Dear Energy Investor,

Recently energy stocks have shown some strength.  Energy outperformed the S&P500 for the first three-month-period since Third Quarter 2016.

Global growth is strong — estimated at 3.8% per year— and oil demand is increasing — estimated at 1.65 million BOPD on a base of 97.2 million BOPD. Global inventories returned to average levels — lower by 328 million barrels since 2017— resulting in higher prices — $70.70 at the writing of this newsletter compared to $45.49/barrel as of the writing of the 1Q17 newsletter one year ago. However, US inventories have increased since the beginning of the year, although they remain lower than they were in 2015, 2016 and 2017.  

It may seem a bit of a contradiction: On the one hand, the OPEC and non-OPEC Declaration of Cooperationthat began in 2016 and was extended through 2018 appears to be working, although some argue that OPEC will overshoot and tighten the market too much. On the other hand, the US is adding more production than all other producers combined, which if supplies rise too much could trigger aprice correction amid financial volatility and overzealous positioning from hedge funds in the futures market. 

Our hope for 2018 is that the Declaration of Cooperation will keep the two biggest producers outside of the US — Russia and Saudi Arabia — focused on “doing whatever it takes” (their words) to maintain prices. “The rebalancing of the oil market has likely been achieved, six months sooner than we had expected,” Goldman Sachs said in a recent note, predicting Brent will hit $82 per barrel before the end of the year.

It’s important to note that while world demand is growing investment in oil has declined. OPEC estimates that capital expenditure has seen a decline of around 42% compared to the 2014 level.The severe cutbacks in upstream spending that began when oil prices initially collapsed in 2014 have yet to really be felt in terms of supply. Large-scale projects that received funding before the market downturn were carried through to completion, allowing new supply to come onto the market even as the industry made sharp spending cutbacks. But that pipeline of projects is now dried up, which raises questions about the availability of supply next year and beyond. 

The outlier in this investment story is US shale, which saw investment rise by more than 42% y-o-y in 2017, to about $138 billion.This helped US crude oil production exceed 10 million BOPD in November 2017. Now the EIA predicts US production will reach 11 million BOPD in 2018 and 12 million BOPD in 2019. In other words, the US has already surpassed Saudi Arabia, and will soon surpass Russia, to become the world’s largest oil producer. 

Some of these figures and forecasts have been floating around for a while now, but the IEA put the situation in stark terms. The agency says that the current growth trajectory in shale production “is reminiscent of the first wave of US shale growth that, riding the tide of high oil prices in the early years of this decade, made big gains in terms of market share and eventually in 2014 forced a historic change of policy by leading producers.” At this rate supply growth from the US alone looks like it will equal total global demand growth.

So how have equities reacted to improving markets and higher prices? The short answer is not very well. For example, ExxonMobil stock (XOM) is down 4% year-to-date, while Chevron (CVX) is slightly positive.  Why? Both majors had big earnings misses in January, which spooked investors and have yet to be forgiven. For the Fourth Quarter 2017 XOM earned $0.88 per share and CVX reported earnings of $0.72 per share, figures that were 15 percent and 40 percent lower than analysts’ expectations, respectively.  First Quarter 2018 saw XOM miss again while CVX recovered. XOM earned $1.09 per share, which was 3 percent lower than analysts’ expectations, while CVX earned $1.90 per share, 28 percent higher than analysts’ expectations.  

Even so, ExxonMobil recently announced plans to spend $50 billion on US shale over the next five years. By 2025, the oil major says it will quadruple its shale production to around 800,000 BOPD. Three quarters of the new production will come from the Permian Basin where the estimated ultimate recovery rose 20% from 3Q16 to 3Q17 and the average well cost per lateral length fell by 35% between 2014 and 2017. This contributed to a drop in the average breakeven price for US shale by as much as 40%.

Investment Themes

We overhauled the energy/natural resources investment strategy at the end of 2017.  We decided to concentrate the portfolio in fewer, higher quality names, and to decrease exposure to US energy because of the ongoing potential for glut.   At the same time we increased exposure to US infrastructure, which is badly in need of being rebuilt, and will benefit from the strong economy and relatively low energy prices. These changes have meant that the portfolio is currently positioned as follows: 

·     Exploration & Production – 25% (was 35%) 

·     Drilling & Oilfield Service – 18% (was 29%) 

·     Chemicals & Refining – 26% (was 16%)

·     Infrastructure – 31% (was 0%)

·     Special Situations – 0% (was 20%)

The last time we were this optimistic about energy was Second and Third Quarter of 2016.  Names added then are up 5% cumulatively since.   Energy stocks have not kept pace with the improvement in energy prices.  This is a good time to add to portfolios because there is more to come.

