- By Holly LaFon
Dear Baron Energy And Resources Fund Shareholder:
Baron Energy and Resources Fund (the "Fund") posted very strong performance again during the third quarter. Following the greater than 17% gain in the second quarter, the Fund rose by another 9.9% (Institutional Shares) and outpaced its benchmark - the S&P North American Natural Resources Sector Index - by 566 basis points. Following the Fund's gains for the quarter, we are now within less than 100 basis points of our benchmark on a year-to-date basis, a big change from the Fund's greater than 1,000 basis point relative deficit that we had at the end of the first quarter of this year.
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Through the second quarter, the recovery in the Fund's performance had largely coincided with the recovery in oil prices. However, in the third quarter, oil prices were essentially flat and yet the Fund's Energy holdings generated a total return of 11.24% and outperformed the Energy holdings in our benchmark by 644 basis points. It is our view that because of our focus on growth oriented small-cap and mid-cap energy and resource companies, our Fund is structured to perform better in flat or rising oil and gas price environments than falling price environments and this has clearly been borne out over the past several years. This is what we saw in the third quarter as it became increasingly clear that Energy's two-year long recession had come to an end. While sharply rising oil prices in the second quarter provided a tailwind for the Fund, prices were flat in the third quarter and our Energy investments still posted solid gains and outperformed the benchmark as noted above.
Based on a combination of industry indicators such as oil and gas inventories, oil and gas supply and demand trends, commodity prices, and drilling rig and well completion activity, we believe that the first half of 2016 will be seen as the bottom of the recession for this industry, and that conditions are in place for fundamental longer-term recovery. We believe that such a recovery will result in a return to more normalized oil and gas prices, which we view as the price level necessary for industry participants to earn returns that are close to the cost of capital and are higher than current futures prices. A return toward normalized price levels should allow many of the companies in our portfolio to realize both cyclical and secular growth in earnings and cash flows over the next several years. As such, we continue to be constructive on the outlook for investing in the Energy sector, which is the dominant portion of the Fund's holdings (80.5% at quarter end). See Outlook section for more detail.
As noted, this quarter's strong performance was largely driven on both an absolute and relative basis by the gains generated by our investments in the Energy sector, although we also finally got some help from our investments in renewable energy and Materials as well. Our Energy investments generated a total return of 11.2% and a contribution to return of 8.9% for the quarter, which was about 91% of the Fund's total return in the quarter, despite representing an average weight in the Fund of just under 80%. The exploration & production sub-industry ("E&P") was the leading contributor to our Energy-related returns, contributing gains of nearly 6.1%, or 62% of the total return for the quarter. Within E&P, the Fund benefited the most from maintaining high exposure to U.S.-based E&Ps that are focused on developing unconventional resources like shale oil and tight-oil reservoirs, particularly in the Permian basin in West Texas and New Mexico. Companies such as Parsley Energy, Inc., Concho Resources, Inc., RSP Permian, Inc. and Energen Corporation are among our largest positions and are all pure-plays on the Permian, which has emerged as the largest and most economical of the oil shale plays in the world today. As we look out over the next several years, we believe that the Permian basin will be the key driver for oil volume growth in the U.S. and will be one of the prime basins for growth on a global basis as well. Companies operating in the Permian basin have just begun to fully understand the size and scope of the opportunity for this basin and there was significant merger and acquisition activity in the Permian basin during the third quarter that further highlighted the values of existing positions for many of the incumbent companies. In our view, energy companies' understanding of the true potential for size of the resource, resource recovery, and production growth potential in the Permian basin is still relatively nascent. Over the next several years we anticipate ongoing improvements in technology, knowledge, and processes will result in higher valuations for companies that have significant exposure and long-lived resource opportunities in the Permian basin.
