors
  • Jones Energy, RSP Permian, Parsley, US Silica, and Newfield were top detractors
  • Most additions in the quarter were OFS companies that are set to benefit from rising US horizontal completion activity and trend towards more intensive completions
  • Smart Sand: sand mining and logistics company whose principal asset is a large sand mining and processing operation in Wisconsin
    • Sand reserves are significant and can support an operation that is at least 3x company’s current capacity, requiring only limited amount of capital for capacity addition
    • Operations among the lowest cost and reserve mix tilts almost exclusively to smaller-sized grains of sand which are the sizes that are currently experiencing the highest level of demand
    • Essentially sold out at its current capacity level and has been signing new long-term contracts with customers that enable investments in expanding the mining, processing, transportation capacity
    • Low-cost supplier of finer mesh sands with direct access to two premium national rail networks and ample room to expand capacity
  • Keane Group: similar theme as Smart Sand; supplier of well completion services with a large fleet of pressure pumping equipment that are used to frack horizontal wells
    • Well completion activities and services tend to lag the rig count by four to six months and the rise in rig count since it bottomed last May/June has been faster and stronger than expected
    • Much of its spare capacity can be reactivated at minimal incremental cost and reasonably quickly
    • Operates in a commoditized business with low barriers to entry – for this reason, do not think of the company as a long-term core holding but makes sense at this point in the energy recovery cycle
  • During the quarter, experienced modest levels of redemption and as a result was a net seller of stocks: top net sales during the quarter included Tallgrass, Kraton, Noble Energy, Schlumberger, and TerraForm Global
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