Nancy 

                                                                                                    

May 23, 2018

Dallas, Texas 75205

646-296-6102

ntschmitt@taumsaukinvestments.com

Dear Energy Investor,

In the fourth quarter, the Energy/Natural Resources (ENR) portfolio returned +6.7%. For the year, Energy/Natural Resources (ENR) portfolio returned +33.3%, outperforming the S&P500 Total Return, which delivered +11.96%.

Taum Sauk holdings are making a comeback: performance in 2016 was the best of any year since 2009. We believe that the re-formation of the OPEC cartel in November 2016, along with the election of Donald Trump, will bring to a close the worst period of low oil prices in 30-years.  When OPEC dissolved two years ago, oil prices dropped 50% (70% at the nadir) and portfolio performance suffered greatly. Over the long term, we believe that Taum Sauk will outperform. The chart below shows the long-term track record of Taum Sauk (dark green) versus an investment in the broader market (S&P 500, red) or passive energy (XLE, light green).  Looking at the chart, it’s obvious that less reliance on the Fed and more on business helps Taum Sauk.

Cumulative Performance 1998-2016

Taum Sauk 677% (12.1% p.a.)[1]; XLE Total Return 344% (8.6% p.a.); S&P500 Total Return 156% (5.3% p.a.)

OPEC Re-formation (Possible Tailwind #1)

OPEC’s re-formation will remove slightly less than 2% of global production from the market. The decision was a long time coming, but it is welcome relief for many. Venezuela and Nigeria are on the brink of collapse; Saudi Arabia is substantially poorer; redevelopment of Iraq and Iran is slow. We estimate that producing at record levels for the two years cost OPEC members half a billion dollars per day[2].

It seems that once per generation OPEC members have to learn why they exist. External limits, like those imposed by a cartel or government agency (e.g., Texas Railroad Commission), are critical to stable prices because of the nature of oil resources.  Oil is hard to find and expensive to develop (high fixed cost) but cheap to operate (low variable cost).

We think OPEC will unify behind lower production for a while. In a prior generation (1970s) OPEC restricted supply causing high prices; then they regretted it, mostly because they lost market share, loosened supply, caused 15-years of low prices, regained some market share but not as much as they lost. Too much time had passed. High prices enabled new competitors with new technology (3-d Seismic, directional drilling, offshore and Arctic expertise).

The same thing happened this time. OPEC allowed high prices for more than a decade.  They could have brought more production to market when oil was $100/barrel, but they didn’t. Once again too much time passed and new competitors (US independents) developed new technology (fracking). Even though there have been over 100 bankruptcies in the oil and gas industry in the past 2-years, there are enough new competitors that have staying power, many of which are in your portfolio, that OPEC will not regain their former market share without bankrupting themselves. Although expensive and painful, fortunately it only took 2-years to learn the lesson this time.

OPEC’s unity won’t last. As we pointed out in a previous newsletter, cartels are inherently unstable. All members are better off if they cooperate, but if everyone else cooperates, the individual is better off if they cheat (a.k.a. Prisoner’s Dilemma). Cheating will resume. Some members will produce more than they are allowed. Others will find that their domestic supplies are limited, like Indonesia that joined OPEC in 1962, dropped out in 2008, rejoined in 2015 and then dropped out again in 2016.  Indonesia, like all OPEC members, wants higher prices, but they are also a crude importer.  It is nonsensical for them to limit their own production in order to buy barrels they could have produced from someone else.

The US is in a similar situation.  Domestic development has been restricted, not by OPEC membership, but by lack of resources and tepid government policy.  But now that the largest oil field in the world has been identified in the US[3], why would it limit domestic development in order to buy barrels from someone else?  Surely the United States is as practical as Indonesia.

US Presidential Election (Tailwind #2)

Which brings us to the other phenomenon that has developed since we last wrote: the election of Donald Trump and Republican majorities in both the House and Senate. This last occurred in 1928. We are as surprised as anyone else, although our middle daughter picked Trump early in February and stuck with him despite the circus.  The result is a dream come true for the domestic oil and gas industry. President-elect Trump’s picks for key government positions just couldn’t be any better:  Rex Tillerson, Secretary of State, former CEO of Exxon Mobil; Rick Perry, Energy Secretary, former Governor of Texas; Scott Pruitt, Environmental Protection Agency Administrator, former Oklahoma Attorney General.

