Dear Baron Energy and Resources Fund Shareholder:
Performance
The first quarter of 2016 marked another period of volatility for the market sectors in which we invest and consequently our Fund. During the quarter, we witnessed another 20% decline in the average price for a barrel of oil seeing oil prices declining at one point to near 15-year lows of $26 per barrel before rebounding to near $40 per barrel by the end of the quarter. At the same time, significantly warmer than normal weather in the U.S. also led to natural gas prices declining to their lowest level since the mid- to late 1990s at around $1.60/MMBtu, and averaging nearly 30% less than the year-ago quarter. The stress that these lower prices put on energy equity and credit markets was significant early in the quarter and was particularly acute on small and mid-cap companies. While energy prices were suffering early in the quarter, metals prices, particularly for gold and iron ore, staged quite an unexpected recovery, catching the Fund a bit flat footed, as we had not been invested in these areas for some time. The challenge of investing amid this period of heightened volatility has been quite acute, but despite the poor performance during the first quarter, we believe that the portfolio is well positioned to show improved performance in the upcoming quarters and years.
If we break down the relative performance of the Fund during the quarter, we find that a combination of poor stock selection as well as sector positioning within three key areas were the major detractors from performance. As noted, we have been underweight the Materials sector, which includes metals and mining, and this proved to be one of the strongest sources of return for our benchmark and the overall market in the first quarter. Materials stocks in our benchmark generated a total return of 18.73% and, with an average weighting of 17.13%, contributed 3.25% to the overall index return. Index returns were mostly helped by gains in precious metals and diversified metals and mining. For example, the S&P Metals & Mining ETF, which is a good proxy for these businesses, gained 37.4% in the first quarter.
By contrast, our limited investments in the Materials sector performed poorly as they are more oil and gas related. Our underweight and stock selection in Materials cost the Fund about 357 bps of relative performance, which is nearly 35% of our relative underperformance in the quarter. The second and third key areas of material negative variation resulted from a combination of poor stock selection and our ongoing overweight position in Oil Transportation & Storage or midstream companies and the continued underperformance of our investments in renewable energy oriented companies. In the case of our midstream investments, the biggest detractor was our investment in Energy Transfer Equity LPÂ (ETE, Financial). ETE continued to be under pressure as Energy Transfer Equity’s pending merger with Williams Companies Inc. (WMB, Financial) has dragged on longer than expected, increasing investor concerns regarding Energy Transfer Equity’s postdeal balance sheet, project funding, and merger synergies.
We see significant value in Energy Transfer Equity whether or not the Williams Companies deal closes, but until it does, this will remain a volatile piece of the portfolio. In addition to the Energy Transfer Equity-Williams Companies saga, another announced merger in the sector also hurt the portfolio. Columbia Pipeline Group (CPGX), the parent company and general partner of our holding, Columbia Pipeline Partners (CPPL), agreed to be acquired by TransCanada Corp. (TRP), raising investor fears that Columbia Pipeline Partners' future expected growth could be diminished as TransCanada extracted value from Columbia Pipeline Group by diverting assets originally intended to be dropped down to Columbia Pipeline Partners to TransCanada’s own MLP instead. The decline in these two investments and the other stocks owned in the sub-industry, coupled with gains in the stocks owned in our benchmark, led to another 528 bps of relative underperformance in the quarter.
Lastly, our investments in renewable energy continued to be problematic. While we had exited our position in SunEdison Inc. (SUNEQ) last quarter amid concerns (proven to be correct) about its liquidity and ability to survive, we did not sell our position in its two “yieldcos” TerraForm Power Inc. (TERP) and TerraForm Global Inc. (GLBL) as our analysis concluded that both stocks were trading well below liquidation value. This is still our view, but the ongoing turmoil swirling around SunEdison in the first quarter, which includes management changes, failed deals, lawsuits and failure to file timely financial statements have continued to obscure this fact and led to further downside in the stocks last quarter. SunEdison recently filed for Chapter 11 protection but the “yieldcos” did not and we believe this is a positive step that will help investors to recognize the value potential in these two entities. As a result, our investments in renewable energy companies also negatively impacted performance by another 129 bps.
While these big variances are facts, they are not excuses. In the first quarter and really in the last nine months or so, we have had too many investments that have performed much worse than the peer group and much worse than the rest of the portfolio. However, we have also done some things that we believe position the portfolio for a brighter future, including sharpening the focus of the Fund on fewer ideas, building up a sizable tax loss position for the sheltering of future gains and continuing to work our cash position down as our confidence in an industry recovery builds.
