AN INTERVIEW WITH ART SMITH, PORTFOLIO MANAGER FOR TRIPLE DOUBLE ADVISORS
OIL & GAS FINANCIAL JOURNAL: Is this a good time to invest in the oil and gas industry?
ART SMITH: Definitely time to "back up the truck." From the integrated majors to the small-cap E&P companies, market valuations are very reasonable to low by historical levels. It's been said that "the path to success starts from low expectations." Oil prices were down 14% in 2012, and the waterboarding to weak natural gas continued apace.
The sector is unloved on Wall Street as the investment community is expressing disdain for energy in all forms with natural gas and coal producers most in the doghouse. Meanwhile, dramatic volume growth in North American crude and NGLs has sparked a renaissance in infrastructure development throughout the energy value chain. Upstream is down. Midstream and downstream are up. The energy sector is not always bullish, but it is never boring.
OGFJ: Which energy sectors do you expect will perform best from a shareholder perspective? Would you give our readers some insight as to how you select companies to invest in?
SMITH: Triple Double Advisors tracks 45 energy subsectors while keeping a weather eye on global and regional energy macro fundamentals. While world markets remain skittish, on a positive note, oil demand trends have recently ticked up nicely.
We expect the surge in North American oil and NGL production to continue – an important positive tailwind for the oil-focused midstream companies – namely those companies involved in oil gathering and pipeline transportation, terminals, and processing. On natural gas, while the surge in shale gas production has flattened, there continue to be bottlenecks and infrastructure that represent great organic opportunities for growth for natural gas-focused midstream companies.
These same two trends also benefit domestic independent refiners. Discounted regional crude prices relative to waterborne imports support robust refining margins. Not inconsequential is the positive impact of cheap natural gas on refining operating costs.
In the E&P sector, we favor selected oil-weighted producers with competitive reserve replacement costs together with low lease operating expense and solid balance sheets. Admittedly, these characteristics screen out the majority of mid- and small-cap independents. We remain cautious on the North American oil service sector. This stems from intense competition given excess capacity additions amid a down-trending total rig count. Margin compression could get worse.
Also, many E&P companies have been outspending cash flow to drill aggressively in order to grow production. These companies have been borrowing heavily and divesting non-core assets. Funding capex outspends through borrowing can't continue forever, and the acquisition and divestiture market is becoming sluggish.
At TDA, we like to make the analogy of investing in energy stocks to horse racing. We can analyze the characteristics of the horse, the track record of the horse, and assess the track (muddy vs dry is equivalent to a positive or negative pricing environment). Yet, in the end, success is most correlated to the jockey – i.e., management.
We do like the outlook for oilfield service companies involved in certain niche subsectors, primarily deepwater and ultra-deepwater drilling and development of global LNG plants and infrastructure.
OGFJ: Generally speaking, when companies announce a large share repurchase, is that a good time to invest in their stock? If not, what are we to make of such an announcement?
SMITH: We would not recommend a kneejerk buy in reaction to a major repurchase headline. Regrettably, there have been situations where share repurchases were ill advised and both balance sheets and residual investors suffered. Nonetheless, we contend that accretive share repurchases (where the Appraised Net Worth or NAV of the repurchased shares is markedly below true NAV) can be a constructive answer to delivering value to shareholders.
Several years ago, the integrated majors favored share buybacks for as much as 30% of their cash flows; I supported this outcome and likened buybacks to a "relief valve" that trumped squandering excess capital on frivolous non-core ventures. It is noteworthy that special dividends can also be a good signal to investors. More special dividends, more share repurchases, less equity issuance, and less borrowing. Can you hear me, Chesapeake?
OGFJ: Is the current contentious political atmosphere in Washington over the debt ceiling and other issues a factor in your investment decisions? Please explain.
SMITH: We acknowledge our limitations in assessing Washington DC politics. Yet, we cannot understate the importance of remaining protective of our investment portfolios in times like this with periods of elevated systemic risk. In such a volatile environment, our top priority is protecting our clients' capital against sudden, significant losses. We achieve this through a combination of asset allocation and options strategies for risk mitigation. Our portfolios have been conservatively positioned for many months.
OGFJ: We hear a lot of talk today about the "Shale Revolution." Do you think that's an apt term? How important is the development of tight oil and gas to America's future?
SMITH: Revolution or economic miracle? You bet it's important. Aubrey (McClendon) got it right with his characterization of widespread prolific and economic shale resources as a "game changer." But, rightly so, to quote Carrizo's Chip Johnson, "We have too much of a good thing." At least that holds true for natural gas.
For decades ahead, North America should continue to see the benefits of ample natural gas supplies and resulting competitive natural gas prices. Low natural gas prices greatly benefit US manufacturing in general and in particular, the petrochemical industry. Lasting bright fundamentals for North American gas have sparked numerous announcements of additions to existing plants and new greenfield developments. The dramatic growth in gas supply has created the need for more pipelines and processing plants, all of which result in increased employment and business activity.