We recently read Eye on the Market Outlook 2017: True Believers by Michael Cembalest[4]. He organizes recent dynamics into a struggle between the forces of globalization and modernization (central bankers, tech companies) and those who are disenfranchised by these forces (inhabitants of industrial rust belts, average citizens).

A couple of charts from his work really caught our eye. First, the chart on the left shows that there has been a 50% increase in the number of economically significant regulations passed during the Obama administration compared to previous administrations. The sense of growing red tape that we know from our work and hear about from our friends is real.  Carl Icahn, Special Advisor to the President on Regulatory Reform, says there are “$1 trillion in new regulations and over 750 billion hours of paperwork resulting from Obama regulatory.”

The chart on the right confirms that people think that too many taxes and too much regulation are the worst problems facing small businesses. We agree with Carl Icahn again when he says, “In my view, it’s the potential change in the regulatory agenda that may be affecting sentiment the most.” 

Investment Themes

For these reasons, we believe that the wind could be finally at our back. We are more optimistic about oil prices and the potential for domestic development than ever. While we don’t know how high oil prices will go (neither does anyone else), we do think there is upside. The OPEC-led production cut is supposed to take effect this month. It may already be having an impact. Stockpiles in the United States, which has the most accurate inventory data, fell during the last week of December by 7,000,000 barrels. 

We expect that the excess inventory built in the last two years will work off during 2017. As shown in the chart below, inventory levels remain elevated by about 20%.  If OPEC extends the production cut beyond the 6-months that was agreed, the market will go from surplus to balance, and possibly even to deficit.  Demand is inelastic, so as long as oil prices remain in familiar territory, we think demand destruction is unlikely.

Ending Stocks of Crude Oil 2014-2016[5]

Since the cut was announced in September, prices have increased from $43/barrel to $53/barrel, yet the rig count in the United States is 5% lower than it was at this time in 2016. Producers hedged about half of their 2017 production at 2016 prices, so they will be slower to restart suspended drilling programs than some may expect. Although some basins, like the Permian, have seen rig counts increase; other basins, like the Eagle Ford and Williston, have seen them decrease.[6] We continue to own exploration and production companies focused in the Permian.

We entered oil field service names during second quarter.  We further increased them during the fourth quarter.  All portfolios contain at least 30% oil field service.  In some accounts with margin and option capability we extended this to 50% during the fourth quarter. 

There is a lot of well work to be done.  For example, with 658 rigs at work, US production has fallen 10%, from a peak of 9.6 to 8.8 million barrels per day.  When production peaked, the US had over 2000 rigs working.  Just to sustain current production, we estimate that the US needs over a thousand horizontal rigs working. Even if the US makes up only a miniscule amount of the OPEC production cut, there is a lot of work for service companies. Companies that made concessions during the downturn are saying they will institute a 25% price increase immediately when work resumes.  With a possible 40% upside in activity, 25% upside in pricing and share prices still beaten down 75% from their 2014 highs, we think oil field service is the best investment in our universe.

Nancy 

                                                                                                   

January 9, 2017

Dallas, Texas 75205

646-296-6102

ntschmitt@taumsaukinvestments.com

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[1] Performance reported net of fees based on CIO track record from 1998-2007: AllianceBernstein Long-only; 2008-2012 Taum Sauk World Development Hedge Fund; 2012-2016 Taum Sauk Investments Managed Accounts

[2] In the April 2016 newsletter we gave this example: OPEC essentially sold 33 barrels for $30 ($990) when they could have sold 30 barrels for $50 ($1500) multiply by a million barrels a day, which is $510,000,000 per day.

[3] In the September 2016 newsletter we wrote that the Permian Basin has an estimated 160 billion barrels of oil equivalent to the largest oilfield known: Ghawar, Saudi Arabia.

[4] Michael Cembalist is Chairman of Market and Investment Strategy for JPMorgan Asset Management.

[5] Energy Information Administration, http://tonto.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCRSTUS1&f=W, Web accessed Jan 5 2017.

[6] Baker Hughes North American Rotary Rig Count, http://phx.corporate-ir.net/phoenix.zhtml?c=79687&p=irol-rigcountsoverview, Web accessed Jan 5, 2017.

HBS 25th Reunion -- Special Edition

Dear Investor ,

Third-quarter-to-date has been the best quarter yet for Taum Sauk's Energy/Natural Resources  portfolio. The portfolio is up 13% in just three months. America truly is the new Saudi Arabia and fortunes are being made every day in energy stocks.