Parsley Energy Inc. (PE, Financial) is an independent exploration and production company focused on the Permian Basin in West Texas. Parsley has a strong balance sheet and a superior acreage footprint that generates some of the highest rates of return in the U.S. Parsley once again delivered strong operational performance in the first quarter, with solid production outlook, better oil mix, lower capital costs and most importantly impressive results from its highly anticipated first horizontal wells in the Southern Delaware Basin acreage.
Rice Energy Inc. (RICE, Financial) is an exploration and production (E&P) company operating in Pennsylvania and Ohio. After we initiated our position in the first quarter, shares increased due to an improved production outlook for 2016 and rising natural gas prices. In our opinion, Rice is one of the most attractively valued gas-focused E&Ps. It offers industry-leading production growth and exposure to premium Marcellus and Utica acreage. We expect shares to benefit as Rice executes operationally and unlocks the value of its underappreciated midstream assets.
RSP Permian Inc. (RSPP, Financial) is an exploration & production company focused on the Permian Basin in West Texas. RSP has extended its core well inventory and provided a strong operational update with capital efficiency that exceeded analyst expectations. Management has effectively removed equity issuance concerns that weighed on shares at the start of 2016. We believe shares will benefit from ongoing improvements in operating results, lower costs, and RSP’s ability to generate high double-digit production growth in the current low oil price environment.
Energy Transfer Equity owns equity interests in energy midstream companies Energy Transfer Partners (ETP), Sunoco Logistics (SXL) and Sunoco LP (SUN). The company’s 2015 bid to acquire a large cap midstream master limited partnership created a significant financing gap in a declining commodity environment and a liquidity crisis, which, in turn, pressured the stock price. We retain conviction based on the company’s premier asset footprint, and strong management team that has proved before to be able to capitalize on market opportunities.
Flotek Industries Inc. (FTK, Financial) supplies chemical additives to the global oil & gas industry. Its proprietary product, the complex nano-fluid (CnF), is proving extremely effective at increasing productivity. Shares fell due to the sharp decline in drilling and completions activity. Data issues that cropped up in the fourth quarter also continued to weigh on shares. Given ongoing declines in drilling and completion activity in the U.S., the near-term outlook remains a challenge, but we believe in the company’s long-term value proposition.
Marathon Petroleum Corp. (MPC, Financial) is one of the largest independent refining and marketing companies in the U.S. with operations focused on the Gulf Coast and midcontinent regions. Shares fell in Q1 due to a combination of refining margins that missed expectations and concerns around forward growth expectations for its subsidiary MPLX LP (MPLX) following the completion of MPLX’s acquisition of MarkWest Energy Partners LP (MWE). We think Marathon is currently undervalued and concerns are more than adequately discounted in the share price.
Memorial Resource Development Corp. (MRD, Financial) is an independent exploration and production company with operations in the Terryville field in Louisiana. Shares fell in the first quarter after the company cut capital expenditures and growth expectations in an effort to preserve its balance sheet. We think the moves were prudent and the ensuing selloff was overdone. We expect shares will rebound as production growth picks up and the company is able to demonstrate improved capital efficiency as a result of lower well costs.
Portfolio structure
During the first quarter, we continued to be fortunate to have positive cash inflows into the Fund and those inflows combined with our initial caution on commodity prices, as expressed in last quarter’s letter, led us to carry a higher than normal amount of cash in the quarter. Cash averaged 16.5% of assets during the quarter, and while that was a help to portfolio performance early in the quarter, it turned into a modest drag as the initial move off of the February bottom was so much faster and more violent than the downturn. However, during February as our confidence in a potential turnaround in the Energy industry began to grow, we began to work that cash down to more normal levels ending the quarter at 7.7%. As a result of the high grading and concentrating process that we began in the fourth quarter and continued in the first quarter, the portfolio continues to be more focused on higher conviction ideas with our top 10 holdings comprising 46.2% of net assets compared to 31.8% at mid-year 2015. Going forward, we can see that proportion shrinking a bit, but not likely returning to previous levels.
At the end of the quarter, the portfolio break-down in the key subindustries was as follows:
Oil & Gas Exploration & Production – The E&P sub-industry represented 39.6% of the Fund at the end of the quarter and continued to be mostly focused on U.S.-based producers that operate primarily in developing unconventional oil & gas reservoirs in the Permian basin in Texas and the Anadarko basin in Oklahoma. These plays are characterized by multiple payzones, industry-leading returns, and expanding resource potential. We continue to be bullish on the long-term growth potential of these two plays and the companies that are the leading developers in each area.
