In this follow-up post to our previous energy piece, we'll look at the movements in the energy sector in the first half of 2016.
Earlier this year, Novus research highlighted how Energy hedge funds were positioned at year-end 2015 to weather challenging sector conditions. Energy prices were in freefall, high correlations were abound, and dispersion was hard to capture. Six months later, the market is revealing signs of recovery. We noted that declines in energy prices are generally followed by increased M&A activity, which in turn presage a recovery in commodity prices. We’re beginning to see this happen- July had the highest total deal value of any month this year with $11bn of oil and gas transactions globally, according to Wood Mackenzie. ExxonMobil gave us a textbook example of an oil major preparing for the hunt and capturing a target. The company announced in early February that aside from acquiring shares to offset dilution, it had no plans for more buybacks. A few weeks later, it completed a debt offering that raised $12bn. By mid-July, Exxon had announced plans to acquire producer InterOil for over $2.5bn.
Production hedging can be another indicator of recovery as it suggests producers plan to increase output. A Reuters’ analysis of disclosures by the largest 30 U.S. shale firms showed 17 of them increased their hedge books in the first quarter, the most since early 2015. Given these signals of recovery, we reviewed how active Energy managers positioned their portfolios for the second half of 2016.
Novus Energy Specialist Portfolio
We created a portfolio that holds the combined 13F holdings of 25 equity hedge funds with consistently high exposure to the Energy sector. The simulation only includes positions greater than 2% of each manager’s public portfolio, skewing the analysis towards meaningful positions. It excludes any non-Energy sector securities. The funds are first equally weighted, and their positions are then value weighted, with quarterly rebalancing. These are the managers:
The climate of the broad equity market impacts the ability of most active managers to outperform the market. Each quarter, we monitor historical correlation and dispersion levels for each Russell 3000 sector. In February 2016, we found that the average pair-wise correlation was second highest in Energy at 37%, peaking as energy prices cratered. It rose steadily from a low of 26% in late 2014 as Energy stocks traded more and more in line. Below is the return dispersion across constituents of the iShares DJ US Energy Index, a more focused energy benchmark with a tilt toward exploration and production companies. Dispersion, a measure of the spread between the highest and lowest performing stocks, peaked as Energy prices began to rebound.
High dispersion theoretically provides an elevated opportunity for hedge funds to outperform through security selection for both longs and shorts. Our managers made some large active bets during the high dispersion first half.
Defensive to Offensive
During 2015, our managers shifted exposure down the oil supply chain from E&P to midstream companies. We saw a reversal of this shift in the first half of 2016, with managers showing a more offensive posture in the larger positions. It’s clear the managers have regained some conviction in explorers/producers:
Oil & Gas E&P exposure (as a % of the top 20) rose from roughly 18% at the end of 2015, to 32% in Q2.
This E&P exposure increase has manifested itself in the portfolio’s oil beta:
Decomposing this E&P positioning, the largest Q2 increases were Cimarex Energy, Pioneer Natural Resources, and Parsley Energy. Its noteworthy that our managers returned capital to the same companies they fled from in late 2015, namely Pioneer and Kinder Morgan.
The Permian basin is a large oil and gas producing area in Texas and New Mexico. The below position size heatmap displays the 35 exploration/production companies in the portfolio. Of the capital allocated to E&P, our managers deployed 65% to companies with significant Permian exposure. They also seem to favor pure-play Permian producers such as Parsley and RSP Permian, both holding an IPO in early 2014.
This concentrated bet on Permian producers was likely a dual bet on 1) The ability of shale producers to resume and scale production faster than conventional producers and 2) M&A speculation. With a production lead-time of under a year, Shale is the first swing producer to challenge OPEC. Shale production has “short-run responsiveness” and as prices rebound, production can be ramped up quickly. In the first chart below, we see Permian producers were able to reactivate their rigs at a faster rate from April lows than other areas of the US. The second chart shows that just fewer than 50% of all active US oil rigs are now operating in the Permian.
Even more meaningful is the level of production the Permian maintained over the last two years, as similar shale plays, such as the Eagle Ford and the Bakken, have had overall production declines.
This ability stems from cash as well as shale technology. In the early months of 2016, Permian producers such as Pioneer and Diamondback raised at least $2 billion from secondary issuances.
On the M&A front, shale plays, and the Permian in particular, were good areas for deal speculation. The Permian basin matched the Marcellus, SCOOP/STACK, and Eagle Ford combined in number of upstream deals. The below table is from Deloitte’s “Oil & Gas Mergers and Acquisitions Report.”
Two of the top three E&P positions in the portfolio, Pioneer Natural Resources and Parsley Energy, share a long established oil bloodline. They’re led by Scott Sheffield and Bryan Sheffield respectively, the son-in-law and grandson of Joe Parsley. Parsley was the co-founder of Parker & Parsley Petroleum, an early driller in the Permian. Scott joined Parker & Parsley in 1979 as a petroleum engineer. Ten years later, Scott was named CEO. He remained in the position after Parker & Parsley merged with T. Boone Pickens’ Mesa in 1997 and the combined company emerged under the name Pioneer. In 2008, Bryan Sheffield returned to Texas after stints as a commodity trader and founded Parsley Energy, a nod to his grandfather, as a Permian pure-play driller.
