TWST: Tell us briefly about Orleans Capital Management and your focus on energy.Mr. Crane: Orleans started its Energy Opportunities strategy back in October of
2000, and we did that in conjunction with a research and subadvisory agreement
with Simmons & Company International, headquartered in Houston, Texas.
Originally, Orleans acted as the investment advisor and Simmons served as a
subadvisor. Recently we've changed, and created a new company called Energy
Opportunities Capital Management, which is co-owned 50% by Simmons and 50% by
Orleans, to serve as the investment adviser to take the Energy Opportunities
strategy forward.
One of the reasons for that evolution was that it enabled us to have Scott Gill,
who was Co-Head of Research at Simmons, move over to Energy Opportunities to
serve as a co-portfolio manager on the strategy. I think that's important to
what we're doing and it has really improved our capabilities.TWST: How your strategy has been impacted by the events of this past year?Mr. Crane: Well, during the first half of 2008, we were pleased with the
strategy's performance, enjoying the effects of oil approaching $150 a barrel in
the summer of 2008. On the other side of that year, in the second half,
obviously we were negatively impacted as oil prices fell dramatically. But I
think more importantly, what we saw was a great deal of forced liquidations and
selling, in energy names in particular, that were divorced from the industry's
long-term fundamentals.
Obviously we've adjusted some things in the portfolio, last year and going
forward this year, but our view is that the long-term trend with respect to
energy supply and demand, which is the primary tenet of our strategy, remains
intact. So far this year, we've already seen oil prices almost double from their
earlier lows, reflecting investor sentiment that we may be on the verge of an
economic recovery that will drive energy demand, or at least put an end to any
further erosion in demand. But more importantly, there are continued concerns on
the supply side, which are now becoming exacerbated as a result of lower capital
spending toward that supply effort.TWST: There's talk that the economy is going to remain weak and it's likely that
energy prices will remain low. Do you go along with that thesis?Mr. Crane: Well, I think that too many think myopically about the economy,
focusing primarily on the outlook for the US and ignoring the size and vigor of
the developing economies such as China and India. So while I share their concern
about the US economy, I feel pretty good about the economies of the developing
nations like China, India and Brazil and the implications to our energy
strategy. If you recall from our prior discussions, our strategy is primarily
focused on the global energy supply and demand fundamentals. On the demand side,
we have always thought that what we would see is an evolution in demand over
time with demand increasing in the developing nations of the world and a decline
in demand among the OECD and developed nations, like the US. I think we are
seeing that scenario play out today.
Our focus primarily has been, and it is one that doesn't seem to get as much
attention, the supply side of the equation. If you step back and look at the
amount of money that has been spent in terms of capital expenditures toward
exploration and production, and the fact that the result of that spending has
been flat to declining production around the world for the last several years,
you get a sense of the problem. We view that problem as a sort of capital
spending treadmill that you can't step off without expecting a meaningful impact
to supply. To us, the future supply concerns far outweigh today's demand
concerns.
I don't think the supply issue is reflected in the current equity markets
because investors are more focused on near-term concerns about the US economy
and how the current recessionary environment is going to play out. Our view is
that, over the longer term, the underlying trends in capital spending,
accelerating decline rates and the outlook for production growth make the supply
side of the equation very compelling in terms of energy investing. In addition,
because the supply considerations are so significant, capital spending will have
to increase substantially even in the absence of a significant increase in
demand as we go forward.TWST: Can you elaborate a bit more on the supply problems that we are having
globally?Mr. Crane: Oil production around the globe has now been essentially flat, plus
or minus a couple of hundred thousand barrels, since about May, 2005, despite an
enormous amount of capital spending and exploration and production activity. If
you look at the last several years' data for the top five integrated oil
companies, you can get a good idea of the supply problem. Over that period,
these companies increased their capital spending more than double yet total
production declined. So, again, we see a treadmill in the form of massive
increases of capital spending coupled with an inability to meaningfully grow
production. We believe this phenomenon is a result of a combination of the
maturing of the giant oil fields around the world, accelerating decline rates
and the fact that the oil that is available to the industry going forward is in
more remote places, more difficult to get, and more expensive to produce and
refine.
