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Baron Energy and Resources 3Q17: US E&P Outlook

Baron Energy and Resources Fund 3Q17 Letter, November 2017

  • Another volatile and eventful one for the energy sector. Started the quarter with another awful two months, despite the fact that oil prices were essentially flat
  • After end of August, oil prices rallied 9.3%. Fund only gained 0.62% during 3Q17 compared to S&P North American Natural Resources Sector Index of 7.41% and S&P 500 Index of 4.48%

Outlook

  • Continued improvement in the supply/demand balance for oil, which should limit the downside price risk and create the potential for higher-than-expected prices
    • Global oil inventories appear to have declined counter-seasonally in both 2Q and 3Q and about 50% of crude oil surplus inventory that was built up in 2014-2016 and most of the petroleum products surplus appear to have been drained from the market this year
    • Improvement in inventory resulted from stronger-than-expected demand, limited supply growth following the OPEC cuts, and slower-than-expected non-OPEC supply growth
    • Term structure of the Brent oil market has shifted from contango to backwardation for the first time since July 2014
  • Concerns about “peak oil demand” have been growing in the market and while we are quite bullish on the potential for electric vehicles (“EV”), think these peak oil demand fears are overblown and could actually result in higher oil prices
    • Most forecast for oil demand indicate that by 2025, oil demand will be impacted by 500,000 bbls/d – 1,000,000 bbls/d from lower gasoline consumption as EV sales rise toward 10 million units/yr from 0.5 million in 2016 and EV fleet penetration moves toward about 3% globally
    • Gasoline is only 25-26% of the barrel and demand for gasoline along with the rest of the barrel has actually been growing at the fastest rate in the past five years than nearly any other five-year period in the last 30-40 years
    • Don’t disagree that future gasoline demand could peak in the next 10 years, think investors need to have the perspective that a peak in gasoline demand by 2025 or so may also coincide with another 10 million bbls/d of overall oil demand growth, which coupled with an annual production decline rate of 3-6%, create a need for significant ongoing investment in new production capacity and production growth
    • If fears of a looming peak oil demand cause companies to limit investment or cap investment, we may see the opposite of what happened when peak oil (supply) was the theory du jour 10 years ago
    • That view contributed to aggressive spending on deepwater, oil sands, and unconventional oil technology that resulted in the oil glut of the past several years
  • Oil & Gas industry appears to be transitioning from a period of overinvestment and a focus on growth at any cost to a more disciplined investment environment, where return-based metrics and balance sheet management garner more focus
    • One of the biggest knocks has been their chasing production and resource growth over the past decade at the expense of returns and the lack of returns-based metrics within the compensation structures for most management teams
    • With the results of this strategy on full display in the underperformance of energy stocks the last several years, numerous bankruptcies, and poor financial returns, it is not surprising that investors want change
    • Oil & gas companies are trying to be more disciplined – they are trying to live and invest within cash flow, under conservative commodity price assumptions so as to limit the issuance of dilutive equity or debt, and altering compensation schemes to shift away from production growth towards metrics that help to ensure that companies are investing wisely, generating better returns, and beginning to return cash to shareholders
    • Recent research shows that production growth alone has no correlation to total shareholder return
  • Renewable energy is gaining a growing share of the capital investment directed toward the overall energy industry, and this should create and foster interesting investment opportunities
    • While investment levels in the oil & gas industry have fallen in the past 3 years, investing activity in renewables has soared and renewable energy costs have continued to fall
    • As the costs fall and the efficiencies of new equipment rise, the competitiveness and, therefore, the addressable market for renewable products should continue to increase
    • Over the next several years, we expect that policy changes will continue to influence the demand for these products and technologies
    • In the period beyond 2020, we think policies like tax subsidies and feed-in-tariffs, among others, become less prevalent and less impactful to these markets
    • Currently invested in companies that supply equipment to the wind power market, energy storage manufacturers, and companies that develop and own renewable power assets with long-term contracts

Review

  • Permian basin-exposed stocks suffered in the quarter as investors became fearful that future oil production growth would not live up to expectations
    • Occurred because of confusing comments from Pioneer Natural Resources around gas-oil ratio (“GOR”) of some of its recent wells, along with concerns about well costs and operating efficiency
  • Despite an abundance of research, including published reports and expert-hosted conference calls that ended up clarifying the issue, the damage had been done. While GOR concerns have faded, expect that issues around well costs and operating efficiencies, driven by high level of activity in the Permian and a shortage of equipment and crews, will be addressed over the next several quarters
  • Encana Corp:
    • Shares outperformed in 3Q as company delivered higher-than-expected production in the quarter, lowered production costs, raised production guidance for the year and increased inventory of premium drilling locations
    • Has been restructuring over the past several years and now has strong positions in two of the most attractive US oil resource plays in Permian and Eagle Ford and two of the lowest cost basins in Western Canada
    • One of the most attractively valued E&Ps and we believe investors still underappreciate the company’s long-term growth and returns potential, particularly in the Permian and Montney basins
  • Concho Resources:
    • Continues to be one of the best run mid-cap E&P companies and we think it is well positioned among companies in its sector to exploit the deep economic inventory of drilling locations in the Delaware basin
    • Investors continue to underappreciate Concho’s multi-year growth potential and the value of its Delaware acreage position
  • Noble Midstream Partners:
    • Outperformed due to a combination of increased visibility around its 20% per annum distribution growth rate following its first dropdown of assets in June and an improving operating outlook for Noble’s own volume growth in both the DJ and Delaware basins
  • Flotek:
    • Shares underperformed on lower-than-expected domestic CnF sales and after one of its main customers identified surfactants as a potential area for cost savings on an earnings call
    • Shares were also impacted by hurricane-related disruptions to the supply chain in 3Q
    • Believe these are transitory factors and that shares are significantly undervalued on a comparable company and sum-of-the-parts bases
    • Expect sales of its CnF and other oilfield chemistries to resume a differentiated growth path in 4Q and 2018
  • SmartSand, Inc:
    • One of the lowest-cost suppliers of “Northern White” sand which is used as a proppant for the hydraulic fracturing of oil & gas wells
    • Shares underperformed in 3Q following a raft of announcements from public and privately held sand companies for greenfield mine developments in and around the Permian basin, which investors fear will diminish, if not eliminate, the need for sand from the upper Midwest
    • Think these fears are overblown but we sold our shares in the company to help meet a redemption request and for tax purposes
  • Forum Energy Technologies:
    • Company’s product offering and related services include a mix of highly-engineered capital products and frequently replaced items that are consumed in the exploration and development of oil and natural gas reserves
    • Shares underperformed after the company provided lower-than-expected 3Q revenue guidance in the drilling and subsea segment and weaker-than-expected incremental margins
    • Sold our shares during the quarter to meet redemption request and tax purpose

Image Source: Carnegie Research

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