Pioneer is moving closer and closer to becoming a pure-play Permian E&P company. Over the last five years, Pioneer has divested many global assets to concentrate even more capital on Texas shale production. The company sold its Tunisia subsidiaries in 2011, its South African offshore gas resources in 2012, its Natural Resources Alaska stake in 2013, and Colorado acreage in 2015. In tandem, Pioneer is adding to its Permian holdings and growing production. It purchased Midland drilling rights from Devon Energy Corp this year and raised its 2016 production budget, in contrast to many E&P companies who have reduced their drilling budgets. Bryan Sheffield and Parsley have followed Pioneer’s lead. It’s expanding its production with current high-potential horizontal wells, and continues to acquire land and production properties in the Permian. “With oil prices rebounding and costs still declining, our decision to maintain a steady activity pace is paying off as we deliver robust production growth”, said Sheffield.
Both companies are conservative with hedging. In a Reuters interview, Pioneer COO Tim Dove said the company hedges production two or three years in advance. This has been the strategy since the 2008 crisis, when the company was caught flat-footed and had to idle almost all of its drilling rigs. “If we’re going to protect ourselves, we’re going to protect heavily,” Dove said. In a Bloomberg dual interview with both Scott and Bryan Sheffield, Scott described Pioneer’s hedging strategy with three-way collars: sell a call, sell a short put, and buy a long put. He also said 85% of production is hedged in 2016 (it gets $60 per barrel for a large chunk of its output), and 50% hedged in 2017. Parsley also maintains an active hedging program: nearly all oil production is hedged for 2016 and a significant hedge position is in place for 2017.
Pioneer and Parsley flag as both consensus and conviction positions in the portfolio. The tables below rank the portfolio using two of Novus’ 4C’s. The left shows the portfolio’s positions ranked by Consensus, or the number of managers that hold each name. 11 of the top 15 are midstream oil and gas companies. The right shows the portfolio’s positions ranked by Conviction in each name (position size divided by number of holders). 8 of the top 15 are upstream names. EPD, CLR, PXD, ETP, PE, and ENLK are both consensus and conviction positions.
One of our newly built analytics tools (currently in testing and set for early 2017 release) is the Overlap Analysis. The overlap tools allow us to see which managers have high position overlap with the Alerian MLP ETF and are contributing to the portfolio’s midstream consensus. The below network shows clustering around both the Alerian MLP ETF and the S&P Oil & Gas E&P ETF.
The below matrix is sorted by the position overlap between each of the managers in the above cluster. The percentage is based on the sum of the minimum position sizes for each position pair two managers have in common.
The below table breaks down the individual positions in the Alerian MLP ETF that are most widely held in the portfolio. Almost all of these names are also on the portfolio’s consensus list.
Our Energy specialists decided to realize profits on some of their largest Q4 bets. Not pictured in the Q4 increases table is Cabot Oil & Gas Corp, which was the largest increase in Q1 2016.
The share prices of the largest decreases and exits over the second quarter all posted double-digit gains in the first half of 2016. Columbia Pipeline’s share price quickly approached its announced acquisition price, then leveled off near its ceiling.
The portfolio’s midstream majority combined with E&P exposure swings has resulted in consistent outperformance during the last 2.5 years above all three of the energy benchmarks charted below.
Below are relative attribution summary tables for both the midstream positions and the E&P positions. Our specialists were more accurate at choosing E&P names that would outperform the S&P 1500 Energy index during the period (Jan to July) and deploying capital to those outperformers (position sizing). Capital deployment was far higher among E&P positions at 82% than with midstream positions. This year, contribution from midstream names was mostly driven by market & sector beta, and contribution from E&P names was driven by security selection alpha.
We can visually see this across the E&P positions below:
The largest alpha generators this year through July were shale producers and high conviction positions.
In the first half of 2016, the Energy sector revealed signs of recovery such as higher M&A activity, hedging for production, and ultimately a resumption of production. For the second half of 2016, the energy specialist portfolio maintained its midstream majority, in which the managers have consensus. The managers regained some conviction in explorers/producers, specifically Permian shale producers. The portfolio’s midstream majority combined with E&P exposure swings has resulted in consistent outperformance during the last 2-3 years above the S&P 1500 Energy index and more focused benchmarks such as the Alerian MLP and SPDR S&P Oil and Gas E&P.
Today, few investors realize that, by some measures, liquidity in the equity markets is below pre-Lehman default levels. For active managers, the moderate decline in trading volumes at the exchanges masks an even greater concern. Liquidity, for active managers in particular, has receded to record lows, and is set to decline even further. The problem is that traditional liquidity measures don’t take the herding behavior of active managers into account.
Crowdedness and crowd selling is now a real risk to investors, and liquidity, or lack of such, is a primary ingredient in this risk factor. This study unpacks trends in liquidity that every money manager should understand—ignoring them could be a costly mistake.
Download our latest report to learn more.Published on October 5, 2016