In addition to the gains in Energy during the quarter, we also had strong contributions from Materials and Utilities (renewable energy) sectors. These two sectors contributed 81 and 44 basis points, respectively, and accounted for about 12.8% of the total return during the quarter, outpacing the 11.5% average weighting for these industries within the portfolio. Within the Materials sector, strong gains from Flotek Industries, Inc. and Kraton Corporation paced the gains in the quarter while our positions in TerraForm Power, Inc. and TerraForm Global, Inc. also posted strong gains within the Utilities sector as both companies continue to restructure their ownership and get out from under the weight of the SunEdison, Inc. bankruptcy.
Parsley Energy, Inc. (PE) is an independent E&P company focused on the Permian basin in West Texas. Shares rose in the third quarter on strong operational performance, significantly raised production guidance, lowered cash costs, and a three-year growth outlook that exceeded even the most bullish estimates. Parsley also boosted its drilling inventory through an acquisition. We expect Parsley will continue to deliver peer-leading operational performance, capitalize on its strong balance sheet, and grow its footprint through acquisitions.
Encana Corp. (ECA) is an E&P company with primary operations in Western Canada and Texas. Shares rose in the third quarter on raised production guidance, lowered cash costs, and significantly increased drilling activity in its highest return area. Encana has strong positions in two of the more attractive oil resource plays in the Permian and Eagle Ford basins and two of the lowest cost natural gas resource basins in Western Canada. Given its long-term growth potential, we think Encana is one of the most attractively valued E&Ps in the industry.
Concho Resources, Inc. (CXO) is an independent oil and gas E&P company focused on the Permian basin in West Texas and New Mexico. Shares rose in the third quarter on increased production guidance, lowered cash costs, and a solid operations update, as well as strong M&A activity in the Delaware basin, which highlighted the value of its holdings in the basin. As one of the best run mid-cap E&P companies, in our view, we believe Concho is well positioned to exploit the deep economic inventory of drilling locations where it operates.
Shares of SolarEdge Technologies, Inc. (SEDG), a leading maker of inverters for solar energy systems, detracted in the third quarter as changes in the U.S. market appeared to dampen growth prospects of large installers. As the business model shifts from lease to own, the U.S. solar market is shifting from large installers to smaller, local vendors. Fears around pricing pressure due to increased competition also hurt the stock price. Although we believe this is a temporary structural adjustment, we decided to reduce our position as the market transitions.
Core Laboratories N.V. (CLB) is a leading provider of core and fluid analysis to the oil and gas industry. Shares fell on moderated short-term growth and margin recovery estimates and reduced revenue guidance. Core Labs dominates its niche, has limited competition, provides value added, non-commoditized services, and generates the highest returns on equity and capital in the industry. We believe strong secular growth drivers in each of its three businesses will allow it to outgrow other oilfield service companies while generating premium returns.
Shares of gold mining company Barrick Gold Corporation (ABX) fell during the third quarter in concert with a decline in gold prices. Gold prices surged following the Brexit vote in late June. As equity markets recovered, concerns over Brexit eased, and concerns regarding less accommodative monetary policies rose, gold and gold equities weakened. We believe it is prudent to maintain a modest exposure to gold at this time. We think the shares are attractively valued based on our outlook for gold pricing, Barrick's growing gold volumes, and falling cost structure.
We ended the quarter with 2.5% cash, which was up modestly from the end of the second quarter, but is at a level that we would still describe as pretty close to fully invested relative to historical cash levels for the Fund. The Fund remains concentrated with the top 10 holdings representing 48.1% of the Fund at quarter end, up slightly from the end of the second quarter and substantially higher than year-ago levels (36.1%).
At the end of the quarter, the portfolio breakdown in the key sub-industries was as follows:
Oil & Gas Exploration & Production: The E&P sub-industry represented 43.1% of the Fund at the end of the quarter, and continued to be focused on North American-based producers that operate primarily in developing unconventional oil & gas reservoirs. Companies that primarily operate in the Permian basin in Texas and New Mexico are our largest focus for E&P investment, followed by companies that are focused on the Anadarko basin in Oklahoma, the Appalachian basin in Pennsylvania/Ohio, and the Western Canadian Sedimentary basin. These plays are characterized by multiple pay-zones, industry-leading returns, and expanding resource potential, and stocks such as Parsley Energy, Inc., Concho Resources, Inc., Encana Corp., and Rice Energy Inc. are key investments in these plays and were key contributors to our performance this quarter. We continue to be bullish on the long-term growth potential of these four plays and the companies that are the leading developers in each area.
