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Aug 2 2010 | 12:08pm ET
Energy funds have suffered this year from a range-bound market, uncertainty over regulation, and the oil spill in the Gulf of Mexico. But one fund is bucking the trend.
Today’s Q&A features Derren Geiger, portfolio manager of the Caritas Royalty Funds. Caritas operates under the management of Cornerstone Acquisition & Management Co., an affiliate of Greenwich-based Centaur Performance Group.
How many energy-focused funds to you manage, and what is your basic strategy?
We manage four funds: Caritas I (onshore/offshore) and Caritas II (onshore/offshore).
The Caritas Funds invest in producing oil and gas royalty interests and minerals located in the U.S. Furthermore, Caritas focuses exclusively on onshore assets in long-life, low-declining conventional basins/reservoirs. The funds receive consistent oil and natural gas royalty income—a percentage of which may be hedged against commodity price movements—as well as appreciation through the ownership and active management of these interests.
Royalties are contractual rights to receive a fixed percentage of revenue from leases on producing oil and natural gas properties, which are owned and operated by third-party exploration and production companies.
Many energy-focused funds have been hit hard this year—especially those with exposure to companies such as BP—though your funds are performing well. Why is this?
Correlation among all markets has been excessively high this year, including energy-related equities and the underlying commodities. Crude prices have been tethered to the broad indices for quite some time, which were negatively impacted by numerous global macro events occurring in the U.S. as well as overseas.
The BP incident exacerbated the declines, especially in those names closely associated with, or with considerable exposure to, the events unfolding in the Gulf. Caritas was able to sidestep market beta through two fronts:
First, the fund portfolios are aggressively hedged. Since inception, we have adhered to a disciplined hedging strategy that has protected investor returns and minimized volatility over several cycles. While we continuously add to our hedge positions through time as prices dictate, we look to lock in prices during certain cyclical and seasonal impact events that are relatively common in the commodities arena. For example, in the 2005 aftermath of Hurricanes Rita and Katrina, Caritas locked in oil/gas prices several years forward. Subsequently, in 2008 Caritas locked in oil/gas prices near the record price peak for several additional years forward.
Second, the private oil and gas assets we manage are inherently stable. Private oil and gas assets typically do not change with the same speed as spot commodity prices and are not nearly as correlated to the equity indices. Private oil and gas asset values tend to trend with the average futures strip pricing three to four years out. Futures pricing is used by the private market in order to determine IRR targets on multi-year development projects. These estimated returns will ultimately dictate where funds will be allocated.
What sectors of the energy market do you think have the most potential?
We are positive on the near-term/long-term future of both oil and natural gas for different reasons.
Despite the recent global economic headwinds, crude oil usage will continue to be robust in developing countries over the next several decades, more than offsetting slowing OECD growth. China, India and other developing countries’ oil consumption growth is staggering and will continue its rapid pace for the foreseeable future. Roughly 70% of oil consumption in the U.S. is used for transportation—primarily gasoline. While strides are being made, outside of existing mass transit there are no viable substitutes for the mass population’s use of cars/trucks that run on gasoline. On the supply side, all of the low hanging fruit is largely gone, requiring companies to look further, deeper and longer for material oil finds. Supply arguably cannot keep up with impending demand.
We are positive on potential near-term natural gas price catalysts as well as the long-term increasing role of natural gas in the U.S. Over the next few months, gas prices have the best opportunity to advance more than we’ve witnessed over the past 18 months due to the combination of the following: First, a very active hurricane season forecast; Second, the start of one of the hottest summer’s on record, boosting cooling demand; Third, lower supplies out of the Gulf of Mexico as a result of the proposed deepwater drilling moratorium; And fourth, likely increased onshore/offshore regulation, which will negatively impact supplies.
Over the long-term, natural gas is increasingly taking market-share away from coal on the electricity generation front and is gaining traction in the transportation sector—both in fleet and consumer vehicles. Natural gas has a much lower carbon footprint than coal and crude oil and is domestically abundant.
Are there any areas that are you avoiding?