In this recent economic downturn we have seen reluctance on the part of the oil
producers to increase capital spending given uncertainty with respect to what
they expect to receive in terms of oil prices going forward. That slowdown,
again, is like stepping off the treadmill. If we doubled our spending and
production fell, it is not difficult to predict what will happen to supply when
spending is held constant or, worse yet, reduced. We expect that we are going to
see some supply problems manifest themselves beginning in 2010 and more
considerably so by 2011 and 2012. Obviously the specific timing of a supply
crunch will depend on the extent to which we see an economic recovery or
continued slowdown. Clearly any increase in global economic activity and a
related increase in energy demand will only accelerate the timing and exacerbate
the issue. I think, ultimately, the supply challenges are going to be the
driving factor in oil prices going forward.TWST: What about the investing side in energy? Can you tell us more about your
particular strategy and the process?Mr. Crane: Certainly. We are in a continuous process of evolving our strategy,
but we have been consistent throughout the execution of our Energy Opportunities
strategy generally favoring companies in the oil service sector as opposed to,
for example, the integrated majors like Exxon or Chevron. That strategy is a
reflection of our view of the relative economics of those companies going
forward. In particular, as we just discussed, when we look at the increases in
spending by the integrated majors and the fact that production has declined, we
are compelled to own those companies that will be the beneficiaries of the
increased spending that will be required. So we favor companies in the oil
service sector and in particular those folks who have significant international
exposure or operate in deepwater environments where many of the remaining good
prospects for exploration and production exist. We also have expanded our focus
to include energy infrastructure companies. TWST: Are you reducing your exposure to the E&P side?Mr. Crane: It is more a modification of our E&P exposure than a reduction.
Historically, our exposure on the E&P side has been directed primarily at North
American natural gas companies that possess opportunities to grow production.
Recently, we have reduced that exposure somewhat as natural gas prices have been
impacted by increased production from the shale plays and declining industrial
demand. But we still maintain a meaningful allocation to exposure to the North
American E&P sector because we believe, much like oil, that the recent slowdown
in North American drilling directed toward natural gas is going to manifest
itself in a supply response, the timing of which will be dependent on the level
of demand. We continue to favor those natural gas companies that we think can
grow production and have superior balance sheets in today's credit-constrained
environment. TWST: Have you been increasing international exposure in your portfolio?Mr. Crane: Yes. Within the oil service and energy infrastructure sectors, we do
emphasize those companies that have significant and growing international
business. If you look at the capital spending going on around the world,
companies like Petrobras (PBR) in Brazil are continuing to increase their
capital expenditure budgets and are not particularly concerned about today's oil
price. Instead, their focus is long term as they are working to become a
meaningful global producer over the next several years in hopes of becoming a
net exporter of crude. TWST: We hear a lot about the new natural gas fields that have opened up supply
for gas and the new technologies for drilling. Would you give us some background
on your natural gas outlook?Mr. Crane: Just a brief history, which you probably already know, and it's
interesting because when we started the Energy Opportunities strategy one of the
areas that we preferred to be invested in was the North American natural gas
market, in particular oil service and drilling companies focused on land
drilling in North America. The rationale then was the need for a large increase
in active drilling to sustain natural gas production. Over time, however,
companies learned how to "crack the code" of the massive shale plays throughout
the US. As a result, the industry ultimately commoditized the oil services
product offering, lowering barriers to entry and creating an oversupply of
equipment and services.
At the same time, natural gas supply got out of whack with supply growth and
that was coupled with a decline in industrial demand associated with the
slowdown in the US economy. This has put downward pressure on gas prices. On the
portfolio side, these events led us to significantly reduce our holdings in
North American service providers - one, because the outlook for natural gas
prices began to deteriorate and, two, because there was less differentiation
among the various service and drilling companies.
Our outlook for the natural gas market today is that there will be a recovery in
prices and E&P activity but the timing of that recovery will depend upon the
rate of any recovery in demand and the speed of the decline in production
associated with the recent slowdown in drilling activity. Domestically we've
seen close to a 60% decline in natural gas directed drilling this year, and we
believe that will be reflected in supply as we go forward. TWST: One of the big changes since the last fall is the election of President
Obama and his Administration has a new policy toward energy, in particular the
focus on alternative energy. How are you playing that theme?Mr. Crane: In October 2007, as a complement to our Energy Opportunities
strategy, we launched an alternative energy equity strategy. We are very
optimistic about the longer-term outlook for that strategy, especially given our
view of the fundamental challenges associated with oil and gas production in the
future. In the shorter term, we think this Administration's policies will
benefit alternative energy companies, either by way of additional subsidy or by
making them more competitive with fossil fuels. As you probably know, a lot of
today's alternative energy technologies today still need some form of subsidy to
make them competitive with fossil fuels. It appears that the President is going
to work toward improving those economics. TWST: What are the valuations of the energy companies and what metrics are you
using for investing in them?Mr. Crane: Within our strategy, we focus first on our primary investment themes
like deepwater, energy infrastructure, and international oil services, but then
look to build a portfolio that has superior earnings and valuation metrics.