Oil & Gas Storage & Transportation: This sub-industry, which is largely composed of MLPs and publicly traded general partnerships, is the second largest sub-industry for the Fund and it represented 19.2% of the Fund's assets at the end of the quarter. We continued to see improving conditions in this sector, particularly for storage and transmission related companies. Many companies in this sub-industry have undergone financial and strategic restructurings in the last 12 months resulting in stronger balance sheets and streamlined corporate structures. In addition to these actions, a more positive outlook for commodity prices has also eased investor concerns about future dividend/distribution growth, enhancing the relative valuation comparison for these stocks versus other yield-oriented investments like Utilities, REITs, and Consumer Staples. As a result, investment flows into dedicated MLP/midstream funds have picked up over the past several months and the increase in investment flows has also coincided with declining capital needs as a result of slower organic growth. The reduction in capital needs along with a series of M&A transactions have reduced the supply of equity, which we view as a positive for our investments in this area.
Oil & Gas Equipment, Services & Drilling: At 14.7%, our exposure to this sub-industry was up from last quarter, as we both added and subtracted from our holdings in this area. New investments in companies such as Forum Energy Technologies, Inc., FMC Technologies, Inc., and Nabors Industries Ltd. were added during the quarter as our conviction on the timing and shape of a recovery in oil company capital spending and drilling/ completion activity grew. It became clear during the quarter that industry activity is bottoming in North America and that the prospects for a recovery in activity and industry pricing were improving. Valuation and normalized earnings power remain concerns in this sub-industry, but we are getting more comfortable that the restructuring of the past two years could result in a stronger earnings recovery than currently embedded in consensus valuations.
Renewable Energy: Renewable or alternative energy is not a specific GICS sub-industry, but we think this is really the appropriate classification for our investments in the Utilities and Information Technology sectors, since our investments in these two areas are primarily companies involved in the construction and operation of solar and wind electricity generation assets and battery storage systems. Investments in this area accounted for 5.7% of the Fund at the end of the quarter, and performance was mixed. Our investments in TerraForm Power, Inc. and TerraForm Global, Inc. continued to be positive contributors, as parent company SunEdison's Chapter 11 process moved forward during the quarter. However, slowing growth in U.S. residential solar installations and fears of pending competition from Chinese manufacturers hurt our position in SolarEdge Technologies, Inc. and offset some of our gains. Tesla Motors, Inc. continued to be volatile during the quarter, particularly after management's decision to propose a merger with SolarCity, Inc. and become much more involved in renewable energy development.
Materials: 9.1% of the portfolio is invested in this area, and while most of our investments are in businesses that are closely related to the Energy sector, we also maintained a small weighting in two of the leading gold mining companies, Barrick Gold Corporation and Newmont Mining Corporation. Our investments in mining were down during the quarter but given the uncertainty around the outlook for global interest rates and the efficacy of monetary policy tools, we are comfortable with our modestly sized investment in the mining category.
Oil & Gas Refining & Marketing: Independent refiners represented 3.5% of assets at the end of the quarter. Our position is well below the 6.4% average weight for this sub-industry in our benchmark. We are not too sanguine about a near-term rebound, but believe that U.S. independent refiners remain competitively advantaged to grow earnings and generate free cash flow over the long term. In addition, we believe that these companies will use much of that free cash to enhance shareholder returns through dividends and buybacks.
All of our top net purchases for the quarter were new positions for the Fund, and several of our purchases were companies that we have owned in the past. Our biggest purchases in the quarter were Anadarko Petroleum Corporation, Noble Midstream Partners LP, and Forum Energy Technologies, Inc. We owned both Anadarko and Forum in the past and decided to re-engage on both companies during the quarter as our confidence in the outlook for both companies improved.
