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Baron Energy and Resources 2Q17 – Contradictions Plaguing the Industry & Peak Demand (Really?)

Baron Energy and Resources Fund – 2Q17 Letter, July 2017

Performance

  • There is no sugarcoating it, 2Q performance was terrible for the energy sector and Fund’s performance of -13.45% (-13.83% YTD)
  • Industry recovery that began last year, remains underway and we still see many reasons to be optimistic about our investments
  • For the first time in 30 years, energy stocks, represented by the S&P 500 Energy Index, have posted negative returns for 6 consecutive months to start the year
    • Longest monthly losing streak for the sector during this time
  • A period such as this had a disproportionate impact on small-cap and mid-cap stocks, particularly those of energy producers and OFS companies
  • Biggest driver has been the weakness in oil prices which averaged 7% less in 2Q than 1Q and significantly underperformed Street expectations
  • Even though OPEC has demonstrated high degree of compliance with the production cuts that were announced last November, recovering production from Libya and Nigeria and to a lesser extent the US, combined with slightly softer demand in 1Q17 led to lower inventory declines than expected YTD
  • It is notable that US and global inventories have been declining in the last 4-5 months
    • Global oil inventories have fallen by ~100 million barrels in 1H with about half of that coming from the US
    • Typically, US and overall OECD inventories build in 1H so the fact that inventories have declined despite the supply/demand issues cited above indicates that the market is cleaning up and could continue to tighten in 2H when seasonally global oil demand is expected to be 2 million bbls/d higher on average than 1H
  • Should also not overlook the role that momentum, indexing, and ETF investing has played in equity markets this year
    • Believe that increased amount of capital employing these strategies exacerbated the gains of winning stocks in sectors like IT, Health Care, and Industrials and created additional selling pressure for stocks in lagging sectors such as Energy

Outlook

  • Continue to believe that the industry is recovering from the oil/Energy sector recession that began in 2H14 and bottomed in 1H16, and the recovery in bottom-up indicators like production growth, rig count, and capital spending have exceeded our expectations
  • Investor response has been completely muted by growing concerns that these improvements will sow the seeds for either another downturn or worse, a period of secular stagnation
    • Don’t dispute that these concerns are legitimate but also believe that they are simplistic and myopic
  • First, it is difficult to reconcile a key contradiction plaguing the industry
    • Current forward strip price for oil is pricing in a certain growth rate for US production
    • Improving single well economics and well productivity, which are being driven by improving knowledge, technology, and processes, is expected to meet nearly 100% of incremental global demand this year and next
    • This growth is also predicated on a level of oilfield activity and capital spending that is barely affordable with oil prices above $50/bbl level that is baked into most oil company budgets, and particularly unaffordable at the current strip price of around $45/bbl
    • While industry is no stranger to outspending CF and has relied on access to bank debt, asset sales, and capital markets to fill those gaps, we think that funding will be a little more challenging
    • Companies will be little more reluctant to borrow aggressively given how fresh the liquidity scars of 2015 and 2016 still are for so many companies and the relatively low level of production hedges in place, particularly in 2018
    • Would not be surprised to see investment levels dialed back later this year or into 2018 if the current pricing situation remains unchanged – this would have a modest negative impact on earnings and CF outlooks for some companies, we think that the likely positive impact on overall industry sentiment would outweigh any downgrades in forward estimates
  • Second, continue to believe that the current strip price represents an existential threat to many oil producing countries including Saudi Arabia that are running large fiscal deficits, draining reserve accounts and piling up debt at historic rates at these levels
    • Overall Middle Eastern debt issuance soared 53% in the first half of this year totaling $57.4Bn, which was largely driven by sovereign bond issuances from Saudi Arabia and Kuwait to help plug budget gaps
    • Even though 2016 OPEC agreement has so far failed to produce higher oil prices and OPEC finds itself in a difficult spot since any effort to try to kill the US shale machine only worsens its fiscal position, OPEC is still relevant and financial distress among a group that produces ~1/3 of global oil is a relevant factor
    • It is also clear that futures markets are not pricing in much, if any, geopolitical risks and yet conditions in the Middle East/North Africa remain anything but calm
  • Third, even though capital spending has recovered for short-cycle projects like US shale, long-term declines in the underlying production base and long-cycle production projects that have typically provided significant new volumes every year are being ignored and underfunded
    • According to IEA, fall in spending in the last 3 years for these types of projects create a significant risk of future shortages of supply relative to demand in the next 3-5 years
    • This is not relevant in the short-term but it is one that could sneak up on the oil market in the next several years as demand growth marches forward, excess inventories are trimmed, and spare capacity is diminished
  • Fourth, it also appears that investors have become more worried about peak demand as a result of technologies like electric vehicles and renewable energy
    • Aggressive adoption/penetration by EV is possible and perhaps probable in the next 10 years – our calculation suggests that the impact on global oil demand will be pretty insignificant until at least the middle of the next decade, if not longer, given the substantial scale of the current installed base and the growth in emerging markets demand in the next decade
    • Interestingly, these concerns about peak demand may actually hinder investment in new long-cycle oil projects, potentially restricting long-term supply growth before peak demand can actually kick in
    • In the last 30 years, this is at least 3rd or 4th time analysts and the press have predicted the end of the oil age – in fact, since one of the last predictions of the end of oil age by The Economist in early 2003, global oil demand has grown by about 20 million barrels/d or over 25% (20 million bbls/d is roughly the combined production of 2 of the 3 largest producers in the world – US and Saudi Arabia)