Caritas invests exclusively in U.S. onshore assets. Since inception, we have avoided offshore and Gulf Coast assets due to the higher probability of production-inhibiting events and a potential reduction of cash flow yield for our investors. Offshore production poses a number of significantly higher risks than onshore development, some of which we have witnessed with regard to BP and their service providers in the Gulf of Mexico. The other primary risk is hurricane-related production shut-ins. June through November of each year is a crapshoot on storm activity in the Gulf. Hurricanes, or even the threat of storms, result in the evacuation of personnel and the shut-in of production for days, weeks, even months. Therefore, Caritas avoids preventable variability of returns.
Onshore, we also tend to avoid the new shale plays (Marcellus, Haynesville, etc…), preferring to focus on long life, predictable, relatively inexpensive, conventional basins/reservoirs. The shale plays are relatively new and provide an abundance of supplies, but also increased risks. The discoveries of certain shale locations are so recent that they are yet to be fully defined in terms of core vs. non-core production potential. Little historical analysis with regard to both acreage and well performance exists, which reduces our confidence in forecasts. In addition, unconventional shale extraction costs are significantly higher than conventional resource basin/reservoir production. When oil and gas prices fall, unconventional plays are often the first to be sidelined as, with their higher breakeven thresholds, they become uneconomic to produce. In addition to the costs, shale’s horizontal drilling techniques use hydraulic fracturing methods, which have led to claims of water contamination due to the chemicals typically utilized in the procedure. These claims, along with a few other accidents, are drawing the ire of state and federal officials, which could soon begin to impose expensive and supply-hindering regulations.
Where do you see the prices of oil and natural gas going by year-end?
Oil and gas prices are difficult to predict, especially given the number of attributes pushing/pulling prices on a minute-by-minute basis. That being said, we believe crude oil prices will continue to remain fairly range bound (barring an unforeseen event) and trend with the broad equity indices throughout the remainder of 2010. If global macro pressures continue to weigh on the markets, we are of the mindset crude prices will follow – to a point where fundamentals take over. On the other side of the spectrum, if the U.S. and other global economies show renewed signs of growth, crude prices will rise with the equity indices (with no restrictive cap). A significant move in either direction is not anticipated as fundamentals will likely not materially change over the course of the next five months.
Natural gas prices will be nearly entirely subject to weather implications – primarily hurricane threats and summer cooling demand. While the U.S. has a large supply overhang to burn off, a series of Gulf hurricanes combined with a hot summer can quickly tip the scales in the opposite direction.
Do you have any plans to launch new funds in the near future?
Yes, definitely. Caritas has a two-pronged growth strategy: First, continue to bolt-on smaller quality assets to the current Caritas Royalty portfolios. It is quite easy to locate smaller interests to continuously integrate into the larger portfolios. Second, we continue to evaluate large oil and gas royalty transactions, with the expectation of launching a new Caritas fund once a portfolio of sufficient size ($10MM+ purchase price) is located, analyzed and acquired. With the capital markets thawing over the last several months, deal flow activity is at its highest point in several years.
We are also considering introducing oil and gas investment vehicles which would provide a slightly higher risk/return profile than the royalty funds currently offer—if the right opportunity presents itself.
Hedge funds have witnessed a tough fund raising environment the last two years. How receptive are investors to this type of strategy? How easy or hard is it educating investors about it?
In general, investors are very receptive toward the strategy. The notion of real asset exposure possessing low correlation to equities and spot oil/gas prices and less volatility than most other energy-related investment vehicles are attractive qualities to the majority of the qualified investors with whom we meet. Since commencing operations in 2004, we have met with a diverse investor base, with differing levels of knowledge concerning oil and gas as well as the general concept of royalties. It usually requires a detailed meeting or two for the investors to grasp the general attributes of oil and gas royalties as well as the overall strategy. We take the time to stress exactly how the Caritas strategy is different from anything they have likely ever been approached with, which includes our team, experience, analysis, and transparency. Once investors allocate to our funds, however, they tend to be very sticky.