Baron Energy and Resources 4Q17: One of the Most Frustrating Years of Our Career

Energy

Performance

  • The first thing we would like to say about 2017 is we are happy it is over. It was one of the most frustrating years of our career as we felt we were very well positioned for the energy industry recovery that unfolded, but which did not lead to the equity performance we expected
  • Actual correlation between oil prices and energy stock price performance deteriorated in the quarter relative to what it had been in the first nine months of the year, and energy shares continued to underperform the recovery in the commodity, the improvement in industry cash flows and the rise of the rig count/well count and oil and gas production
  • Oil prices both on an average and year-end to year-end basis gained significant strength during the year, oil inventories declined and end the year well below the peak levels experienced in 2016, global oil demand continued to rise and outpace expectations, and industry cash flows and capital investment levels were materially higher in 2017 boosting the rig count and the well count, especially in the US
  • While evidence of an industry recovery was abundant in 2017, the only sub-industry within Energy that produced strong results were independent refining & marketing companies, which helped us last year but not enough to offset the sharp share price declines experienced by independent E&P companies, oilfield service & equipment companies and midstream companies that make up the majority of the Energy exposure in our Fund
  • Low weighting of Energy in the S&P 500 at the end of August represented the third lowest level since 1990 following slightly lower weightings in January 1999 and November 2003, and well below peak levels in June 2008
    • Unlike 2015 and 2016 when Energy sub-industry profits and cash flows were falling relative to the rest of the market and therefore a lower weighting could be justified on an earnings basis, this was not the case in 2017 as the recovery in Energy sub-industry earnings and cash flows appeared to be disregarded by investors

Top Contributors & Detractors

  • Top contributors: Golar LNG, RSP Permian, Concho Resources, Parsley Energy, Encana Corp
  • Top detractors: NCS Multistage Holdings, Tesla, Infraestructura Energetica Nova S.A.B. de C.V., TPI Composites, Noble Midstream

Recent Activity

  • EQT Corporation
    • Acquired the position because EQT purchased Rice Energy in the fourth quarter
    • Potential for a corporate restructuring of EQT could result in further value creation by fully separating its E&P subsidiary from its publicly traded midstream MLP and GP
  • NCS Multistage Holdings
    • Added after the stock fell following disappointing 3rd quarter results and 4th quarter guidance
    • Believe that the issues that caused NCSM’s earnings shortfall in the 2nd half of 2017, will prove to be transitory, and we anticipate a resumption of strong growth for the company in 2018 as market penetration of its pinpoint fracture stimulation system grows and the company introduces new products into the markets
    • Its earnings were particularly impacted by a revenue slowdown in the 2nd half of the year that we believe was largely a matter of timing related to many new potential customers finishing test trials and beginning to ramp up commercial operations and some customers experiencing a seasonal slowdown at year-end
  • Siemens Gamesa Renewable Energy
    • Second largest supplier of wind turbine systems in the world following last year’s merger of the wind turbine businesses of Siemens AG and Gamesa Renewable Energy
    • Although the merger brings together two complementary businesses and offers the potential for significant cost savings, product rationalizations, and market share gains, a series of disappointing events followed the deal’s closing including profit warnings, management turmoil, and uncertain industry demand following regulatory and tax changes in key markets
    • Near-term earnings outlook for the company continues to have some uncertainty, we believe that the long-term demand growth for wind power is going to be significant
    • Combination of strong demand growth and rationalization of the combined company’s cost structure and product portfolio should result in improving margins, cash flows and earnings and drive shares materially higher
  • Select Energy Services
    • Largest publicly traded supplier of water sourcing, transfer, recycling, and disposal services to the US E&P industry; company has a presence in every major shale basin in the US and is especially strong in the Permian and Williston
    • Demand for fresh water and for recycled water to be used during hydraulic fracturing operations has been rising strongly in recent years as fracturing jobs get bigger
    • In mid-2017, the company completed a merger with its largest competitor (Rockwater Energy Solutions) increasing its access to proprietary water sources, lay flat hose, completion and production chemicals, and water recycling capabilities
    • Combined company is poised to grow organically over the next several years as each of its three principal business segments (water, oilfield chemicals, wellsite services) are each well positioned to take advantage of the increasing rate of well completion activity and the increasing size of well completions anticipated over the next several years
    • Unlike other services or materials that are tightly linked to completions like pressure pumping and sand, Select operates in a less fragmented market with higher barriers to entry and has a bigger relative market presence

