Friday, 25 May 2012

Specialist Manager Series - Selecting Oil Stocks with RoundRock Capital

Selecting Oil Stocks

“Hedge Fund Insight” will feature a series of articles to share the expertise of specialist equity managers. The first explores the approach taken by RoundRock Capital Partners, LP which specialises in oil and gas shares in the hedge fund format.

Since 2001 RoundRock Capital Partners, LP (“RoundRock”) of Dallas, TX has run a long/short equity fund and managed accounts investing in American oil and gas related companies – everything from integrated oil companies, through E&P  stocks and the oil service sector to utilities and refiners. The whole universe for RoundRock is given in Table 1.  

 Peter Vig, the Founder and Portfolio Manager, and the two Co-Portfolio Managers  Wade Suki and Ben Vig  employ a bottom-up, research intensive approach, focusing on company management and fundamentals, within a thematic framework.  In the day to day Wade Suki focuses on US E&P , diversified energy companies and natural gas, whilst Ben Vig specializes on the oilfield service sector and Canadian energy stocks. 

RoundRock takes a private equity approach to assessing the value of an energy company. That is it will calculate, given its assets in the ground and prospective production (and where those assets are located), what the company might be worth to someone else in the industry. The view taken by RoundRock as investors is that if the market does not recognising the inherent value at the time it  purchases shares it will do at some point.  RoundRock Capital is not an activist shareholder itself, and cannot be given the size of the capital it manages, but Wade Suki says that they have assisted activist shareholders in names other than Pioneer where they have been invested.

Macro Investment Themes Provide the Framework

RoundRock Capital sets medium and short term themes for its energy strategy, based on its extensive fundamental industry-level knowledge and recent network input.  The themes will inform the biases built into the portfolio structure.  Two of the current medium term themes are given in Graphic One.

The macro theme of being bullish for oil prices in the medium term started to come into play after the collapse of oil prices along with other commodity prices in the Winter of 2008-9. The RoundRock team took the view that oil demand was going to increase in the longer term and hold up better than the pessimists were predicting in the shorter term.
                                    Graphic 3. Crude Oil Futures Price (Brent) Sept 2007 to Sept 2010

The second macro theme was that there will be a natural ceiling to gas prices in North America. This is essentially because of the impact of new large resources on the supply of gas. A lot of associated gas is produced as a by-product of the exploitation of unconventional resources like shale. The gas goes into a pipeline for distribution even if the resource is primarily being exploited for oil. So there is a lot of potential gas production that can be readily switched on. RoundRock Capital believe that there will be ready new supply of gas once the traded price of gas gets to between $4.50 and $5.00/MMBtu, so creating the cap.

These two themes led to the team at RoundRock Capital, who share decision making, to look for stocks in their universe with a bias to oil in the hydrocarbon production mix.  This did not throw up a long list of candidates as the industry had been consciously drilling gas wells onshore for the previous decade. The managers were looking for shares that would receive incoming flows of capital when the oil price recovered. One of the handful of domestic (US) E&P companies with a substantial oil (price/production) exposure was Pioneer Natural Resources (PXD). At the time Pioneer described itself as “a large independent oil and gas exploration and production company, headquartered in Dallas, with operations in the United States, South Africa and Tunisia.”

Pioneer – An Oil Price Play for the Top-Down and Cheap from the Bottom Up

“The other reason we alighted on Pioneer Natural Resources, apart from the oil exposure, ” says Wade Suki, “was that it was incredibly cheap, and cheap on just about any metric we looked at.”  Many observers thought it deservedly cheap: at various times it had been financially over-leveraged, but more significantly to investors, the management had not been able to articulate to investors on what basis they allocated capital within the business.  In particular this was an issue for investors of the exploitation of cheaper-costing onshore domestic exploration and production, versus the prospecting of expensive offshore and overseas exploration acreage. 

An initial position in Pioneer Natural Resources was bought in January-February 2009. Within six or eight weeks of acquiring their position at a mid-teens stock price RoundRock got lucky. They knew from the shareholders’ register who owned the stock. But RoundRock Capital could not know that the largest holder, Southeastern Asset Management, Inc. of Memphis, a value-oriented investment management firm with a stake just under 20%, was going to go from a passive ownership stance to becoming activist holders of Pioneer stock.  

In March 2009 Southeastern Asset Management put three of their own nominee directors on the Board of Pioneer, replacing incumbents and offered assistance to management. O. Mason Hawkins, Chairman of Southeastern Asset Management, stated in the press release “We believe the newly constituted Board will bring a fresh focus to intelligent hedging and capital allocation to complement Pioneer's operational strengths.”

The consequences of the intervention by Southeastern have been that Pioneer Natural Resources management began to live within their cashflow, and strategically focus on what they had to do. The focus was put on domestic activity, and the expensive foreign adventures were either sold off completely or PXD’s interests were reduced. South Africa is the only overseas territory to which the company has exposure today, and it is a very minor contributor to the company reserve/production profile.

