Seeking to capture above-average returns in a frothy energy-equity market while cushioning themselves against major commodity-price corrections, more and more high-net-worth individuals and qualified institutions are pouring dollars into a burgeoning number of hedge funds. Indeed, New York-based Hennessee Group LLC, an advisor to hedge-fund investors, notes that since 1992 hedge funds have ballooned in number from 880, with assets under management of $55 billion, to a recent level of more than 8,000, with $1.12 trillion of managed assets. An estimated 500 focus on energy. Meanwhile, an increasing number of sellside energy analysts have begun exiting investment-banking firms to participate in the hedge-fund sector. This includes Shawn Reynolds, a former Petrie Parkman & Co. energy analyst who joined New York-based Van Eck Global Associates, a firm with $3 billion of assets under management, one-third of which is currently invested in energy across several hedge funds; Ryan Zorn, a former Simmons & Co. International analyst who teamed with Houston-based Saracen Energy Advisors, a $700-million investment house; and John Selser, a former Johnson, Rice & Co. researcher who joined Baton Rouge, Louisiana-based Maple Leaf Partners LP, a nearly $1-billion general hedge fund. The attraction? For both investors and former sellsiders, hedge funds offer the kind of investment flexiblity to manage market risk and volatility not available in the public market, and to potentially achieve above-average returns not correlated with the general market. Unlike mutual funds or long-only portfolios, hedge funds can short securities. Through such transactions, they sell borrowed securities, betting those securities will decline in value; later, they buy back the securities at a targeted lower price, profiting from the spread. Also, hedge funds can use leverage to own a dollar amount of securities greater than the net equity in their portfolios. In addition, they can buy and sell stock options or commodities futures with the aim of profiting from the spread between the price at which the options or futures contracts are bought and the price at which they're sold. Finally, hedge funds have no restriction on the amount of cash they can hold or the amount of money they can invest in any one industry. There are, in fact, hedge funds today dedicated solely to energy-equity investments. For this sort of investment flexibility, these funds typically charge a 1% management fee and receive a 20% incentive fee, taken out of investors' capital gains. Not surprisingly, as hedge funds have drawn a growing crowd of investors, they've also drawn the scrutiny of the SEC which is seeking more regulatory control over them. Why? "This is a market [where] there are too many potential conflicts and abuses that can arise," observes one hedge-fund manager. To find out more about those hedge funds focused on energy, Oil and Gas Investor talked with some of the newer entrants into that arena. Seizing the day Up until late 2003, John Olson had been director of research and chief investment officer for Sanders Morris Harris, the Houston-based investment-banking firm. But that year, he and the company saw an opportunity emerging in the energy space. "It looked like the energy sector, indeed the whole stock market, had hit rock bottom following the Enron debacle and the domino-like collapse of Enron's competitors," explains Olson. "We also perceived that a massive spending cycle was about to get under way that would greatly benefit all energy companies. So we launched the 2003 Houston Energy Partners hedge fund to take advantage of the market peaks and dips in the coming stock-market recovery." This entry was followed by the 2005 Houston Energy Partners hedge fund and the 2005 Houston International fund. The aggregate size of the funds: $163 million, with Sander Morris Harris owning 25%. Olson and Steven Pouns, a veteran Houston money manager, co-manage the three funds. "By having the flexibility to take both long and short positions in stocks-and leveraging our long positions by as much as 20%-we've been able to take advantage of the volatility in the energy markets since that time," says Olson. The funds' returns during 2004 and 2005 were about 36% and 29%, respectively, net to investors. Their focus? In 2004, the first fund took advantage of the rise in dayrates for tanker stocks, which soared from $35,000 to $250,000 in a six-month period, and the attendant rise in valuations in that sector. Then, going into 2005, all three funds took aim at Canadian oil-service stocks, notably Trican Well Services, Ensign Energy Services and Calfrac Well Services. This year, the hedge fund is about 80% invested in oil-service stocks, particularly pressure-pumping providers like BJ Services and Carbo Ceramics, and engineering and offshore construction firms such as Halliburton, Shaw Group, Chicago Bridge & Iron, McDermott International and Helix Energy Solutions (formerly Cal Dive International). "The pressure pumpers have been the single biggest bottleneck in the North American oil-service business," observes Olson. "Very simply, drilling activity has outdistanced the ability of such service companies to acidize and fracture wells." Meanwhile, amid rising commodity prices, spending has ballooned in offshore construction, repair and maintenance, he adds. "This market has expanded to the entirety of West Africa and has ramped up massively in the Gulf of Mexico as the result of last year's hurricane damage." Both a bottom-up and top-down investor, Olson believes crude prices are probably going to trade around $60 until there is a measurable dent in global demand. "High oil prices have not created demand destruction. On the contrary, daily world demand rose between 1- and 2 million barrels for most of the 1990s and that phenomenon continues through today. Meanwhile, supply has remained tight." Noting the entrance of so many sellside analysts into the energy hedge-fund arena lately, Olson observes, "The economics have virtually vanished for the institutional research part of Wall Street. Hedge funds allow former sellsiders to put their money where their mouths are and to operate on their own independent judgment." Given the explosion in the number of hedge funds, Olson also believes such investment vehicles should receive closer scrutiny by the SEC. "This is a market that warrants regulation because there are too many potential conflicts and abuses that can arise. Clearly, hedge funds need to have a discipline that provides for transparency and common performance standards." E&P only One of the newer energy hedge funds, Houston-based E&P Strategic Partners LP, was formed at the start of 2004 to focus exclusively on the upstream oil and gas sector. "When I was the senior oil and gas E&P analyst with Banc of America Securities, we would identify the most undervalued names in the upstream sector, highlighting the top