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 7th. 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
1/3rd. 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 2nd
and 3rd 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 1st
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 3rd 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
[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.
