Written by Tom Armistead
The Energy Report: Evan, welcome. You have achieved successes in growing portfolio value in the commodities space. What are the best ways to do that for an energy portfolio?
Evan Smith: It depends on the investment cycle and the markets. Sometimes it's better to buy the stocks because the assets are cheaper on Wall Street than they are out on the field. Generally, we construct a portfolio of oil and gas companies that have the ability to produce above-average growth in production, reserves and cash flow on a per-share basis. If it's an early-stage company in the exploration phase, reserve growth and success with the drill bit will be very important.
North American shale plays have become an enormous focus for many investors because you're eliminating much of the geologic risk: The resource is known to be there, it's just a matter of the application of technology to bring down costs and to extract commercial volumes from a known resource.
The technology has really changed the game. Horizontal drilling and hydraulic fracturing have created a lot of value. It's a big shift we've seen over the last several years away from conventional exploration, whether it's in North America or overseas, and more capital has flowed into North America.
TER: What role do the prices of oil, gas and natural gas liquids (NGLs) play in growing an energy portfolio?
ES: They are an important piece of the puzzle, but there are other things to consider. Over the long term, selection of quality management teams and a quality asset can override a difficult or challenging commodity environment. In the short term, stocks are going to be more correlated with the relevant commodity price.
An active manager can add value through the selection of companies with management teams and assets that can show growth, production and cash flow on a per-share basis. At high commodity prices, many people in the industry can make it look easy.
A lower commodity price shakes out either the weaker assets or the weaker participants. Commodity price makes a difference, but it's not one of the key drivers over the long term. Management teams that are able to grow reserves, production and cash flow per share will create value for shareholders.
TER: Natural gas has been stuck below $4/thousand cubic feet ($4/Mcf) since June. What will it take to move the price above that line?
ES: It is going to take some kind of balancing of supply with demand. We've seen supply growing enormously over the last several years, much faster than demand has risen. That's principally due to the prolific nature of some of the shale plays here in North America. We don't have an opportunity to export. Some companies are working to export via liquefied natural gas (LNG), but that's at least a couple years away. The power market is the big growth driver for demand over the next decade. It will be slow to develop, but that will be the biggest incremental opportunity to raise demand relative to supply.
The rig count has declined by more than 50% over the last two years, and yet we continue to see a steadily increasing supply of natural gas. It's a testament to the technology that has been developed by the industry to drill faster and more efficiently and to unlock and produce more reserves with less input. It truly is a disruptive technology, so disruptive that we've found ourselves in a glut of natural gas.
The key is for dry gas extraction to become profitable. The focus is going to have to be on reducing costs, as an operator has to focus on drilling only the very best wells that have good rates of return in a sub-$4 natural gas environment. That excludes many conventional reservoirs in the U.S. Many of the larger, independent oil and gas companies are saying they haven't targeted a dry gas well in three years, yet the associated gas (gas co-produced with oil) from oil shale reservoirs has been enormous. We continue to see an oversupply situation, and probably will for the rest of the decade.
TER: You referred to the prolific nature of the wells; do you think that's sustainable? There are some analysts who are seriously questioning that.
ES: There have been some questions raised about the sustainability of certain fields, and that's a valid question. We saw that with the Haynesville field in northwestern Louisiana and east Texas several years ago. That was the fastest-growing natural gas field in the country—massively prolific wells—but they were expensive wells to drill and there's no capital being directed there. Haynesville will phase out and continue to decline unless natural gas prices are high enough to justify drilling wells there. The Marcellus and Utica shale wells have taken the spotlight; the resource is enormous in these plays. The wells are getting better. Completion methods are improving and production continues to ramp up.
Most of the activity has been more oil-directed these days, for instance, in the Bakken in North Dakota and in South Texas in the Eagle Ford. Those are the biggest oily plays right now. I think in 2014, people in the field will have delineated most of their acreage and are going to turn these things into a pure manufacturing process with pad drilling. Continental Resources Inc. (CLR:NYSE) is testing 16 wells per pad in the Williston Basin in North Dakota. The company will repeat that pattern and drive costs down. We've seen a big shift to multi-well pad drilling in 2013, but I think it's going to become much more standardized in 2014. The efficiencies that we've seen, which have led to more productivity with fewer rigs, will probably remain and perhaps even accelerate in 2014.
TER: Your Global Resources Fund (PSPFX) has several master limited partnerships (MLPs), which all need to constantly raise capital. How will the end of quantitative easing affect them if it results in rising interest rates?
ES: The low cost of money has aided many asset classes. I don't think the S&P 500 would be at record highs if we didn't have accommodative Federal Reserve policy, but that goes for many risk assets. Since the word "taper" was mentioned by Chairman Bernanke in the April-May timeframe, we've seen the MLPs as a group trade pretty much sideways. MLPs rely on access to debt and equity financing to finance their growth. How they create value is historically through consolidation and acquisition of existing infrastructure or through organic projects, because of the need for infrastructure in many of these prolific, rapidly growing shale basins.
MLPs have generally outperformed dividend-paying stocks like utilities and telcos. The key differentiator for MLPs is the growth in dividends that most MLPs and their business strategies provide. The MLP asset class is still a better opportunity than 10-year government bonds, with 5–7% yields on average, versus 2.8%. I think the Federal Reserve is on path to keep interest rates low for a long time, so I think midstream MLPs are still an attractive opportunity.
TER: Your fund invests in natural resources for both energy and basic materials. What are the most exciting equities in the fund and why?
ES: We take a diversified approach to natural resources investing: energy, food, timber, base metals, precious metals and chemicals. We're attracted to opportunities like Sanchez Energy Corp. (SN:NYSE)and Bellatrix Exploration Ltd. (BXE:TSX).
