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