Anadarko (APC) is a U.S.-based independent oil & gas producer that has a more diversified mix of operations than most of its peers. The company has strong onshore positions in some of the most attractive U.S. shale basins, including the Delaware sub-basin in the Permian basin. These positions are complemented by one of the best offshore, deepwater exploration and development teams in the industry, which drove Anadarko's successful growth in deepwater production in both the Gulf of Mexico and offshore West Africa. In the third quarter, Anadarko purchased the bulk of Freeport McMoran's deepwater Gulf of Mexico assets for an attractive price, and in doing so, it added assets that will generate substantial free cash flow in the next five years and improved its own liquidity position. This deal removed some of our biggest concerns around Anadarko's growth and liquidity profiles, which combined with an attractive valuation created the catalyst for us to add the stock back into the portfolio. We think that Anadarko now offers a great combination of accelerating growth and improving returns at a solid discount to both net asset value and peer cash flow multiples.
Forum Energy Technologies (FET) is a U.S.-based oilfield equipment manufacturing company that we think will benefit significantly from the pending upturn in drilling and well completion activity in the U.S. and Canada. It is our opinion that the long downturn in drilling and completion activity came to an end in the second quarter of this year and we expect to see rising levels of activity into year end and throughout 2017. Many of Forum's products are critical consumable components that are used during the well completion and hydraulic fracturing process, and some of its capital equipment products are in high demand as customers seek to upgrade and refurbish equipment that has either been idled or cannibalized for parts. We believe that industry inventories of these products have been depleted in the past two years, which should lead to a quicker turnaround in Forum's business than in other oilfield equipment and service business, which are still dealing with capacity and inventory overhangs. Not only are we interested in Forum because of the likelihood that its business is one of the first responders to an upturn in activity, but we have been impressed with the cost cutting and organizational restructuring management completed in the past two years to strengthen the company and improve its mid-cycle margins.
Noble Midstream Partners LP (NBLX) was spun out of Noble Energy, Inc. as an initial public offering during the third quarter. Noble Midstream owns and operates portions of the oil and gas gathering, transportation and processing assets that are primarily located around Noble Energy's operations in Colorado and Texas. We know the Noble assets extremely well, having been investors in Noble Energy for the past several years and see solid organic and inorganic growth potential at Noble Midstream over the next five years. The primary drivers of distributable cash flow growth at Noble Midstream will come from Noble Energy's ability to grow oil and gas production volumes in Colorado and Texas, and Noble Midstream's dropdown acquisitions over the next several years.
During the quarter all of our top sales were the result of decisions to reallocate capital within the portfolio to what we believe are better risk/ reward situations. For example, we reduced our position in Noble Energy, Inc. and exited Western Gas Equity Partners LP to make room for our purchase of Anadarko and Noble Midstream Partners, two companies that have similar operational and risk characteristics to Noble Energy, but where we felt there was better reward potential. Another situation in which we made a similar risk/reward swap was our decision to sell Helmerich & Payne, Inc., which is the leading U.S.-based land drilling contractor, to facilitate our purchase of its close competitor in the land drilling business - Nabors Industries Ltd.
As we head into the fourth quarter and turn our attention to 2017 and beyond, we continue to be bullish on the outlook for energy and resource-related companies. Since Energy companies represent over 80% of our portfolio, our outlook remains largely focused on that sector. We think there are three key messages that investors should think about as it pertains to investing in Energy over the next two to three years.
- The worst Energy recession in a generation is coming to an end.
- The U.S. 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.