Taum Sauk is a private money manager that started in 2008. Taum Sauk is the creation of my husband, Tom, who had gotten tired of managing institutional money after 15-years on Wall Street.  Looking for some upside for himself and his family, Tom decided to launch his own fund. What he didn't know was that in just a few months the financial crisis would strike, quickly followed by the Bernie Madoff scandal. After a few years of slogging through that mess, Tom decided he was just tired of Wall Street.  So in 2012 he went back into the oil industry working for a private company and handed the fund off to me. Tom still picks stocks, while I do everything else.  

Taum Sauk's strategy is simple: select a portfolio of mainly small and mid-cap companies in the energy/natural resources space, and hold onto them for several years to take advantage of the outstanding returns these companies generate when conditions are favorable. There are many catalysts for share price appreciation such as: new technology, new resources, increasing demand, geopolitical events.  Quarterly returns are highly dependent on timing.  

***

Right now the portfolio is concentrated in the United States because industry is increasingly focused here.  A look at the rig count confirms the US-centric structure of the industry.  Out of 1,961 drilling rigs working in the world today:  871 (44%) are working in the United States; 379 (19%) are working in the Middle East, including 124 in Saudi Arabia; 182 (9%) are working in Canada, and 115 (6%) in India.[1]  The others are spread out in concentrations of less than 5% of the global total.

Shale 

The oil industry is investing in the US because of shale, especially the Permian Basin in West Texas, which is now acknowledged in oil circles as possibly the largest oilfield in the world.[2] The Permian consists of two sub-basins: the Midland and the Delaware, which together cover an area the size of Massachusetts.  Oil formations are stacked in layers thousands of feet thick.  With more than one horizon per well, producers are very excited about the wealth of possibilities and the long productive life implied. The Permian Basin has produced a small fraction of its oil compared to Ghawar, which is thought to be the largest oilfield in the world.  With modern techniques (high volume hydraulic fracturing) it is estimated that much more will be produced. Even so, there is still a lot not known about how big the Permian really is. As horizontal wells are drilled these questions will be answered and much will be learned.  The bottom line is that we expect reserves will be upsized significantly.  

Apache (APA) confirmed our hypothesis when they announced the “discovery” of a new giant field, Alpine High, on September 7^th.  The new field is located in Reeves County in the southern portion of the Delaware Basin, an area that had been lightly drilled in the past and was written off as unproductive.  Apache quietly acquired hundreds of thousands of contiguous acres and drilled 19 wells to delineate the area.  They estimate that Alpine High contains three billion barrels of oil and 75 trillion cubic feet of natural gas.  The announcement sent the stock soaring 17%.  It has since retreated 5% as the market realizes that there is no infrastructure in place to develop the field, and constructing it will take billions of dollars of investment. 

Four out of six portfolio holdings in exploration and production are Permian-only players. A large holding is Callon Petroleum (CPE) a Midland Basin focused small independent out of Natchez, Mississippi. The company sold its Gulf of Mexico leases several years ago and entered the Midland Basin before it was rediscovered. It eschewed leverage during the shale boom and made a couple of acquisitions recently that richly rewarded the stock. We bought it a year ago, and added to our position when oil prices went down in February.  It is +73.6% year-to-date.

Given the stabilization of oil and gas prices, we recently added drillers: Nabors (NBR) and Helmerich&Payne (HP); and a service provider, Weatherford (WFT).  These companies remain beaten down more than any other part of the oil industry, down 2/3rds on average, and they stand to gain more as the industry recovers.  In accounts that have option capability, we added these positions as long-dated calls.  These are high Beta names that respond quickly up or down to changes in outlook.  They have not added to portfolio performance so far, but we think that going into 2017 we are well positioned (no pun intended) for continued strengthening of oil markets.

Another large holding in the portfolio is US Silica Holdings (SLCA). US Silica is the premier supplier of Ottawa sand, which is the proppant used in fracturing operations since they began in the 1940s.  Ottawa sand is the industry standard because it is exceptionally strong, pure and uniform, plus it is impervious to hydraulic fracturing chemicals. Data shows that the average pounds of sand per lateral foot of well used in completions went from 800 to 1400 over the past 3-years[3].  Leading operators have talked about experimenting with loadings as high as 5000.  Producers are gaining better wells by doubling and tripling the sand, so while the number of wells drilled is down, the amount of sand used per well is up.  This is a position that we held through the downturn.  It has the high Beta typical of this sector, and despite being +134% year-to-date, it is just now beginning to add to portfolio performance.