RoundRock, along with other investors in Pioneer Natural Resources in 2009-10, also begin to benefit from a new trend amongst investors in oil and gas shares in the United States. There was a growing investor engagement with the exploitation of unconventional resources in the lower 48 states, and PXD had significant successes in two resource plays in recent years which tied in with that engagement.

The company has large acreage in South Texas (below San Antonio) and the Eagle Ford turned out to be one of the most attractive shale oil play in the United States, according to RoundRock’s Peter Vig.  Large domestic E&P company EOG has stated that their interest in Eagle Ford amounts to a net 1.6bn barrels of oil, making the Eagle Ford a very significant discovery for Pioneer. The anticipation of and then the actual event of the company announcement related to Eagle Ford propelled PXD shares to a new level in 2009 and into 2010 (see Graphic 4). 

Graphic 4. Price Chart for Pioneer Natural Resources Shares
- June 2008 to June 20010

Pioneer had a history of producing from small good-return-on-investment wells in the Permian Basin of Texas, an area with a long history of oil production. And it was a Permian Basin property, the Spraberry play, owned by Pioneer that was the second resource play that has impacted the share price since RoundRock Capital became an investor.

The Commodity Price And The Application Of Developing Technology

Two things fed into the growing worth of the Spraberry Play to Pioneer: the commodity price and technological developments. The appreciation of the oil price made the Spraberry Play more attractive to exploit.  The second thing was that production potential for the play grew as the resource was delineated - adding zones with multi-stage completions, a relatively new approach which made production more efficient. On top of that an additional horizontal play developed in the Wolf Camp formation in the Permian Basin.

RoundRock’s approach to E&P company selection encompasses a bias to production from technically easier resources that have the potential to be significantly enhanced by new techniques. Pioneer fits this template. Senior Analyst Wade Suki explains the principal, “We have biases towards onshore rather than offshore production. Onshore production typically has multiple pay packages, multiple sections/zones/reservoirs.  In contrast, in offshore production when your well waters out you plug and abandon it. The oil company just moves on to the next well. “ He continues, “ The advantage of onshore resource plays is that the oil companies can go back to old properties and apply the new technologies of drilling, stimulation and recovery in a way that is just not economic offshore. Also as the oil price changes, and if new zones containing hydrocarbons can be identified near old wells, then those wells that were only marginally economic can become very viable. “

Bennett Vig adds: “You will notice that when a deepwater offshore discovery is made the operators talk about how much oil they have discovered and the flow rate. They hardly ever talk about the returns to be made from deepwater, because they are not  as attractive. It can take 3-5 years to get from discovery to first oil production, and with a huge up-front capital investment: the returns are not as strong as the unconventional plays.  Onshore production does not have the long lags and massive capital spending, so returns are much better, and that is before we get to the cost of maintaining flow rates.

He explains, “Offshore wells decline very rapidly – the flow rate drops 50 or 60% in a year, and the well can peter out in 5 to 8 years.  So oil companies have to reinvest a lot of cash flow in maintaining production (by stimulation), whereas in  unconventional onshore wells  there is high decline rates in the first 12 to 24 months, afterwards there is a much gentler decline rate and the production life of the well is longer. Remember an offshore well can cost up to $100m, and it may be dry”

A Key Insight

A key insight of the RoundRock team was that they recognised early on that all the technology used in shale gas development  was applicable to conventional and non-conventional oil reservoirs.  This technology shift was going to be a game-changer for the onshore oil business in time. RoundRock was able to understand the implications of increased recovery rates and the impact on the value of reserve bookings.

According to RoundRock,  Wall Street was a little slow recognising that for unconventional plays like the Eagle Ford or the Barnett shale; the productivity per rig and the recovery factor get better through time. Experience in exploiting these resources drives down the cost per well (and you get better wells). In exploiting these onshore shale resources the  E&Ps do not have as many exploration risks - these are extensive formations covering a vast area and many times there are existing production logs from when previous wells have been drilled through them. The  companies know where the reservoir is, what the thickness is, and the quality of the rock. So, once the operators have established and held (in a legal sense) their base of acreage, drilling becomes a manufacturing process – drill bit success can be 100%.

Horizontal drilling has a big part to play in the economics of the unconventional plays. A vertical well may not even produce hydrocarbons if the rock is tight. Horizontal drilling allows for more of contact with the formation containing the hydrocarbons. The horizontal component of the drilling plan can give as much as 3-7,000 feet of contact zone. There may be 20 to 40 stages of rock penetrated with fraccing. The result is a massive increase in the surface area that is producing from the reservoir relative to a vertical bore hole.

