Review and Outlook
The first quarter of 2016 marked another period of volatility for the market sectors in which we invest and, consequently, Baron Energy and Resources 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/barrel before rebounding to near $40/barrel by quarter end. Significantly warmer than normal weather in the U.S. also led to natural gas prices declining to their lowest level since the mid-late 1990s, 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, metals prices, particularly for gold and iron ore, staged a quite 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 amidst this period of heightened volatility has been quite severe; but despite the disappointing performance, we believe that the portfolio is well positioned to show improved performance in the upcoming quarters and years.
It is our view that energy markets have bottomed, and while we expect ongoing volatility in the commodities and stocks, we are more convinced that the current industry setup is going to lead to a more sustained business recovery over the next three to five years as hydrocarbon demand grows faster than supply.
Our focus remains on owning companies that we believe have the wherewithal to survive the current environment and thrive as prices recover. With our investments in conventional energy companies, we remain focused on those that 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. We have also 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 no concerns about financial viability or financial stability and believe that the markets are significantly undervaluing the assets and growth potential of these companies.
Over the long term, we see continued growth and return opportunities for oil & 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 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 & gas industry to bring increasing growth and prosperity to more parts of the world today and for the future.
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 declined 3.94% in the first quarter and trailed the S&P North American Natural Resources Sector Index by 10.20%, due to a combination of stock selection and sector/sub-industry weightings.
The Fund’s investments in the oil & gas exploration & production (E&P), equipment & services, and drilling sub-industries of the Energy sector and its sole Industrials holding contributed the most to relative performance. Strength in E&P was mainly due to the outperformance of Parsley Energy, Inc., Rice Energy Inc., and RSP Permian, Inc., which were also the Fund’s three largest contributors on an absolute basis. Oil States International, Inc. added the most value in equipment & services, while Helmerich & Payne, Inc. aided relative performance in drilling. Within Industrials, shares of Primoris Services Corp., a specialty construction and infrastructure company, rose after announcing a slew of significant projects in the quarter. These announcements added to the company’s already strong backlog and provided additional earnings visibility over the next 12 months.
The Fund’s Materials and Renewable Energy investments, its oil & gas storage & transportation and refining & marketing holdings within the Energy sector, and its average cash exposure of 16.5% in an up market detracted the most from relative results. Weakness in Materials was mostly attributable to the underperformance of Flotek Industries, Inc. and lack of exposure to the strong performing gold and diversified metals & mining sub-industries, which together account for more than one-third of the benchmark’s exposure to the sector. These sub-industries rose 50.2% and 40.2%, respectively, within the index, detracting 208 basis points from relative results. Within Renewable Energy, underperformance of TerraForm Global, Inc. and TerraForm Power, Inc. detracted from relative results. These stocks fell due to uncertainty related to the implications of a potential bankruptcy of parent company SunEdison. We continue to hold these stocks as we believe they are solvent and have enough liquidity to continue operating in the near-term. Underperformance of oil & gas storage & transportation holdings detracted the most from relative performance after declining 16.2%, led by Energy Transfer Equity, L.P., Columbia Pipeline Partners LP, and Scorpio Tankers Inc. Energy Transfer Equity was the largest detractor on an absolute basis, while shares of Columbia fell after its parent sold itself to TransCanada, creating uncertainty around Columbia’s growth plan. We exited our position. Shares of tanker company Scorpio declined as macroeconomic concerns around economic activity and ability to raise capital overshadowed the solid fundamental performance of tankers. Oil & gas refining & marketing holdings Marathon Petroleum Corp. and Valero Energy Corporation also underperformed, but this negative effect was mostly offset by lower exposure to this lagging sub-industry, which declined 8.6% in the index.
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