As we have said before, we believe US shale is an excellent investment.  As oil prices moved from the $30s into the $40s, the rig count in the Permian grew by 1/3^rd.  There are 202 rigs working in the Permian compared to 152 at the end of first quarter, which is still less than 253 rigs that were working a year ago.[4] At $30-40 per barrel US shale has proven to be resilient, and it will explode if prices reach $50-60 per barrel or higher.

Refining and Petrochemicals

During 2^nd and 3^rd quarter we completed the exit from refiners. Refining margins decreased substantially during this period and we think that structural changes caused government regulation – the initiation of crude oil exports – plus the fraught implementation of the Renewable Fuel Standard (RFS) program will depress margins for the foreseeable future. 

The RFS is a particularly pernicious problem.  The program was created by Congress in 2005, and further strengthened in 2007.  It was intended to nudge America off petroleum by increasing the volume of renewable fuel in gasoline, a noble goal at the time.  No one anticipated that America was on the verge of discovering how to produce oil from shale.  In the RFS, Congress specified how many gallons of renewable fuel should be burned each year through 2022.  Congress put EPA in charge of the program.  The problem is that Congress did not correctly calculate the “blend wall”, or the maximum amount of renewable fuel that can be blended without creating problems for gas stations and motorists.  America has hit the blend wall and EPA refuses to retool the program.   If nothing changes, independent refiners like ones we owned pay a huge price.  

We began selling refiners during 1^st quarter with the sale of Phillips 66 (PSX) for a gain.  We thought it was an opportune time to sell after Warren Buffet’s portfolio manager made PSX his sixth largest holding.  We were right, but we should have sold all refiners. During second and third quarter we sold the remaining holdings in the portfolio: Valero (VLO) for a slight gain and HollyFrontier (HFC) for a loss. 

Acquisitions and Special Situations

We added a position in Monsanto (MON) during 3^rd quarter.  On September 14th Bayer and Monsanto announced a friendly deal between the companies for Bayer to acquire Monsanto for $128/share cash.  The deal is dependent upon anti-trust approvals from the US and the EU, and contains a $2 billion break-up fee payable from Bayer to Monsanto should it not occur. The market is skeptical that the deal will close and has driven the value of Monsanto stock down since the announcement. We calculate that the market is giving the deal a 30% chance of success. The companies do not compete in most of the segments in which they operate and regulators just approved the acquisition of Syngenta, a Swiss agribusiness firm, by ChemChina, a Chinese firm, so we think the market is being too pessimistic.

We also sold the Chesapeake (CHK) bond we bought in March.  We bought the bond for .54 and sold it for .96 in August.  It was a small position so it didn’t impact portfolio performance much, but we mention it here to illustrate how difficult it is for capital markets to price some securities.  CHK in particular has been misjudged.  The stock went from $21 to $1.50 back to $7 all since 2015.  We sold our equity in 2015 at $14.57 for a loss and have made some back in bonds and options.  We currently hold 2018 calls with a strike price of $5.

***

The link between most of Taum Sauk's clients and Tom & me is that most of us graduated from Harvard Business School. If there was one thing HBS taught us, it was to set a strategy and stick with it. Tomorrow Tom and I will fly to Boston to attend the 25th Reunion of our HBS class.  We are looking forward to seeing investors there and talking about energy.  We have our personal assets in Taum Sauk's Energy/Natural Resources portfolio, and over the long term, we think it will turn out spectacularly well. 

Nancy                                                                                                    

September 21, 2016                                                                                     

Taum Sauk Investments

Dallas, Texas 

646-296-6102

ntschmitt@taumsaukinvestments.com

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[1] Baker Hughes International Rig Count, August 2016.  Web accessed Sep 21, 2016.

[2] The largest oilfield in the world, Ghawar in Saudi Arabia, is estimated to contain more than 100 billion barrels of oil, but no one really knows how big it is.  As prices go up, more wells and edge locations can be developed.  Development adds infrastructure, which causes costs to go down and even more edge locations to become profitable – a virtuous circle.  This is true of every oil reservoir, so it is possible that the Permian Basin will become the largest oilfield in the world as it is developed. Chart from Pioneer Natural Resources Investor Presentation September 2016.

[3] Foiles, William, Bloomberg Intelligence Frac Sand Demand, Aug 2016.

[4] Baker Hughes North American Rig Count Summary, 9/16/16. Web accessed Sept 16, 2016.