Eventually the Street has taken on board the conceptions of RoundRock Capital about the impact of the exploitation of unconventional resources and, in particular, what the techniques applied to those resources will do to the economics of conventional oil and gas fields.  Those concepts have been baked into the share price of Pioneer Natural Resources by now – as shown in Graphic 5, the longer term share price chart, which shows the shares trading around $97 at the time of writing.
Graphic 5. Weekly Price Chart for Pioneer Natural Resources Shares
 3 Years to end-March 2012 (price rhs with 200-day mav, volume lhs)


Advantages of a Specialist Energy Manager

Would a non-specialist asset manager have been able to assess the prospects for Pioneer Natural Resources in the same way as RoundRock Capital did and does? The answer is no because of a number of capabilities that feed into RoundRock being a specialist manager.

The Firm’s professionals take advantage of industry information that others do not consider or do not have the technical background to analyze:

qExtensive Industry Contacts with both public and private companies.
qManagement and non-Management Interviews.
qIndustry Functions and Conferences , particularly those geared toward geology, technology and operations. At a recent oil industry conference of 3000 delegates RoundRock were very unusual in not being operators.
qField research and site visits.

qAccess to proprietary field level data in addition to state level commission data

RoundRock Capital, as an industry specialist, has technical capabilities beyond most professional investors.  The team’s professionals can:

qRead and interpret well logs, drilling data, production history/declines rates and rig counts
qAssess and critique engineering reserve reports
qApply industry-related adjustments, when applicable, to company forecasts
qFully comprehend operating data and metrics

RoundRock Capital has the background to implement its investment edge. There are over 5o years of combined investment and management experience in the energy sector in the team. They have over 15 years combined years of direct energy operating experience. Plus between the three principals there is significant energy equity research experience at investmet banks, mutual funds and hedge funds.

It is the combination of fundamental industry knowledge and understanding of how the Street does perceive and will perceive the emerging facts that power specialist sector hedge fund managers. In the case of RoundRock Capital they are long-term, value-oriented investors who employ a bottom-up, diligence-based ‘private equity’ style approach. They also have an industry-wide edge, which is the ability to triangulate information to reveal trends not yet manifested in current equity prices.


It could readily be thought that the example of energy stock selection given here cannot be typical. For one thing the shares have been a five-bagger over the three years since they were first purchased. Given the return and the holding period, isn’t the example an extreme one? Yes and no.

The yes is that no asset manager’s portfolio is made up solely of 5 or ten-baggers. Returns come from managing a whole portfolio of assets with a range of different risk attributes and, importantly for specialist managers, varying correlations to one another. Portfolios targeting double digit returns should have some potential 3-5 baggers in there.  PXD is still RoundRock’s largest position and given the targets that they have for the shares they still see a further upside of 40% for the shares.

The no, the manner in which the holding in PXD is typical for a specialist long/short equity manager, is that holdings that are held for multiple years and have generated outsize returns to date are highly likely to have multiple stages of development. Or, if you like, the underlying story for a successful holding of such size over such a (relatively) long period will have to have changed. 

 Initially this was a value play with a commodity price kicker. Then there was a period in which the shares were driven by activism, then major exploration success, then, through the application of technology, a period in which the shares appreciated because of the owned assets were better than previously thought. And finally the shares of PXD have been appreciating partly because the management are doing the right thing for stakeholders – production estimates are being revised up, as is the rate of reserve replenishment. 

The example of Pioneer Natural Resources for RoundRock Capital Partners LLP illustrates that equity hedge managers need to be able to assess the shares by different attributes over the cycles experienced by companies – value, a special situation, a growth phase have each been seen in the last three years or so in this example. To knowingly hold on to the shares required an understanding of the management, the assets on a static basis, how the value of the assets is changed by the drill bit, and how investor flows and valuations are likely to be impacted by the developments seen. All of those things are also impacted by the global and industry level factors – the biggest externality being  oil and gas prices, but also the impact of the dynamics of supply and demand as they impact the oil service industry, which is a supplier (input cost) to exploration and production companies like Pioneer.  

The story at Pioneer may have got better through time, but that does not mean that RoundRock held the same position size throughout. The market perception of the value of Pioneer varied through time, but so did the assessment of value by RoundRock. When Wade Suki, Ben and Peter Vig judged that the market valuation did not allow enough (probability adjusted) upside potential to their own target price they reduced the position size And the same is true for the reverse situation - RoundRock have added to their position in PXD when the appreciation potential between their own fair value estimate of NAV and the market’s estimate of prospective NAV got very wide.  

Research resource is constrained in all hedge fund shops. Having spent a significant portion of that resource on a company and its shares, and bought a position, nearly all hedge fund managers will leverage that newly acquired expertise in a stock by varying the position size through time.  Nothing concentrates attention like owning a share, and ownership forces the news flow to be monitored and assessed regularly. If you are a seasoned industry specialist manager you have a much higher probability of interpreting the industry and company specific developments and the implications for share prices more accurately than a generalist portfolio manager or a junior analyst in a diversified asset management firm. So it has been for RoundRock Capital and Pioneer Natural Resources shares.