The salutary effect on gas supply resulting from horizontal drilling and fracture completions is now manifest in oil directed drilling. Our work at TDA supports the expectation of US liquids production growing (net of depletion) at an annual rate of 600,000 to 800,000 bbls/day in coming years. One important caveat: volume growth in oil in the US and Canada is highly dependent on wellhead prices north of $80/bbl and tempered oilfield cost inflation. A strong economic margin is essential for all US tight oil basins to remain economic.
We recognize that the phenomenal resurgence of US oil production will be increasingly influential in global oil market dynamics. Domestic volume gains amid stagnant demand have halved waterborne imports. Future potential pricing pressure on Light Louisiana Sweet (LLS) is a favorable factor for Gulf Coast processors of NGLs and inland crude refiners.
OGFJ: Are you concerned at all that politics and regulation could negatively impact the development of tight oil and gas resources in the US?
SMITH: Well, like the rest of the industry, the national attention on "fracing" has been a surprise to us. Fracturing has been around so long and employed safely and successfully while, in our view, adequately regulated by state governments. The data do not lie: the oil and gas industry has executed more than 1.1 million frac jobs since 1947. The incidence of problem wells is infinitesimal.
In the coming days the EPA will release a draft of its long-awaited "scientific study" concerning links between water pollution and fracing. The completed EPA study won't be finished until 2014, but the draft will provide an early indication as to which energy path the Obama administration will take in the next four years.
Many of us in the industry fear the report will depict fracing in a negative light and give the White House political cover for cracking down in the name of the environment and science.
We trust that fracing's economic benefits will trump environmental hysteria. To its credit, in the recent past the energy industry is getting the message out there: responsible new investment in growing domestic oil and gas production as a key source of tax revenue while generating new, high-paying jobs.
OGFJ: Except for Canada, worldwide development of global unconventional resources such as shale seems to be lagging behind the US. What countries, if any, do you think will move forward with exploitation of their tight oil and gas resources?
SMITH: We used to lament North America's maturation as the most developed global oil and gas province. Today we celebrate this amazing circulation system of existing petroleum infrastructure. The US and Canada are the most densely drilled countries, but we boast a vast network of legacy assets such as oil service field locations, supply routes, and skilled oilfield workers. Similarly, the midstream and hydrocarbon transportation and processing sector gives us a great competitive advantage in exploiting the Shale Revolution. Schlumberger is said to have identified 263 prospective shale basins around the globe. Surely, there will be great shale resources of oil, NGLs, and natural gas found and developed worldwide. Time is on their side. Infrastructure is on ours.
OGFJ: China seems to be especially aggressive in acquiring access to shale oil and gas supplies through joint ventures and partnerships with US and Canadian companies and also in South America and elsewhere. Presumably, the Chinese are using the JVs to learn the latest drilling and completion technology as well. Should Americans be concerned about this? A decade or so ago, there was a major uproar about a Chinese company's bid to acquire Unocal, which resulted in the deal not happening. Has the political climate here changed since then?
SMITH: I have always been in favor of free markets so I perceive no harm in establishing JVs with foreign entities. JVs can be beneficial for both parties: 1) The overseas investor enjoys and achieves technology transfer; and, 2) the North American E&Ps recoup a significant portion of their "land grab" investment in these very large lease positions plus a financial carry on the development drilling. It is a win-win.
It appears the northern portion of the North American political landscape has changed but also with new limitations. On Dec. 7, the Canadian government approved two foreign takeovers in the E&P sector but also set limits on future deals. 1) Malaysia's state-owned Petronas to buy Progress Energy Resources, and 2) China's state-controlled CNOOC to buy Nexen. The Progress Energy takeout had been initially denied in October.
While both deals have been approved, the Canadian government has laid out a tough new framework that essentially rules out future acquisitions of oil sands assets by state-controlled companies. Prime Minister (Stephen) Harper said: "Foreign state control of oil sands development has reached the point at which further such foreign state control would not be of net benefit to Canada." The new policy does still allow state-controlled companies to take minority stakes in oil sands projects.
OGFJ: What is your opinion of renewable energy 1) as an investment option, and (2) as something we need to pursue to augment current energy supplies and as an eventual replacement for hydrocarbons many years down the road?
SMITH: Think AE and substitute "Awful" for "Alternative" and "Economics" for "Energy." That's the root of the problem with the idealist's Green Energy and Green Jobs. Renewable energy is a great concept, but it must make economic sense in order to be a viable investment option. If you think the high-cost natural gas producers have had a difficult couple of years due to low natural gas prices, just take a look at the alternative energy stocks. These companies have been decimated by low natural gas prices and will continue to be challenged in a sub $4/MMBtu pricing environment. Economists hate tax grants, subsidies, mandates like the RFS, and outright government grants and investments.