Interestingly, we appear to be in an environment today where those traditional
equity concepts such as earnings and relative valuation seem less important to
the market than the state of the global economy. Recently, energy stocks have
been trading more in line with investor sentiment about what the global economic
recovery looks like. Certainly, the decline in energy stocks and in oil prices
that we saw during the second half of last year was reflective of a growing
concern about global economic activity going forward. Likewise, the upward move
that these stocks have enjoyed so far this year is more a reflection of the fact
that investors are beginning to feel better about the prospects for global
economic growth than any specific metric for these companies. We think this is
additional confirmation of our view that economic growth and energy demand are
inexorably linked.
Having said that, we continue to focus on earnings and earnings growth and focus
on valuations toward the goal of assembling a portfolio of stocks that have
superior earnings and lower valuations. But I do think that activity in the
market in the near term will be driven more by sentiment about the global
economic outlook than by specific fundamentals for these companies.TWST: What about dividends? I know you have a strategic dividend strategy. .Mr. Crane: Dividends are not an important consideration in the Energy
Opportunities strategy. That said, Orleans Capital does manage an equity
strategy focused on dividend paying stocks and equity income. The fundamental
challenge there has been avoiding companies that have cut their dividends. That
strategy continues to be premised on emphasizing those companies that pay a
healthy current dividend, and those that have the capacity to grow dividends
over time and increase cash flow to investors. TWST: One of the advantages of focusing on a particular sector like energy is
that I'm sure you do a lot more research into the management of the companies.
How important is that?Mr. Crane: That's been very important to us and I think there are two important
points to make. First, because we focus exclusively on the energy sector, we
have a very good understanding of each of the companies within our universe,
which allows us to make selections on a qualitative basis as well as a
quantitative one. Second, one of the things has made us better at what we do
today is having Scott Gill move from Co-Head of Research at Simmons to portfolio
manager at EOCM. At Simmons, a major part of his research effort involved
developing relationships with company management and meeting with them on a
routine basis to gain a detailed understanding of their specific dynamics. He
has continued to do that on the Energy Opportunities side now, and it has
enhanced the execution of our investment strategy.TWST: What about the sell strategy? What are the reasons for a company exiting
your portfolio?Mr. Crane: Our sell decisions are much the same as our decisions to buy a
security and involve two primary considerations. We start by trying to delineate
investment themes within the energy sector and increase exposure to those that
we view as positive and avoid those that we view as negative. The North American
natural gas service companies are a perfect example. About a year or so ago, we
saw the North American service market becoming more commoditized and we began to
see an uptick in natural gas production, which led us to reduce our exposure to
that investment theme or sector.
With regard to the decision to sell a specific security, we generally look at
all the factors that bear on the outlook for that company both absolutely and
relative to its peers, including company revenues and earnings of the company,
valuations and our assessment of what we are learning from company management.
To the extent these consideration change our outlook for the company in a
negative way, we will reduce our exposure. Again, we do not have a specific set
of quantitative metrics that we look at; instead we lean more heavily on our
qualitative analysis of a specific company.TWST: What else gives your firm its edge when it comes to investing in energy
compared with portfolios at other peer companies?Mr. Crane: I think primarily it is the depth of our knowledge of the industry
and the companies in our investment universe, which as we just discussed,
enables us to employ a qualitative assessment. More specifically, I believe we
have exhibited a superior understanding of the global energy supply and demand
picture and how that influences our investment themes within energy. In
addition, being focused exclusively on the energy sector and a limited universe
of companies that we would consider for inclusion in our portfolio allows us to
more fully dedicate our research and analysis on the details of each company. We
have the luxury of analyzing each of the 100 or 150 companies within our
universe, allowing us to fully understand what each one of them is doing, which
allows us to be more quantitative in our assessment. I think that is a real
advantage versus broad market managers that invest in energy as a subset of
their overall portfolios. Those managers, who have to consider investing across
all economic sectors and have something like 2000 names to consider, will have
to resort to some quantitative assessment in the portfolio construction process.TWST: You mentioned that your exposure has increased with the oilfield service
providers. They have significant international operations in the Middle East and
the other areas. Is that a risk factor for you? Could you tell us more about
your risk concerns and how you attempt to control them at the portfolio level?Mr. Crane: We are not particularly worried about the risk associated with our
international exposure including owning oil service companies that have
operations in the Middle East. Going forward, the world needs as much supply as
it can get, and while some of these areas may provide some political or
geographic risk, these international service companies have been managing those
considerations for a long period of time, and I don't expect those factors to
have a meaningful impact on their operations.
