It's no great secret that energy has taken a beating over the last few quarters. In this post, we'll learn how funds have stayed afloat.
When a mainstay of the global oil complex announced it may reduce its long-term exposure to oil with a public offering, the news sent a bearish signal reverberating across the Energy sector. While this possible IPO by Saudi Aramco wouldn’t involve the most valuable production assets and reserves, it embodies the current turmoil in Energy. There is additional negative news coming from almost all major Energy players. BP plans to cut 7,000 crude oil production jobs. Chevron plans to reduce its workforce by a similar amount. Schlumberger has laid-off 34,000 employees since 2014.
The energy shock has naturally spread to investment managers who choose to concentrate on this volatile sector. Investments in the distressed debt of energy companies in 2015 led to the closure of Achievement Asset Management, whose founder blamed losses not only on the decline in energy prices, but also on “the crowded nature of this market” and a “decline in the availability of liquidity”. These are both frequent themes in Novus research. We have found that one advantage of the sector is its relatively high dispersion, theoretically providing ample opportunities for alpha. Thus, even with the present risks, managers are unlikely to meaningfully reduce their exposure to the sector. Given these trends, we wanted to uncover how active energy managers are navigating this turbulence. To answer this, we constructed a simulated portfolio of energy specialists to analyze the composition of their recently filed holdings, shifts they’ve made over time, and the level of hedge fund crowding in energy.
We chose 25 equity hedge funds that have consistently high exposure (most with 90% or more) to energy. The simulation excludes positions that are less than 2% of the manager’s public portfolio to reduce noise, while skewing the analysis towards meaningful positions. The funds were equally weighted and positions were value weighted, with quarterly rebalancing. Below are the managers in our energy specialist portfolio:
Each position in the simulation was tagged with its sub-industry code, so we could highlight which areas of the sector our set of energy specialists has the most conviction in. Looking at the top 50 positions, we see oil and gas storage/transport companies represent just under 50% of the portfolio and exploration/production companies represent about 30%. Isolating only the top ten positions, we see midstream energy companies hold a much larger majority (65%). This majority has been consistent over the last two years: In aggregate, these managers have sought midstream exposure.
The composition of the top 20 positions at the start of 2014 shows a 60% midstream majority, with the remaining exposure mostly upstream. As of December 2015, the top 20 has slightly reduced exposure to midstream companies, still representing 56% of the portfolio, and diversified the side once controlled by upstream companies.
Our managers have reduced exposure to companies with revenue directly correlated to the price of oil, while adding exposure to companies which are purportedly more insulated. Fundamentally, midstream companies and MLP’s are perceived as safer investments when oil prices are falling because they do not take ownership of the commodity. Midstream companies can also diversify the type of commodity and aren’t confined to crude oil storage/transport. They’re able to process natural gas, natural gas liquids (NGL’s), and other petroleum products.
This midstream tilt has been a relative benefit to the portfolio in terms of return on invested capital. Annualized ROIC was -16.13% for Storage/Transport compared to -22.48% for exploration/production companies.
Relative to energy benchmarks, the above tilt has resulted in outperformance above both the S&P 1500 Energy TR index and the Alerian MLP TR index over the last two years, although the three return streams have converged in the fourth quarter of 2015.
The chart below compares the simulated performance of the portfolio to both the Bloomberg Sub Brent Crude TR index (BM1) and the Bloomberg Sub WTI Crude Oil TR (BM2). These indices reflect the return of their underlying crude futures prices. The performance of our simulated portfolio had a lagged reaction to the severe drawdown in oil prices during the second half of 2014. By the beginning of 2015, it began to move in a more correlated manner with the two oil indices.
Top Positions in Q4
Here are the top ten positions behind the midstream majority above, and the number of our sample funds who hold them. They accounted for 30% of the portfolio as of the Q4 2015 public holdings.
Enterprise Products Partners (NYSE: EPD) is the largest position in the portfolio and has the highest consensus among our group of managers with 11 owners. EPD was conservative while oil/natural gas prices were high and didn’t issue excessive debt or significantly increase its cash distribution, preserving sustainability in times of financial stress. These decisions have allowed the company to maintain its investment grade rating without cutting its distribution, in contrast to say Kinder Morgan in late 2015. The company is perhaps favored for its commodity diversification. Its largest business segment is natural gas liquids pipelines, not oil, and record exports of NGL’s are benefitting its fee-based pipeline businesses.
The chart above displays EPD’s share price over the last two years, as well as the quantity held by the simulation. Beginning in Q3 2014, our managers began accumulating shares of EPD as the price decreased and aren’t alone in their EPD buying. The stock has 56 owners in Novus’ Hedge Fund Universe, who collectively control 3,700% of the trailing 90-day average daily volume. This results in a 0.96 crowdedness score, the third highest score in the portfolio.
Our main tool to identify hedge fund crowding is Novus’ Hedge Fund Universe (HFU), a value-weighted portfolio that combines public holdings data from 1,200+ hedge funds. We can compare the positions in our simulated portfolio to the HFU’s aggregate ownership and calculate a proprietary crowdedness score. In the table below, we show the largest 20 positions in the portfolio sorted by crowdedness. They comprise 45% of the portfolio and have a weighted average crowdedness score of 0.88. This is near the 95% percentile of most crowded names, as the distribution is non-normal (heavy negative skew). Our managers are clearly trafficking in crowded energy names.