Sanchez went public just a couple years ago. It had a decent-sized position in the Eagle Ford, which it has grown to over 125,000 acres—pretty sizeable for a small-cap. Sanchez was producing 600 barrels of oil equivalent per day (600 boe/d); now it's over 12,000 boe/d and should be around 15,000-17,000 by the end of the year. When it became public, its acreage was in the Eagle Ford, but not all the Eagle Ford acreage is the same. Sanchez was a little on the fringe, not considered as attractive as some plays. But the company has shown that it's very competitive and that the wells have performed better than expected.
You've got a high growth opportunity here with a relatively large acreage base for which the market's only paying about 3.5 times cash flow.
Bellatrix Exploration is a Canadian company with just under $1B in market cap. The stock has done very well this year, but it continues to trade at a discounted valuation versus its peers, given its level of growth. It's trading at 3.5 times cash flow. Cash flow is probably going to grow 60%-plus next year. I've been impressed with the economics of the wells. Relative to its peers, the company should be one of the faster growers over the next couple of years as far as cash flow per share. Yet its recycle ratios, which are a measure of capital efficiency, are some of the highest of the peer group. To combine high growth with high capital efficiency usually drives returns higher and creates value for shareholders. Bellatrix has done a good job of that in 2013, and I think that should continue through 2014.
TER: For the Global Resources Fund, you rate the potential risk/reward squarely in the middle of the range. Do the energy stocks push that rating up or down compared to the other stocks in the fund?
ES: For energy, we're more constructive on the growth opportunities. We're probably a little more constructive on oil prices than some other commodity prices. We'll see quite a few opportunities where the value creation by management teams should be achievable over the next several years in an $80–100/barrel ($80–100/bbl) crude price environment.
It's a little more challenging on the mining side. Commodity prices have been a little weaker. You're seeing a needed pullback in the capital that's being spent on mine expansions. But there are some interesting opportunities in the mining space, some really cheap stocks that investors have walked away from and left for dead. I don't think it would take too much to change the sentiment in that space and revive some of those cheap stocks.
TER: Diamondback Energy Inc. (FANG:NASDAQ) and Pioneer Natural Resources Co. (PXD:NYSE)have both enjoyed very strong years. Diamondback's share price has gone up triple from what it was a year ago. Pioneer has risen 85%. Should we expect that growth to continue?
ES: It's hard to predict what the share prices are going to do for those stocks over the next year, especially considering how well they've already done. I think the key driver that unites both of those stocks has been the Permian Basin and successful tests of horizontal wells there. The unconventional resource is enormous. This year seemed to mark the official entrance of the Permian Basin into the shale space.
I think 2014 will continue to be a big year for delineation. As you mentioned, the stock prices have reflected a lot of potential value creation in a relatively short amount of time. In some cases the resource will have to catch up with the stock prices, but in the case of Pioneer Natural Resources, the stock's trading at around $180/share after touching $220 just a few weeks ago. It's had a nice healthy pullback, but if our assumptions are correct, the estimated net asset value could be $350/share or $400/share for Pioneer Natural Resources. Theoretically, there's a double still in the stock. When will that be realized? It's hard to say. What would take it take for it to happen? It could happen any time. We remain constructive on Pioneer. That's been a holding for us for some time. Despite some sizeable gains, I think there's a good opportunity for the shares.
The supermajors have largely missed the North American shale boom, and they've made ill-timed acquisitions in the past. The Permian seems to be getting better. Pioneer Natural Resources released some really amazing results recently from its wells in the middle of the basin. Some wells measured over 3,600 bbl/d in initial production, a record for the basin. This would be a likely target for a major or national oil company.
TER: The price for West Texas Intermediate has been retreating for the last several months. Does that threaten the continued growth of the shale oil producers?
ES: If there's a meaningful decline, I think you would see a reduction in capex spending. Most of these plays show favorable economics down to $60 or $50/bbl, even less than that in some cases. You just might have a pause by some players in the industry at under $80/bbl, but it would take a decline closer to $65 or $60/bbl to see any real, sustained declines in drilling budgets.
TER: What's your parting recommendation for energy investors in oil and gas today?
ES: We've had a good year; 2012 was kind of a tough year for energy investors, flattish at best. 2013 made up for that. Generally the oil price helped, but it was really growth in North American shales that buoyed the market. That's a trend that's going to continue. Especially as the manufacturing process becomes more widely implemented by more producers, you're going to see cash flows growing faster and companies self-funding, perhaps even with excess cash remaining.
It's going to be important for investors to monitor what the management teams do with that cash. In an ideal environment, they will find places to deploy that capital for growth. If the rates of return don't appear to be that attractive, then they would return cash through dividends and stock buybacks. We're fans of dividends and stock buybacks in general. We like growth, but if profitable growth is hard to find, then we'd rather see that cash returned to shareholders.
TER: Evan, thank you very much. This has been a very interesting talk.
Evan Smith joined U.S. Global Investors in 2004 as co-portfolio manager of the Global Resources Fund (PSPFX). Previously, he was a trader with Koch Capital Markets in Houston, where he executed quantitative long-short equities strategies. He was also an equities research analyst with Sanders Morris Harris in Houston, where he followed energy companies in the oil and gas, coal mining and pipeline sectors. In addition, Smith was with the Valuation Services Group of Arthur Andersen LLP. Smith holds a Bachelor of Science in mechanical engineering from the University of Texas in Austin.
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1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family owns shares of the following companies mentioned in this interview: None.
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3) Evan Smith: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Global Resources Fund holdings include Continental Resources, Sanchez Energy, Bellatrix Exploration, Diamondback Energy and Pioneer Natural Resources. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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