Review and Outlook
The second quarter was much improved for Baron Energy & Resources Fund, as commodity prices continued the strengthening trend that emerged in the latter half of the first quarter. This strengthening was largely a function of improving supply/demand fundamentals in energy commodities and low to negative interest rates driving up demand for precious metals. The key events/developments were 1) accelerating U.S. oil production declines; 2) fires in Canada that negatively impacted oil production; 3) political unrest in Nigeria, Libya, and Venezuela that also impacted production levels; 4) the failure of OPEC and non-OPEC producers to reach an agreement to “freeze” production, let alone cut it; 5) the ongoing saga regarding the potential for additional U.S. interest rate hikes this year; and 6) the surprising vote in the U.K. to exit the European Union.
Our outlook for investing in the Energy and Resources sectors remains positive. The trends leading toward a rebalancing in the energy markets remain in place and leave us confident that the energy industry recession of the past two years is coming to an end. The key drivers of this rebalancing are: declining non-OPEC production resulting from a sharp and prolonged reduction in capital investment; relatively flat OPEC production for the past year despite a sharp rise in Iranian volumes; continued growth in global oil demand despite the sluggish global economy; barring a recession, longer-term growth in global oil demand that could outpace supply growth; excess inventory that in the near-to-medium term will likely provide a headwind and perhaps a ceiling for prices until they are closer to normal; and a recent rebalancing of the U.S. natural gas markets as low investment and drilling activity leads to small declines in production following years of rampant growth.
Given our constructive outlook for the rebalancing of the oil and gas market, we continue to focus our holdings among mostly domestically oriented exploration & production companies and oilfield service and midstream companies, as we believe these are the businesses best positioned to benefit from the long-term need for additional oil supply over the next five years. U.S. and Canada-based companies are driving down costs and driving up operating efficiencies and taking a more disciplined approach to capital investment, which we believe will yield better shareholder returns over the long-term. In addition, M&A activity has become meaningfully more active in the last several months at both the corporate and asset level. We think this consolidation will result in additional capital efficiency gains through concentration, scale and competitive advantage and historically is a sign of a more healthy investment environment in the sector.
Top Contributors/Detractors to Performance
Quarterly Attribution Analysis
When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.
Baron Energy and Resources Fund jumped 17.16% in the second quarter and outperformed the S&P North American Natural Resources Sector Index by 465 basis points, due to a combination of stock selection and relative sector/sub-industry weights. Smaller cap energy companies performed well in the quarter, and the Fund’s bias towards these companies also helped relative performance.
Investments in the oil & gas exploration & production (E&P), equipment & services, and storage & transportation sub-industries of the Energy sector and outperformance of Flotek Industries, Inc., the Fund's largest Materials holding and the second largest contributor to absolute performance, contributed the most to relative performance. E&P holdings outperformed their index counterparts after increasing 25.1%, with Rice Energy, Inc., Memorial Resource Development Corp., and Newfield Exploration Co. leading the way. Rice Energy was the third largest contributor to absolute results. We sold Memorial when shares rebounded in the wake of news that it was being acquired. Shares of Newfield rose on two raises in production guidance during the quarter, driven largely by strong performance of its highest return assets in Oklahoma. Significantly larger exposure to E&P stocks, which gained 17.6% in the index, as well as positive stock selection, contributed 344 basis points to relative results. Strength in equipment & services was mainly due to the outperformance of U.S. Silica Holdings, Inc., which was added in May. The company produces industrial minerals for the oil and gas, glass, chemical, and building products industries. Lower weight in Schlumberger N.V. and outperformance of Halliburton Co. within equipment and services also aided relative performance. Within storage & transportation, meaningfully larger exposure to this strong performing sub-industry and outperformance of Energy Transfer Equity, L.P. and Targa Resources Corp. added the most value. Energy Transfer Equity was the largest contributor on an absolute basis, while shares of Targa increased on the strength of improving commodity prices and cash flow prospects.
Lower exposure to outperforming gold stocks within the Materials sector, average cash exposure of 4.4% in an up market for energy and energy-related equities, and underperformance of Renewable Energy investments detracted the most from relative results. Weakness in Renewable Energy was mostly attributable to the underperformance of SolarEdge Technologies, Inc., a provider of solar panel optimizers and inverters, and Tesla Motors, Inc., an electric vehicle manufacturer. SolarEdge was the third largest detractor from absolute performance, while Tesla’s shares fell due to concerns over dilution from recent equity financing and the complex Model X ramp and execution risk. The market also appeared skeptical of Tesla’s announced intent to buy solar energy company Solar City. We feel good about Tesla’s strong brand and its execution on two top-of-the-line cars. We are evaluating the potential implications of a Tesla/Solar City deal.
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