Review and Outlook
The third quarter was terrible for commodity prices, with domestic (WTI) oil prices falling almost 14% and international (Brent) prices falling 15.7%, driven down by weakening global demand and rising output. Over the next 6-9 months, global oil balances look quite loose barring a cutback in OPEC production, stronger-than-expected demand, or some other event that tightens the balances. Softer demand forecasts reflect economic weakening abroad, especially in Europe and China. Driving rising output: the return of production from Libya and a lack of cutbacks from the other OPEC producers.
Natural gas prices declined in Q3, due to strong domestic supply growth and a cooler-than-average summer. We believe the near-term outlook for prices will be weather dependent, and upside will likely be limited by the ongoing growth in gas production capacity. Longer-term, we think we could see a significant uptick in demand due to the startup of several LNG export facilities, an expected $100 billion in new petrochemical plant investments in the U.S., and the accelerated retirement of coal plants.
The U.S. rig market continued its upward progression. Improving well productivity bodes well for production growth and net asset value improvements for E&P companies, as well as for service and equipment companies.
Midstream business conditions remain robust, with U.S. infrastructure spending about $32 billion last year. We anticipate another strong year for construction of pipeline, rail, processing and export facilities as domestic oil & gas supplies continue to grow.
In a reversal of Q2, Energy stocks underperformed the broader market this quarter, largely due to the decline in commodity prices. Within the S&P 500 Energy Index, we saw significant divergences among sub-industries and individual stocks. The only sub-industry winner this quarter was refining & marketing. All other sub-industries fell, ranging from midstream (down 2.2%) to drilling (down 22.9%).
For the past several years, we have opined that oil prices would trade in a range of $80-110 for WTI for the foreseeable future. The rollover in demand and return of Libyan volumes has shifted the supply/demand balance enough that it now appears we may spend several quarters at the lower end of the range. However, we don’t think the basic premise for holding in this range has changed. Production costs, finding and development costs, and capital intensity per barrel of oil produced have not improved. Non-OPEC, non-North American production looks likely to decline and at the lower end of this price range, reinvestment could slow, which will also pressure the global production growth rate.
We remain positive on the outlook for price stability and growth for our portfolio companies, and believe that consensus will prove too conservative, causing flows to shift again and shorts to be closed. We see the best opportunities in E&P stocks with above average growth in production and cash flow per debt adjusted share, undervalued oilfield equipment and service stocks, and high growth midstream MLPs.
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.
The Baron Energy and Resources Fund (Institutional Shares) declined 8.81% in the third quarter, yet outperformed the S&P North American Natural Resources Sector Index by 122 basis points.
During the quarter, the Energy and Natural Resource segments of the overall market underperformed due to concerns about slowing global economic growth and its impact on oil demand and, potentially, corporate profits. The sharp decline in oil and natural gas prices during the quarter also weighed on these segments. In this challenging environment, the Fund’s stock selection added value and more than offset the negative effect of its relative sector weights.
The Fund’s investments within the Energy sector and its average cash exposure of 5.6% in a down market were the largest contributors to relative results. Nearly one third of the Fund’s Energy exposure is in the oil & gas storage & transportation sub-industry, including numerous MLPs which are not represented in the index, and general partnerships. Its larger exposure to this outperforming sub-industry contributed to relative results. Tallgrass Energy Partners, LP and Rose Rock Midstream, L.P., which were two of the Fund’s largest contributors on an absolute basis, were the largest contributors to the sub-industry. Other contributors were Western Refining Logistics, LP, an MLP formed by Western Refining Corporation to acquire, develop, and operate midstream energy assets; and Golar LNG Ltd., which is engaged in transportation and regassification of liquefied natural gas (LNG). Shares of Western Refining rose after it announced an agreement to acquire its parent’s southwest wholesale business, and shares of Golar LNG increased after its vice chairman bought $300 million of stock and Sir Frank Chapman joined as chairman. The Fund’s oil & gas exploration & production (E&P) holdings declined 9.8% as a group, yet outperformed their counterparts in the index by 318 basis points. Strength within E&P was mainly due to the outperformance of Athlon Energy, Inc., the Fund’s largest contributor to relative and absolute performance, and Bonanza Creek Energy, Inc., which is primarily focused on developing new resources in the Niobrara shale play in northeastern Colorado. We believe Bonanza Creek’s outperformance was attributable to positive test wells results.
While the benchmark has no exposure to Industrials, the Fund invests in energy-related companies within this sector. The Fund’s investments in the sector declined 20.5% during the quarter, detracting 85 basis points from relative performance. Weakness in the sector was mostly attributable to the underperformance of Civeo Corporation, an oilfield and mining offsite accommodations provider, and Chart Industries, Inc., an independent global manufacturer of engineered equipment. Shares of Civeo fell sharply at the end of the quarter after the company announced that it would not convert to a REIT structure as expected. Civeo also expected weaker demand in Canada and lower cash flow estimates for the fourth quarter and 2015. The Fund exited its position as the investment premise had changed and the resulting valuation no longer met our objectives. Shares of Chart Industries were under pressure due to challenging biomed and industrial gas markets and uneven sales in China. We see these as non-structural issues and believe that Chart Industries will benefit as global development of LNG infrastructure accelerates.
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