five stocks in our 20- to 30-company universe that looked to have the greatest appreciation potential during a 12-month period," says Mark Fischer, director of Fischer-Seitz Capital Partners LLC, the general partner of E&P Strategic Partners. "What we found between October 1996 and April 2002 was that the top five E&P companies in our portfolio gained more than 24% on a compound annual basis while stocks in the overall sector gained an average 8% per year compounded," he explains. "Concurrently, we also found that the bottom five E&P companies in our portfolio achieved a negative 7% rate of return versus the sector average of 8%. It seemed to me at the time that such market performances could be more fully exploited from an investment standpoint in a long/short hedge fund." The result: the $12-million E&P Strategic Partners fund. In that fund, Fischer and John Seitz, formerly chief executive of Anadarko Petroleum Corp. and currently co-chief executive of North Sea-focused producer Endeavour International Corp., concentrate on eight to 10 upstream stocks in each of the firm's long and short portfolios. Weighted most heavily are the top five holdings with the greatest and least near-term appreciation potential in those respective portfolios. "We have the option to take the fund as much as 40% net long or, using leverage, 40% net short if we think there's an excellent opportunity that has arisen in terms of making a bet on the E&P sector," says Fischer. "Thus, if we perceived that the cycle [for upstream stocks] was ending and that a down cycle was beginning, we would take the fund to our maximum 40% net short position to take advantage of that event." This aside, he expects that two-thirds of the firm's future returns will result from its ability to select individual upstream stocks that are inexpensive on the long side and relatively expensive on the short side. Therefore, it's primarily a bottom-up investor. Last year, E&P Strategic Partners, investing long and short in 20 large and midcap upstream U.S. stocks, achieved an 11.8% rate of return. The E&P stocks that have performed best for the fund this year: Kerr-McGee Corp. and Anadarko Petroleum. "Both are turnaround situations," says the seasoned analyst. "They've each struggled in recent years but have restructured themselves such that they're now on a growth path-yet their valuations relative to proved reserves and cash flow are lower than all of their peers that we've analyzed. So their stocks have room to continue to move up." The fund has also done well in the past year with several short positions in the E&P sector, including one in Stone Energy Corp., a producer now being acquired by Plains Exploration & Production. "In recent quarters, it didn't meet production targets, partly because, like most Gulf of Mexico producers, it sustained hurricane damage last year," Fischer says. "In addition, it has strained recently to develop good prospects in the deepwater and deep-shelf Gulf and has taken some significant reserve write-downs." As for SEC regulation of the mushrooming hedge-fund industry, Fischer urges caution. "While some regulation might be needed, if it's overdone that could drive small funds out of business. The risk is that a hedge fund may become large enough to have to meet regulatory requirements, but not yet be quite large enough to comfortably afford the costs associated with meeting those heavier requirements." Hedging its bets A distinctly different approach to investing in the energy sector is offered by Dan Tulis, New York-based managing director and senior portfolio manager for the $20-million Elco Select Fund. This hedge fund resides within Elco Management Co. LLC, which handles an aggregate $155 million of investments, including the $15-million, long-only Elco Energy Fund. "We invest across the entire energy sector, from E&P and oil-service stocks through midstream plays, utilities and companies engaged in the construction of energy infrastructure," says Tulis, formerly a Smith Barney sellside analyst. "Since energy is, by definition, volatile, this approach is much more risk-averse since it has countercyclical components, that is, one subsector may do well at a given point in a cycle, offsetting the less positive results of another that may be out of favor. This affords us the ability to achieve more steady investment performance." After fees, the long/short fund produced gains of 30.11% in 2003, 19.25% in 2004 and 18.62% in 2005. But these returns weren't just the result of being invested across the entire energy spectrum. They also arose from knowing when to shift weightings from one subsector to another. "We started out 2003 heavily involved in the E&P sector in companies like Devon Energy, Chesapeake Energy and EnCana, and combined that with aggressive investment in the merchant-energy sector, in names like The Williams Cos. and AES Corp.-companies that we felt had the best opportunity for recovery after the Enron collapse," he explains. But as time wore on and upstream cash flows rose significantly, it became apparent that E&P companies and the major integrated oils would be stepping up spending and that the oil-service sector was the place to be. "So we shifted our money first into land drillers such as Nabors, Patterson-UTI and Grey Wolf, later into jackup drillers like Ensco and Noble Corp., then finally in late 2004 into deepwater drillers Transocean, GlobalSantaFe and Rowan Cos." Moves like these helped Elco Select Fund last year to more than offset the disappointing investment results it experienced in the flat master limited partnership (MLP) sector. "However, if interest rates ease later this year, then midstream MLPs like Enterprise Products and Energy Transfer Partners have the opportunity to grow distributions by 8% to 10%," says Tulis. "During the past 10 years, MLPs have been the best-performing asset class in the energy sector, with average annual rates of return exceeding 20%." The portfolio manager is also sanguine in his outlook for gas producers like Chesapeake and EnCana. "The futures market is telling us that gas prices, recently around $7, are likely to be at least $10 this time next year." Still, Tulis notes that Elco Select Fund will remain heavily invested in the service sector-more so than in E&P stocks-and will buy on any corrections in the group. This includes not just drillers but service providers like Halliburton, Schlumberger, National Oilwell Varco and Grant Prideco. "The whole energy sector complex now looks to be in more of a tighter supply position than it has been in the past 25 to 30 years-and the idea that energy could be a good sector to invest in long term has caught the eye of a lot of investors," he says. "That, in turn, has created the need for more investment vehicles. Given the hedge-fund structure, there are several investment approaches investors can use within it that simply aren't available in the public market."