Steven Romick on Energy Companies: ESV, OXY, RDC, APA, TOT, CVX

We work hard to understand risks that might impact your Fund’s investments. Once understood, we try to handicap them — a task that’s more art than science. We sometimes do not handicap the risks correctly and, more rarely, miss the risk entirely. In the case of our investment in oil service companies, we understood that occasionally a rig would blow up and might have to be scrapped. Were that to occur, the earning power of the company would be reduced by the loss of that rig, but the rig would be insured and the company would receive those dollars to put toward either buying or building another rig. What we did not expect was that, while we could fly a man to the moon, British Petroleum couldn’t cap a well 5,000 feet under water (in any kind of reasonabletime frame) and that oil would spew continuously into the Gulf of Mexico (GOM) after Transocean’s Deepwater Horizon rig exploded this past May.


We also did not anticipate that the government would place a temporary ban on deepwater drilling in the Gulf. We found the ban to be a rash response to a discrete incident. Were an Airbus A320 to crash en route from Los Angeles to New York, we doubt that the entire fleet of airplanes (other Airbuses, Boeings, and private jets) on that route would be grounded. The government’s action, however, was to do just that. No distinction was made between shallow and deep water. There were no allowances for differences in the type of equipment, redundancies, and procedures on these rigs. It was illogically indiscriminate. All of these stocks declined in the quarter, including Ensco International, the Fund’s largest position. We believe that both shallow and deepwater drilling will resume in the GOM, since permanently removing this critical oil production capacity would cause a supply/demand imbalance that would trigger a spike in oil prices. How quickly GOM drilling resumes will depend on capping the well, assessing the damage, the price of oil, politics and more.


With conviction in the ultimate return of drilling in the GOM, however, we have increased our exposure to the drillers. These companies trade at deep discounts to their replacement value and single-digit P/Es on normalized earnings. We currently hold a 6.0% position in the drillers, up from 4.8% at the end of March 2010.


Our economic interest in these companies has grown by even more, given the lower average stock prices. Not only has our position size been increased, but we now own far more of these companies given the share price decline.

We have spoken about our position in Ensco International in the past and we revisit this second largest position today, as we believe that the market has priced this investment at levels that we deem silly. Rikard Ekstrand, prior to joining the Crescent Team, purchased it in 1999 for other accounts managed by First Pacific Advisors at about $10 per share, only to sell it in 2001 above $40. We then purchased the stock for Crescent after it declined back to $18.55 in 2001. We have held the position ever since, although the number of shares has been trimmed at substantively higher prices than where its stock trades today. We value Ensco using two methods, P/E and its premiumor discount to replacement value. We first bought the stock at an infinite P/E when it was break-even and sold it in 2001 at 28x trailing (but still far below normal) earnings per share and 137% of its replacement value and bought it back later that year at 14x earnings and a 77% discount to replacement value. We still hold our position and have been increasing it as it has declined to levels that we would deem to beless expensive than 1999 when oil and gas were trading at just $25.60 per barrel and $2.30 per mcf, respectively. You can see the earnings and replacement value at the inflection points when we have been either buyers or sellers of its stock in the table below. It is important to note that Ensco is a drilling company and its livelihood is predicated more on the need for pulling oil and gas from the ground than it is by its price. We believe drilling will continue relatively unimpacted by the decline in the price of the commodities, as long as the oil stays above $65 per barrel and gas stays above $8 per mcf.

This focus on a longer time frame will hel explain our continued emphasis on energy stocks. The business of energy production is one of declining supply and increasing demand. Oil companies are discovering, on average, less than one third of what the world consumes. Discoveries have been on a declining trend since the early 1960s peak, while consumption has exceeded discoveries for more than 20 years. Meanwhile, the cost to produce a barrel of oil has increased due to the higher cost of raw materials and energy itself. Energy is needed to produce oil, whether it be to inject steam into a well or transport crude across the Atlantic. The energy cost per barrel has increased from 1:20 twenty years ago to 1:4 today. This means that it now takes the equivalent energy of one barrel of oil to produce four barrels. Harder to find and costlier to produce; such a recipe will likely keep a floor under the price of oil not far below current prices, barring a recession which would curb demand. To make it all the more attractive, many of these stocks remain inexpensive despite healthy run-ups the last few years. We do not know what will happen to the price of oil over the short term and the subsequent impact that may have on the companies we own in the sector, including, Ensco International, ConocoPhillips,


GlobalSantaFe, Rowan Companies, Patterson-UTI Energy, Chevron, National-Oilwell Varco, and Plains Exploration & Production. Nevertheless, like the Weizmann scientists, we remain focused. We believe the future will bring better economics and higher valuations for the aforementioned companies, a future that is not entirely dependent on higher oil prices, although that is something we believe is quite likely.