Oil & Gas Storage & Transportation – This subindustry, which is largely composed of MLPs and publicly traded general partnerships, is the second-largest subindustry for the Fund and represented 18.9% of its assets at the end of the quarter. Our exposure to this subindustry is lower than in prior periods as a result of performance and a shift in our focus.
Oil & Gas Equipment, Services & Drilling – Our exposure to this subindustry was up to 13.0%, and our holdings in this area were relatively unchanged during the quarter. We continue to be concerned about the business outlook for many companies in this subindustry due to the collapse in oil company capital and operational spending, and this has resulted in our small relative underweight position.
Oil & Gas Refining & Marketing – Independent refiners represented 6.3% of assets at the end of the quarter. After experiencing strong results in 2015, these stocks got off to a rocky start at the beginning of the year due to concerns about refining margins and MLP valuations impacting their ability to generate incremental shareholder value from their own publicly traded MLPs. We believe that U.S. independent refiners remain competitively advantaged to grow earnings and generate free cash flow, and they will use much of that free cash to enhance shareholder returns through dividends and buybacks.
Renewable Energy – Renewable or alternative energy is not a specific GICS subindustry, 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. Despite ongoing weak performance from our investments in TerraForm Global and TerraForm Power, our weighting grew to 5.8% (8.6% if we include our position in Tesla Motors Inc. (TSLA)., which is included in the portfolio as a way to capture some of the future growth in the demand for high capacity batteries that can be used to change the way energy is consumed in transportation and for grid storage solutions) as we added to all investments believing in the long-term growth opportunity for renewable energy supply and demand.
Industrials and Materials – About 5.9% of the portfolio is invested in these areas, but most of our investments are in businesses that are closely related to the Energy sector, and we believe they will benefit from our longterm view on key growth trends affecting various parts of the Energy sector.
Rice Energy was our top purchase in the quarter and proved to be one of our best-performing positions during the quarter as well. We have been researching Rice for several years, going back to when it was still a private company and have admired how well the management team has executed on its growth strategy to become a leading low-cost natural gas producer in Appalachia. The company has demonstrated strong operational expertise, built a valuable midstream gathering & transportation subsidiary, and been prudent with its hedging strategy. Its shares declined sharply early in the year and presented us with an excellent opportunity to initiate a new position. We continue to see strong potential in the company and upside in the valuation, which remains at a meaningful discount to larger peers.
SolarEdge Technologies Inc. (SEDG) is an Israeli-based technology company that manufactures and sells leading technology products dubbed “module level power electronics” (MLPE) that utilize semiconductor technology to more safely and efficiently convert DC power from solar panels to AC electricity that can be used in customer homes or sent to the grid. SolarEdge has been gaining significant share from traditional power inverter manufacturers and other competitors as it has brought down costs and boosted performance in recent years. We believe the company is well positioned with an ongoing rampup of new technology and lower cost manufacturing to continue to gain share and to benefit from the growth in residential and commercial solar installations in the U.S. and around the world.
Encana Corp. (ECA, Financial) is a Canadian-based company that was another new E&P position in the quarter. Following a management transition a couple of years ago, Encana has been restructuring over the past several years and now has strong positions in two of the more attractive oil resource plays in the Permian and the Eagle Ford basins and two of the lowest cost, prolific natural gas resource basins in Western Canada. The shares had been under severe pressure from lower commodity prices and misplaced (in our opinion) concerns about its balance sheet and liquidity. This pressure provided us with a good opportunity to begin accumulating a position in what we believe is another undervalued company with solid long-term growth and return potential.
Columbia Pipeline Partners LP (CCPL, Financial) was our top sale in the quarter as we exited our position following initial speculation about and then the actual takeover of Columbia’s general partner owner by TransCanada Pipelines Inc. The acquisition of Columbia’s general partner potentially leaves the MLP in a precarious position as TransCanada has its own MLP and could choose to “orphan” Columbia by redirecting future projects that we believed formed the basis of Columbia’s future growth to its own MLP.
We also exited positions in Hess Corporation, Western Refining Logistics LP (WNRL) and Methanex Corporation (MEOH) during the quarter to focus our attention and assets elsewhere.