The recession is coming to an end: Since late 2014, the energy industry has been through a sharp and painful recession that at times has felt like a depression. This downturn produced as significant a contraction in industry activity as anything we had experienced in my 28 years in the business. It was clearly driven by the precipitous decline in oil prices that resulted from an excess of oil supply relative to demand, leading to record levels of crude oil inventory building up on a global basis. While the market was clearly oversupplied for much of the past two years, the magnitude of the excess capacity was never much more than 1-2 million barrels per day (mmb/d) in the context of a 95 mmb/d market. However, since oil, like nearly all commodities, is priced on the basis of marginal supply or marginal demand, collapsing prices led to collapsing cash flows and investments. Industry-wide capital investment in the past two years fell over 50% and in some markets like the U.S., the decline was even sharper, as evidenced by a nearly 80% decline in the U.S. rig count (measured quarterly peak to trough) and sharp declines in pricing for all types of oilfield products and services. These declines essentially wiped out the profitability for E&P companies and many oilfield service & equipment companies. Over 100 energy companies in the U.S. filed for bankruptcy during this period and a number of others barely skirted chapter 11 or were forced to raise expensive capital to stay afloat. While this period has been very painful, it has forced adjustments in oil supply, stimulated oil demand growth, and created an impetus for significant improvements in cost structures and operating efficiencies. As a result, we believe that a number of companies will emerge from this recession/depression stronger than when business turned south two years ago.
Oil demand growth has strengthened: In November 2014, the International Energy Agency (IEA) estimated that 2014 oil demand would be 92.4 mmb/d. In its most recent monthly report, the IEA now estimates that 2016 demand will be 96.3 mmb/d. This nearly 4 mmb/d increase in global demand has significantly exceeded trend line annual growth in oil demand, which has averaged 1.1 mmb/d since 2005. This significant amount of growth occurred within the context of a sluggish global economy, including a slowdown in Chinese growth, economic crises in Russia and Brazil, and the negative economic effects on most oil producing countries that had been fast growing consumers of oil and oil products during the 2010-2014 period when oil prices averaged nearly $100/barrel. As oil prices recover, we expect demand growth to slow back toward historical trend levels over the next several years. The strong growth in the past two years has helped to significantly narrow the gap between supply and demand and has put the market onto firmer fundamental footing.
Oil supply growth has stagnated: While oil demand growth has surprised to the upside in the last couple of years, non-OPEC oil supply has changed as expected. It continued to rise through much of 2015 before peaking and, since late 2015, has declined by about 1.5 mmb/d due to a combination of the reduction in capital investment in new and existing fields and the normal underlying decline rate of existing production. Most of this decline resulted from short-cycle projects and the sharp drop in U.S. shale oil output, which has already fallen by over 1 mmb/d since peaking in early 2015, and should continue to trend lower through the rest of this year. The supply side of the oil market is really governed by two factors: 1) underlying field declines and 2) capital investment to offset declines and to bring on new sources of production. In 2015, and even continuing through this year and next, global oil markets were still seeing strong levels of production additions from long-cycle projects that had been sanctioned in the 2010-2014 period when oil prices were much higher. The effects of the decline in capital investment have yet to be felt in production from long-cycle projects as there have been almost no new large scale oil projects sanctioned for investment in the past two years and few that are expected to be sanctioned in the next 12 months either. We think much of this impact will show up as potential supply shortfalls in 2018-2021.
OPEC's market share is up, but at a great cost: As a result of the strength in demand and the stagnation of non-OPEC supply, OPEC's share of the market has increased by about 200 basis points since November 2014 and in that sense its "market share war" has worked. That being said, we believe OPEC's victory has been a pyrrhic one as most OPEC countries find themselves in much worse financial situations than was the case two years ago. The group's gains in volumes outside of Iran, which has benefited from the cessation of economic sanctions on the oil industry, have not compensated anyone for the fall in prices. Therefore, budget deficits across OPEC have swelled and political unrest is more prevalent among nearly all OPEC producers than was the case two years ago. Countries like Venezuela, Nigeria, and Libya are economic and political messes, and even the mighty Saudi Arabia has felt significant pressure. In the past 12 months the Saudi government has attempted to begin to restructure its own economy by reducing subsidies for fuel, water, and electricity. It has also sharply cut salaries for government employees. At the same time, Saudi Arabia faces military challenges on nearly all its borders, necessitating high levels of defense spending. Inflation has increased and foreign currency reserves have dwindled. Saudi Arabia has been accessing the sovereign debt market for the first time in years to cover its budget shortfalls, and press reports indicate growing tensions within the country.