With respect to portfolio risk and risk control, we generally take a different
approach than most managers that employ a quantitative analysis focused on
volatility as a measure of risk. We are less concerned about volatility and view
risk more in terms of events and issues that might negatively impact our
investment themes or the specific holdings in our portfolio. To us, managing
risk is primarily an exercise in making sure we understand the global energy
environment and events that bear upon our portfolio. So our risk management
focuses on being as smart as we can be about the world of energy, what's going
in it, and how it might affect the companies that are within our portfolio.TWST: What are the headwinds that you see down the road that investors should be
wary of?Mr. Crane: I think the biggest headwind, which is probably common to most of the
investment community, is uncertainty about the state of the global economy and
the outlook for a resumption of economic growth. Our expectation is that we are
likely to see a protracted period without significant economic growth,
particularly in the US, but we expect to see continued growth in the developing
nations around the world where economic growth is particularly energy intensive.
What differentiates our strategy is that its success is not dependent upon an
economic recovery, given the supply problems that we have discussed. Energy has
a supply side dynamic created by accelerating decline rates and a slowdown in
capital spending that will influence the economics of our portfolio regardless
of an uptick in energy demand resulting from an economic recovery. I think that
makes it different than almost all other sectors. TWST: You are saying that global economic growth is dependent on increased oil
supplies, and without that increased oil supply, then the economies are at risk?Mr. Crane: One could argue that as we go forward energy supply may become the
ultimate headwind to global economic growth and economic recovery. As we begin
to have a recovery in the economy and increased economic activity around the
world, we will see an increase in the demand for energy, given the link between
economic growth and energy demand growth. If we are right about the supply
challenges that exist, and I think the evidence would support that, energy will
likely become a limiting factor on economic growth. Depending on the shape of an
economic recovery, it would be possible to see oil creep pretty quickly back up
to $80, $90, or $100. This raises a question about the effects of $100 oil on a
more fragile global economy, trying to recover. TWST: There was talk a while ago about energy companies not even being cyclical,
and now we are back to cyclicality. Are they cyclical?Mr. Crane: I suppose that depends on your definition of cyclical. When one looks
at the history of energy demand, it has been on a long-term uptrend mirroring
that of global GDP growth. So at its core, energy is a growth industry. The so-
called cyclicality is more a matter of one's time horizon, reflecting near-term
dynamics in the supply and demand. One of the important comparisons that we have
made from the inception of this strategy was to go back and look at the period
of the 1970s, which we would define as a similar period of exceedingly tight
supply. During the 1970s, energy stocks, and oil service in particular, did
remarkably well, significantly outperforming the broad market. And while there
was price volatility along the way during the 1970s, that "cycle" didn't end
until there was fundamentally a change in the supply picture and the creation of
substantial space capacity. The world brought on additional production faster
than the world could use it.
I think what's interesting at this point in the current cycle is that the recent
price declines have come exclusively from a decline in energy demand related to
the global economic slowdown. Oil prices have not declined as a result of
increased production. The supply side is likely to be permanently challenged and
I think we're going to have a very hard time having a cyclical response from the
supply side. TWST: It's certainly a confusing picture. What advice would you give to
investors about investing in energy? Are there opportunities out there they
should take advantage of?Mr. Crane: There are investment opportunities in energy. First, I think
investors have to focus on the long term and the link between economic growth
and energy demand. We often refer to energy, and oil in particular, as
industrial oxygen because there is that link. Arguably, all equity investments
are predicated on the concept of global economic growth which infers an increase
in energy demand. At the same time, you have significant supply challenge. Our
view is people who are invested in equities and believe that we will have global
GDP growth going forward have a unique entry point in many of these energy
names, especially those that will be the economic beneficiaries of the capital
spending that is essential in light of the supply and demand fundamentals. Most
of these stocks have had a nice recovery in the first half of this year but
remain attractively valued, and have a very positive outlook going forward over
the next two to three years.TWST: Thank you. (PS)Note: Opinions and recommendations are as of 7/21/09.L. FARRELL CRANE JR.
Energy Opportunities Capital Management, LLC
400 W. 15th St.
Suite 712
Austin, TX 78701
(504) 592-4687
Energy >> Money Manager Interview >> July 27, 2009
Investing In Energy Opportunities
L. Farrell Crane Jr.
L. Farrell Crane Jr. serves as Director of Research and Portfolio Manager for
Orleans Capital Management. He has over eight years of investment management
experience managing both fixed income and equity allocations, and has served as
the portfolio manager of the Energy Opportunities equity strategy since its
inception in 2000... More