Top Contributors

  • Tesla
    • Shares appreciated as a result of enhanced investor confidence in the Model 3 production schedule following management’s comments suggesting no fundamental issues that will limit initial production
    • Increase in reservations for Model 3 before its launch and without marketing
    • Tesla now offers its solar roof product and has downsized the operations of recent acquisition of SolarCity, focusing instead on cash generation that suggests lower merger-related risks
  • Rice Energy
    • Shares rose on an announced acquisition by EQT at a 35% premium to prior day’s close
    • Believe the combined company offers industry leading production growth and exposure to some of the best acreage, enhanced by operational synergies from combination of adjacent acreage
    • Expect shares to perform well as the company executes operationally on its acreage, integrates the acquired acreage, and unlocks the value of midstream
  • NCS Multistage Holdings
    • Shares increased following the IPO in April and strong execution in 1Q
    • Proven player in Canada with 25+% market share and we see major opportunity for this technology in the US, where market penetration is still in early phase
    • NCS’ differentiated technology, FCF generation capability, and low capital intensity will produce significant returns over time
  • Tesoro Corporation
    • Recently closed an acquisition of Western Refining
    • See underappreciated value of non-refining segments, particularly midstream and retail
    • Expect shares to increase as the company realizes the value of synergies from its acquisition and unlocks the value of its logistics MLPs

Top Detractors

  • Flotek Industries:
    • Investors became concerned about potential slowdown of activities due to lower oil prices
    • As revenue from CnF continues to outpace industry levels by a wide margin, we retain conviction
    • Customers seek capital optimization and CnF has demonstrated its efficiency in oil & gas shale well productivity
    • Anticipate increased CnF loadings and higher customer penetration will benefit Flotek
  • RSP Permian:
    • Falling oil prices pressured shares due to investor concerns regarding levels of CF outspend and ability to maintain the pace of rig additions among high-growth Permian companies like RSP
    • Retain conviction due to ongoing improvements in operating results, prudent cost management, and strength of its resource base and balance sheet
    • Continues to generate peer-leading production growth and integrate the acquired Silver Hill properties in Delaware sub-basin
  • Encana:
    • Declined due to lower oil prices and concerns about Encana’s balance sheet and cash flow outspend
    • Is improving capital efficiency and balance sheet, as demonstrated by recently announced productivity increases in Texas and accretive non-core asset sales in Colorado
    • Believe Encana is one of the most attractively valued E&Ps and that investors underappreciate its long-term growth potential
  • Newfield Exploration:
    • Declined due to lower oil prices and concerns about ability to maintain its drilling activity
    • Continues to improve per-well productivity and capital costs within its highest return Cana-Woodford assets in the Anadarko Basin
    • There is more upside to resource potential in the Anadarko Basin and opportunities for Newfield to sell non-core assets to accelerate development of this higher return asset

Portfolio Structure / Recent Activity

  • E&P represented 41.8%, Midstream represented 18.4%, OFS represented 17.9%, Renewable Energy represented 12.9%, Materials represented 4.1%, and Refining & Marketing represented 3.8%
  • TPI Composites (top purchase):
    • Leading independent manufacturer of wind turbine blades with plants spread across the world and a deep and diverse customer base of leading wind turbine manufacturers
    • Has long-term contracts with its customers under which it will double its manufacturing capacity in the next 3 years
    • Even though GE, one of its key customers, purchased a rival last year, we are comfortable with the risks that this brings to TPI’s business and think those risks are adequately discounted in our estimates and the current valuation of the shares
    • Expect TPI to post strong growth in earnings over the next several years and generate substantial FCF
    • Also think that TPI’s core competence in manufacturing large composite structures like wind turbine blades could lead it into several other applications and markets which would expand the company’s addressable market opportunity for the long term
  • Fund continued to sustain outflows related to redemptions and this was a driving force behind some of our sales during the quarter – such as Encana, Westlake Chemical Partners, RSP Permian, Valero, and Rice Energy

Image Source: PIRA

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