Time for another change in OPEC policy: We believe the fact that oil markets have become more balanced through stimulated demand growth and curtailed non-OPEC production growth combined with rising tensions within many OPEC producers led to the reversal in OPEC (really Saudi ) policy that was announced last month at a meeting in Algeria. At that meeting, OPEC surprisingly announced plans to cut its output by 0.5-1.0 mmb/d, with formal cuts to be announced in November. There is still considerable skepticism in equity and commodity markets as to whether OPEC will follow through with these cuts, which countries will bear the brunt, and whether Russia will go along as well. Nevertheless our view is that: 1) this announcement represents a decided and positive shift in OPEC policy and 2) even if OPEC only manages to freeze its production, our analysis indicates that the oil market has already transitioned from oversupplied to undersupplied as third quarter inventories fell when third quarter inventories typically rise, and they should fall further during the fourth quarter. An OPEC cut would just exacerbate this trend and lead to a more rapid rebalancing of the oil market. We think that the tightening of the supply/demand balance and the prospects for inventory reduction over the next 12 to 18 months is supportive of flat to rising oil prices and is an important feature of a more positive backdrop for investing in energy and energy-related companies.
A focus on U.S. Energy Renaissance leaders: Our portfolio is heavily weighted toward U.S.-based energy companies, and particularly companies with significant investments and exposure to the U.S. Energy Renaissance that has been ongoing for the past decade. While the energy recession hit this sub-segment of the industry as hard, or harder, than any other part of the industry, there has also been perhaps no other part of the industry that has done so much to stay competitive. U.S. unconventional oil and gas companies have been successful in making their businesses much more efficient by lowering drilling and operating costs, improving resource recoveries per well, and making structural rather than cyclical changes to their businesses. There is no question that some of the cost reductions are cyclical and result from lower service and supply pricing, but many of the changes are structural and will survive a return to more normal levels of investment and activity. For example, the industry has reduced the number of days it takes to drill a typical shale oil well in the U.S. by more than 50% and it has reduced the time it takes to hydraulically fracture wells by 25% to 30%, even while increasing the complexity and size of these "frac" jobs. Since 2014, U.S. government data indicates that the amount of production added per active rig in the key unconventional oil plays in the U.S. has increased by over 70% and underlying production declines from existing shale wells has slowed down. New technology, streamlined processes, focus on supply chains, fat trimming, and going up the learning curve in nearly all shale plays has positioned the U.S. industry to be a leader in global oil supply growth over the next three-to-five years if not longer and do so at a normalized oil price that is perhaps 20% to 30% lower than what we would have thought possible two years ago. As a result of the gains in efficiency and the reductions in cost, we think that the U.S. Energy Renaissance is alive and well and will continue to be a focus of our Fund.
Investor sentiment improves but still underweight: Investor surveys continue to show that while institutional investors are less skeptical about the outlook for energy and resource-related stocks, and are less underweight than earlier this year, they are still cautiously positioned toward these areas and remain underweight relative to historical norms. We think this means that there is still a significant amount of capital remaining on the sidelines that could be put to work in the areas in which the Fund invests.
Furthermore, it is possible that index weightings will get revised upward over time, adding more pressure for both active and passive investors to get involved. The Energy sector has been the least correlated of the major sub-sectors of the S&P 500 Index to the overall performance of the S&P 500 Index over the past five years, so an allocation to a dedicated energy & resource fund may provide a differentiated return and diversification for investors.
I am pleased to have had the opportunity to share my thoughts with you in this letter. Thank you for having the confidence to join me in investing in Baron Energy and Resources Fund.
October 17, 2016
The discussions of the companies herein are not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed in this report reflect those of the respective portfolio manager only through the end of the period stated in this report. The portfolio manager's views are not intended as recommendations or investment advice to any person reading this report and are subject to change at any time based on market and other conditions and Baron has no obligation to update them.
This report does not constitute an offer to sell or a solicitation of any offer to buy securities of Baron Energy and Resources Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.
This article first appeared on GuruFocus.
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