Compared to the top ten positions sub-industry pie chart above, sorting on crowdedness results in nine of the top ten positions being midstream companies. Aside from Pioneer, we don’t come across another upstream energy company until Diamondback Energy, whose crowdedness score is below our internal threshold of being a crowded security. The last column displays each security’s return from 7/1/2015 to 2/29/2016 and shows some of the most crowded names had steep losses when compared to securities with a score less than 0.85.
Q4 Position Changes
Below are the largest position entries and increases during the fourth quarter of 2015.
The recently announced acquisition of Columbia Pipeline Group by TransCanada strongly suggests our managers sizing of CPGX was speculation that the company would become an acquisition target. The CPGX acquisition represents a pivot to external growth for TransCanada, after it was denied a federal permit for the highly contested Keystone XL pipeline. Columbia Pipeline has a developed midstream natural gas business which connects the Mid-Atlantic States to the Gulf of Mexico. Its storage business is also robust, described on its website as “one of the largest underground natural gas storage systems in North America”. The company’s declared dividend and high dividend growth rate (“Through 2020, we expect a 15 percent annual average growth rate for our dividend”) is another likely reason for the built up position.
Occidental Petroleum Corporation, an oil and gas exploration/production company, was the second largest increase in the fourth quarter. OXY, like Enterprise Products, has diversity in its revenue streams. It runs a chemicals business which tends to benefit from lower oil prices as oil is the largest cost. The company is also geographically diverse, with output from the Middle East and North Africa, in addition to North America. Occidental is considered a “mini-major”; larger than most exploration/production companies, but not a giant. Both its size and diversification could make it a prime acquisition candidate for a larger energy company that may be hunting for smaller companies that can be cheaply acquired during this drawdown.
The two largest decreases in the fourth quarter were major upstream producers, with well-known midstream company Kinder Morgan the third largest decrease:
In the final weeks of 2015, Kinder Morgan cut its dividend payment by 75% to preserve cash for its budget and retain its investment grade rating. Our managers decided to shed their holdings of KMI, in contrast to both Berkshire Hathaway, which purchased 26.5 million shares at close to $400 million, and Appaloosa Management, which purchased 9.4 million shares of Kinder Morgan Inc. with a market value of $140.9 million. Appaloosa is not only apparently bullish on KMI, but also bought 5.9 million shares of the Alerian MLP ETF which holds midstream energy companies.
Over the course of 2015, Kinder Morgan and Energy Transfer Equity were major alpha detractors for the simulated portfolio. Surprisingly, it is an upstream company that stands out as a major contributor of security selection alpha.
As we saw above in the crowdedness table, Diamondback Energy (NYSE: FANG) is not a crowded stock based on our HFU, but is a favored upstream company by our set of energy specialists. It’s one of the few upstream energy companies that didn’t take on excessive debt from the high-yield debt markets when oil prices were high and credit was readily available. The company continued to resist the debt markets by holding three stock offerings in 2015 and announced a fourth offering in January to raise needed cash. Our managers trimmed their ownership throughout 2015 as the price appreciated. Diamondback was the 5th largest position in the portfolio based on Q2 2015 public holdings, and then fell out of the top ten in Q3. As of Q4, it still maintained a 1.5% position size in the simulated portfolio. Our set of managers may like the company for its debt ratios relative to other producers, or are speculating that it could become a takeover target by the larger energy producers.
Analyzing our simulated portfolio of energy specialists, we saw three major themes that answer how they are navigating the energy industry’s turbulence. Our managers are shifting their exposure down the oil supply chain, diversifying their commodity exposures, and speculating on possible M&A activity in the energy sector. Defensive posturing towards more insulated midstream and service companies in the energy supply chain is common among our managers. They diversified their commodity exposure across oil, natural gas, and natural gas liquids with companies such as EPD, CPGX, and OXY. Finally, M&A speculation drove sizing in stocks such as CPGX, FANG, and OXY. Exxon Mobil’s recent debt offering reinforces this concept and is a sign the giant may begin an acquisition spree. Declines in oil prices are usually accompanied by an increase in M&A activity, which in turn indicates a general recovery in commodity prices.
What makes a good portfolio manager? Is it superior research and their feel for the markets? Or is it their ability to time trades and manage risk? Is it art or science? We think there are definite elements of gut and instinct in portfolio management but for the most part, we’re concerned with things we can measure. The decisions that PMs make must be quantified and analyzed. After all, whatever drives the PM’s investment process should ultimately translate into returns for investors.
In this report, we ranked the best portfolio managers in the world, and found 16 that, year after year, have landed in the first quartile for win/loss ratio and position sizing skill among all hedge funds. Analyzing data since 2008, these managers have proven their ability as they navigated through disparate market environments and survived massive alpha drawdowns.
What’s in the report?
- A ranking of the best portfolio managers
- Detailed analysis on the top five managers
- The top five positions for these managers entering 2016