Baron Energy and Resources Fund (BENIX)

Portfolio Management

James H. Stone

Fund Manager since 2011

View All Commentary by James

Fund Description

Baron Energy and Resources Fund invests in securities of energy and resources companies and related companies of all sizes.


Portfolio Commentary

Institutional Performance

Review and Outlook (for quarter ended 6/30/2016)

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

Contributors (for quarter ended 6/30/2016)
  • Energy Transfer Equity, L.P. owns equity and general partner interests in several master limited partnerships. During Q2 Energy Transfer recovered all recent losses due to the increased probability that the proposed merger with Williams Companies would fall apart. The deal had begun to look increasingly unattractive to Energy Transfer investors due to the continued fall in oil prices. Its collapse was viewed as a positive as it will reduce Energy Transfer’s leverage and add to its financial flexibility.

  • Flotek Industries, Inc. supplies chemical additives to the global oil & gas industry. The company has a proprietary product (CnF) that helps improve oil & gas shale well productivity. Shares rallied sharply in Q2 following results for CnF sales that exceeded Street expectations and an announcement by a major customer for plans to significantly increase drilling activity. We expect Flotek to benefit from expected ramp-up in well completion activity, higher customer penetration, and increased average CnF loadings per well.

  • Rice Energy Inc. is an independent oil and gas exploration and production (E&P) company focused on the Marcellus and Utica shales in Pennsylvania and Ohio. Shares rose on a rally in natural gas prices, strong production and lower well costs. In our opinion, Rice is one of the most attractively valued E&Ps and offers exposure to some of the best acreage and industry-leading production growth. We also think that the market underappreciates the value of Rice’s midstream holdings.

Detractors (for quarter ended 6/30/2016)
  • Valero Energy Corporation is the largest independent refining & marketing energy company in the U.S. Shares suffered in Q2 due to refining margins that missed Street forecasts. Stronger-than-expected production and inventory of gasoline overwhelmed strong demand, resulting in lower-than-anticipated margins. Valero continues to produce strong free cash flow and return cash to shareholders through rising dividends and share repurchases and we think this will result in a higher share price over the next several years.

  • Bonanza Creek Energy, Inc. is an independent oil exploration and production company operating in Northeast Colorado. The shares underperformed during the period held as balance sheet concerns were magnified by lack of visibility on non-core asset sales, which we had anticipated would close and enhance the balance sheet. Instead, Bonanza saw a reduction in the size of its bank credit facility that was larger than we expected, adding further risk to the company’s outlook. We chose to exit our position.

  • Shares of SolarEdge Technologies, Inc., a provider of solar panel optimizers and inverters, fell due to fears of slowed growth in the residential market. While we agree the U.S. solar market is transitioning, as long as regulatory support is intact and prices for adoption continue to fall, we think SolarEdge will grow its share in a growing market. SolarEdge is focused on long-term growth by diversifying its customer base, increasing automation, rolling out new inverters, and seeking market share in the commercial and energy storage markets.

Quarterly Attribution Analysis (for quarter ended 6/30/2016)

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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The prospective performance of the companies discussed herein is based on our internal analysis and reflect our opinions only. We cannot promise future returns and our opinions are a reflection of our best judgement at the time of publication. Our views are not intended as recommendations or investment advise to any person and are subject to change at any time based on market and other conditions and Baron has no obligation to update them. Investing in the stock market is always risky. Current and future portfolio holdings in the Fund are subject to risk.

Source: FactSet PA.