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
    • Inventories continued to decline in 4Q beyond seasonal norms following the counter-seasonal declines in both 2Q and 3Q; by year-end greater than 50% of the crude oil surplus inventory that was built up in 2014 to 2016 and most of the petroleum products surplus have been drained from the market; improvement in inventory resulted from stronger-than-expected demand as the global economy strengthened, limited supply growth following the OPEC cuts earlier this year, and slower-than-expected non-OPEC supply growth despite robust growth in the US
    • Term structure of the Brent and WTI oil markets shifted from contango to backwardation for the first time since July 2014, or just before the massive decline in oil prices that has plagued energy markets for three years
  • Concerns about “peak oil demand” have been growing in the market and, while we are bullish on the potential for EV, we think these “peak oil demand” fears are overblown and could result in higher, not lower, oil prices in the future
    • Forecasts for future oil demand indicate that by 2025, oil demand will be impacted by 500,000 barrels to 1 million barrels per day from lower gasoline consumption as EV sales rise toward 10 million units per year from 0.5 million in 2016 and EV fleet penetration moves toward about 3% globally; gasoline is only 25% of the barrel, and demand for gasoline along with the rest of the barrel has been growing at the fastest rate in the past 5 years than nearly any other five-year period in the last 30-40 years
    • While we don’t disagree that future gasoline demand could peak in the next 10 years, we think investors need to have the perspective that a peak in gasoline demand by 2025 or so may also coincide with another 10 million bbl/d of overall oil demand growth, which, coupled with an annual production decline rate of 3% to 6%, create a need for significant ongoing investment in new production capacity and production growth
    • It is too early to proclaim the death of the oil industry, to say nothing of the gas industry, which is gaining prominence in many parts of the world as an alternative to coal and a bridge/complement to renewables
  • Oil & Gas industry appears to be transforming 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 on the major oil companies and independent E&Ps 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 over the last several years, numerous bankruptcies, and poor financial returns, it is not surprising that investors want change
    • There is growing movement among investors to rightfully try to get oil & gas companies to be more focused and more disciplined in their capital allocations; this includes trying to live and invest within cash flow under conservative commodity price assumptions to limit the issuance of dilutive equity or debt, and altering compensation schemes to shift away from production growth towards metrics that help ensure companies are investing wisely, generating better returns, and beginning to return cash to shareholders
    • A potential, and not insignificant benefit of a transition to greater capital discipline and more managed growth may be a more stable oil market in which US supply growth is a prominent and needed source of supply growth, but not an overwhelming force
  • 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 for us
    • While investment levels in the oil & gas industry have fallen in the past 3 years, investing activity in renewable energy has soared and renewable energy costs have continued to fall; this is mostly a good thing as it is accelerating the penetration of clean energy in many parts of the globe and creating strong demand for supplies of wind turbines, solar equipment, and in the not too distant future, energy storage products
    • As costs fall and efficiencies of new equipment rise, competitiveness and the addressable market for renewable products should continue to increase; we expect this will reduce the need for government support and allow a more natural functioning of these markets; over the next several years, we expect that policy changes will continue to influence the demand for these products and technologies
    • 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; we see the renewable power industry as one that has undergone significant change in the past five years and will continue to go through a significant evolution in the next 10 years or more, and we will continue to look for companies that we believe have strong growth profiles, competitive advantages, entrepreneurial managements, and either strong current returns or potential for a significant improvement in financial returns over our investment time horizon

Baron Energy and Resources Fund 4Q17

Image Source: EIA, Labyrinth Consulting Services

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