The question of whether America or any nation ought to pursue alternative energy supplies is one that is best answered by the market. Private investment poured into alternative energy in 2007 and 2008 when oil prices were peaking, but has subsequently reversed as the price of both oil and gas has fallen from those highs. The market is incredibly efficient, and to quote Walter Heller: "It is hard to study the history of modern economics without developing a great respect for the market mechanism."
Unfortunately, in the case of alternative energy, over the past four years the Obama administration has provided large amounts of capital in the form of grants and loan guarantees to alternative energy companies – in the face of deteriorating economics. First solar: Solyndra, A123 Systems, Amyris, and Solazyme are some of the most egregious examples of government support for alternative energy companies that have accepted hundreds of millions of dollars in government support only to destroy that capital due to products that could not compete in a $3MMBTU energy economic world.
OGFJ: The late Matt Simmons famously argued that the world is running out of oil, and he pointed to declining fields in Saudi Arabia, Mexico, and elsewhere to bolster his position. With our new ability to economically develop shale gas and oil with improved extraction technology, are we past this immediate concern as voiced by the "peak oil" proponents? How much extra time does the Shale Revolution give us?
SMITH: I greatly miss my friend Matt and his incredible enthusiasm and analytical mind for all things related to energy. You must remember that what Matt saw was that the data since 1970 were clear in supporting Peak Oil concerns. That is: declining petroleum output; more wells with fewer reserves; inexorably rising costs; and resource nationalism.
Recent data since 2005 are very promising but must not be extrapolated with abandon to new information. Yes, Hubbert's Peak has been eclipsed by technology advances in horizontal drilling, fracing, and shale resource development. But we would caution against complacency. The Shale Revolution, like a runaway train, has a head of steam and an unknown destination.
OGFJ: When we first met, you were head of John S. Herold Inc., a very highly regarded research institution covering the oil and gas industry. You sold it to IHS Inc. in 2007. What prompted you to make that change?
SMITH: Christine Juneau, Herold president, and I like to think that we sensed (in 2007) an overheated market and the portent of the Great Recession. Maybe so; maybe not. In any event, at the time IHS expressed interest we had concluded that Herold's next major growth platform was overseas which would necessitate costly new JSH research and marketing offices in Europe and Asia. In short, combining with IHS brought immediate benefits through international distribution and research gathering outposts around the world. Plus, as all of the Herold team and board of directors were shareholders, the fair financial offer from IHS was well received. We have no regrets.
OGFJ: Can you tell us a little about Triple Double Advisors, your colleagues, and how you happened to start a portfolio management company?
SMITH: As a sell side oil analyst on Wall Street for nearly a decade, then manager of Herold for some 22 years, investing in public energy stocks is my passion. All sell-siders want to be buy-siders, deep inside. With support from a valued Herold client, the predecessor to TDA was launched in late 2006. TDA emerged in 2007, and we have recently celebrated our fifth business anniversary.
Triple Double Advisors specializes in managing portfolios of publicly traded equity, master limited partnership, and fixed income securities in the energy sector. Our clients are family offices and high net worth individuals.
We take a prudent approach to managing risk in this historically volatile industry by utilizing options with the goal of providing clients superior risk adjusted returns. We manage several products that offer both strong current yields and the opportunity for long-term capital appreciation.
We are all analysts and love the energy sector. Gabe Chavez manages our client portfolios and deep analytical efforts. John White and I contribute research and input on energy stocks, MLP and bond selection. John also interfaces with current and prospective clients. I give speeches to industry groups, something I have always loved.
Debra Claxton, our outstanding executive assistant, keeps the well-oiled Triple Double machine on track.
OGFJ: Historically, the petroleum industry is noted for its volatility. Investors and other participants have made and lost fortunes in oil and gas. This is a broad question, but how do you manage the risk? Can you give us an example?
SMITH: To start, we work with our clients to understand their goals for their energy investments. We manage four different energy portfolios. Each portfolio offers a different combination of energy commodity price exposure, income, upside potential, and downside protection. Each investor is different. We have developed this suite of products to allow investors to tailor their energy exposure to their overall financial goals.
Specifically, we are able to manage risk in these portfolios through a combination of both asset allocation and option contracts. In terms of asset allocation, we have the flexibility to invest in equities, master limited partnerships, and fixed income securities in the energy sector. This provides us a great deal of flexibility to increase or decrease the risk of our portfolios. In addition, we also utilize different option strategies for risk mitigation. For example, we use collars to manage downside risk and covered calls to increase the income generation of our portfolios.
OGFJ: Do you ever plan to retire and go fishing?
SMITH: To answer, I would like to relate a teasing I received from a good friend in Houston. I told him I just returned from a fishing vacation in Alaska. He prodded me, "How do you know the difference from vacation and being at Triple Double?" But exactly! I enjoy my board service with PNG and PSE, some non-profit volunteer activities, my wonderful family, and – of course – regular times on the water with rod and reel and great optimism something big will bite any minute. How could retirement top that!
OGFJ: Good point. Thanks for taking time to talk with us, Art.