Outlook
Last quarter, we wrote extensively about what we felt had led to the sharp decline in oil prices and the factors and industry trends that would drive a recovery, and we encourage you to refer back to that letter if you want a refresher on our views. While we were cautious at year-end that there could be additional downside in prices during the first quarter, we were also pretty optimistic that we were nearing the bottom of the cycle and the forces of recovery were beginning to manifest themselves. This is essentially how things played out in the first quarter and while the depths achieved in oil and gas prices in February and early March were perhaps lower than we anticipated, the subsequent upturn appears to be following our expected script and seems to be durable. It is our view that energy markets have bottomed and, while we expect ongoing volatility in commodities and stocks, we are more convinced that the current industry setup is going to lead to a sustained business recovery over the next three-to-five years as hydrocarbon demand grows faster than supply.
The following are some key points that update our previously expressed views including new information gleaned during the quarter:
1. Non-OPEC oil supply growth has gone negative around the globe and in particular in the U.S. where production is clearly declining from year-ago levels and is set to fall further due to a combination of declining existing production and lack of new well drilling and completion activity/investment.
2. In February, the International Energy Agency (IEA) put out its Medium Term Oil Market Report, which attempts to forecast oil supply and demand through 2021. In that report, the IEA estimated that global oil demand will grow by a cumulative 9 mmb/d from 2014-2021, but that non-OPEC supply is only set to grow by 3.5 mmb/d. This gap of 5.5 mmb/d is well in excess of current OPEC or non-OPEC spare capacity and represents a significant challenge to fill given the current price and capital investment climate. Few investors are focused on this long-term challenge, but we see it as a looming risk that the next price shock is a shock to the upside.
3. Oil and gas demand growth remains reasonable, even though it is not expected to be as robust as last year. Demand concerns were part of the panic in oil and equity markets early in the first quarter. However, more recent economic data in the U.S., and in a number of emerging markets, point to a continuation of modest economic growth, but no recession. In the absence of a recession, we think that risks of falling oil and gas demand remain low.
4. Global oil inventory growth slowed in the first quarter and the inventory data lends support to the view that markets are not as oversupplied as forecasts from agencies such as the IEA or the U.S. Energy Information Administration (EIA) imply. Further slowing or even a reversal later this year in inventory trends would be a powerful sign that would likely lead to a normalization of prices at higher levels.
5. OPEC and other large producers like Russia met earlier this month to discuss the potential for a “production freeze.” These discussions were not about cutting production, which is usually how oil producers cooperate, but just freezing it from growing further in the short term. We did not think these discussions were actually all that relevant to the long-term supply/demand picture, and were not surprised that the lack of an agreement was brushed off very quickly by oil and equity investors. In the long term, the things that really matter for supply are the fact that global spare production capacity is currently limited and declining investment in operations and in new capital projects will result in challenging conditions for maintaining current production let alone growing it in the next three to five years.
6. Capital market access for energy companies remains a complicated issue. Capital markets are not “frozen,” but they are certainly not wide open. In the first quarter, we saw a number of higher-quality companies access the equity market either to pay down debt or to finance acquisitions and those deals have largely been a success. On the other hand, there has been little to no high-yield debt issuance, and the number of distressed companies and bankruptcies in the energy industry continue to rise. The ongoing distress in the energy industry will continue despite a modest rebound in prices and will be another factor that elongates the next upcycle as managements of survivors will not quickly abandon balance sheet discipline to chase growth again.
Our focus remains on owning companies that we believe have both the wherewithal to not only survive the current environment but also thrive as prices recover. Within our investments in conventional energy companies, we remain focused on companies that we believe have: 1) low-cost assets and high relative margins; 2) significant resource development potential; 3) strong balance sheets; 4) entrepreneurial management teams; and 5) advantaged competitive positioning. While these are the characteristics of our core positions, we have been interested and willing to take on a bit more risk in the portfolio as demonstrated with some of our recent purchases, but even in these cases, we have worked to risk adjust any concerns about financial viability or financial stability, and, in each case, we felt as if markets were significantly undervaluing the assets and the growth potential of these companies.
Over the long term, we see continued growth and return opportunities for oil and gas companies that have competitively advantaged access to lower cost, long-lived resources. At the same time, as a result of climate change regulation, public policy changes and technology development, we remain aware of the long-term challenges that the energy industry may face in terms of altering our assumptions about future energy supply/demand, the value of resources and the costs of adapting. We continue to remind ourselves that we run an “energy and resources fund not a hydrocarbon fund,” and therefore, continue to look for investments that can also capitalize on these regulatory and technology changes. However, we are also mindful of the fact that the real world needs a stable and functioning oil and gas industry to bring increasing growth and prosperity to more parts of the world today and in the future.
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