The global financial chaos and low commodity prices that plagued late 2008 and most of 2009 left much of the investment community in limbo, eager for signs of recovery. In the interim, several prominent institutional investors quietly reduced their exposure to energy stocks. This year, some have opted to leave their energy weighting low, still smarting from the market crash and skeptical about gas prices and ongoing reforms on Capitol Hill.

But other buysiders are taking a more strategic, optimistic view, seeing valuable investment opportunities in the major integrated oils, independents with seasoned management teams and “underdog stocks” Wall Street may be underestimating. These buysiders are applauding many energy companies for applying lessons learned to their balance sheets and asset-development strategies.

And, while buysiders investing in energy aren’t immune to what’s creating industry buzz—unconventional assets and oil-weighted E&Ps—many are reluctant to exchange foundation beliefs for what’s in fashion. Now that buysiders are looking again, are they valuing companies based on assets, balance sheets or just commodity prices? Here, six buyside firms discuss current investment strategies, holdings that are exceeding expectations and energy subsectors poised to outperform this year.

Liquidity Driven

West Coast Asset Management Inc. was formed in 2000 by Lance Helfert and Kinko’s founder Paul Orfalea. Today the firm has $260 million in assets under management and more than 100 clients, primarily high-net-worth individuals and a few foundations. It offers separately managed equity and fixed-income accounts, along with a private partnership. The partnership is primarily focused on debt-oriented investments in small publically traded companies that offer upside potential through warrants and the option to convert into equity.

“The equity accounts have historically had a significant weighting toward energy, about 15% to 25% of the portfolio,” says Atticus Lowe, chief investment officer. “In the private partnership it’s more than half, so there’s an even larger focus on energy. Our investment style is very entrepreneurial, similar to Berkshire Hathaway. Our investments are typically concentrated in 10 to 15 companies at any given time, and we don’t limit ourselves to certain industries or market caps.

“All of our due diligence is done in house. We review Wall Street research, but all of our investment decisions are based on our own research. Our concentration sets us apart from the competition. We’d rather put more of our money into our favorite investments and be rewarded for being right.”

In energy, Lowe’s group prefers E&P companies. “We think it’s a more lucrative business, and less risky if managed appropriately. E&P and the service sector have similar risks as far as commodity downturns, but we like the opportunity to find catalysts in E&P companies that can move the stock multiples if they work out. It’s easier to identify those opportunities in E&P.”

West Coast takes a three-prong approach to energy investments. The first involves a review of the management team, including its track record of capital allocation, business philosophy and incentive structure.

“It can be tempting to overlook this part if the asset or play is really enticing, and we’ve been guilty of it before, but we’ve learned lessons that really drove this home for us. We want to invest alongside people that have integrity and an intense focus on per-share value creation.

“Secondly, we look at the value of the underlying proven reserves with a focus on proven producing assets. Finally, it’s great to find the real catalysts that could drive multiples on the investment. That’s the third prong.”

Companies that fit the bill for West Coast include Contango Oil & Gas Co. and Canadian Superior Energy Inc. “Contango’s chief executive Ken Peak is one of the best in the business,” Lowe says. “He owns roughly 20% of the company and is responsible for growing its equity value to $900 million. Its shares outstanding over time have actually decreased. This is extremely rare if not unheard of in the E&P industry, where most companies are focused on growing aggregate production and reserves as opposed to per-share value.”

Since 2001 Contango has raised $60 million of equity and repurchased more than $70 million in shares. It also has $70 million in cash on the balance sheet, and zero debt.

“Peak is a good capital allocator—the Warren Buffett of oil and gas. Contango made one of the largest discoveries in the Gulf of Mexico in the last 25 years and was a first mover in plays like the Fayetteville shale. Natural gas is extremely out of favor right now, but Contango is one of the lowest cost producers in the industry and roughly 20% of its production is in the form of natural gas liquids, which command a premium. I don’t know anywhere else I can invest in top-notch management at a price of only $2.50 per Mcfe (thousand cubic feet equivalent) of proven producing reserves.”

Canadian Superior Energy has been a bittersweet investment, Lowe says. On one hand, it has made three of the biggest gas discoveries in the world during the past few years offshore Trinidad. On the other hand, the company had some significant issues in the middle of the economic meltdown in early 2009. Eventually, it was forced to dilute its interest in Trinidad to recapitalize its balance sheet.

“But they’ve emerged from that place and maintained a substantial asset base. The company reconstituted its board of directors and is looking for a new chief executive. They’re likely sitting on more than 4 trillion cubic feet of gross natural gas reserves in Trinidad, which is one of the biggest LNG (liquefied natural gas) hubs in the world. They also have a western Canada asset base that’s the bread and butter for the company, producing 3,000 barrels of oil equivalent per day and growing.”

The buysider believes the margins and opportunities in oily companies are incredible at current prices, but scarce in number, since there are only a handful of E&P companies with oil as the majority of their production.

As for gas, “long-term, there’s a great opportunity there, but the short term is scary because of the supply-and-demand imbalance. Also, we’re skeptical about a lot of these average type curves you see for the shale plays. We wouldn’t be surprised to see the economic threshold of these plays really increase during the next five years, so we aren’t attributing as much value to the gas shales as many investors are. But, looking forward, it’s hard not to see gas replacing a meaningful portion of oil demand as a fuel source.”

Lowe notes that many independents have announced changes in their business strategy with a renewed focus on oil, a trend he says will likely continue as long as gas prices stay low. While drilling to hold acreage should continue, he expects cash that was earmarked for gas projects will probably be used for oil and condensate projects.

“A lot of investors and E&P companies are very cautious about gas investments in the short term, and for good reason. Those relatively few companies that have good liquids-oriented projects are going to do phenomenally well for the foreseeable future.”

Sell Winners, Buy Losers

Greenwich, Connecticut-based Sound Shore Management Inc. was founded in 1978 and has kept the same investment structure over the years. The independent investment-management firm manages about $7 billion in assets. One-third of this is in its mutual fund, the Sound Shore Fund, and two-thirds make up funds the firm manages for institutions. At year-end 2009, energy investments represented 19% of its portfolio.

“There are four things that differentiate us as an investment firm,” says Jim Clark, Sound Share’s analyst responsible for its energy investments. “One is our focus. It’s hard to find 32-year-old firms that still do one thing. Our goal is to be the best value-investment firm around and we feel we can do that through our 40-stock portfolio. The second thing is our independence. We’re owned by the partners, and answering to our clients and ourselves at the end of the day gets us to zero in on picking the right stocks for the portfolio. Or, if we make mistakes, we reckon with them and move on. The focus and independence allow us to stay as contrarian as possible about stocks.

“The third thing is our investment process. We call it disciplined fundamental value. It starts with a valuation screen, and then includes detailed fundamental work from our seven-person investment team.

Finally, we are significant investors in the fund, including our employee profit-sharing program that’s entirely invested in the Sound Shore Fund.”

Clark says his team is bottoms-up in all sectors, meaning they don’t start off with a macro view and then work into the stocks. Instead, their process starts with stock-specific research, and then moves toward a macro view. Though the commodity markets were very volatile during the past few quarters, he says Sound Shore has stuck to a strategy of “selling winners and buying losers.”

Price volatility allowed the firm to pick up stocks “that are terrific franchises at low prices,” Clark says. While the firm was selling some of its energy positions in the first half of 2008, by the fourth quarter of that same year a lot of buying opportunities with attractive valuations surfaced, he adds.

“As value investors, we’re much more inclined to invest in names when prices are down, and we prefer to take one risk at a time. Generally speaking, we look at out-of-favor stocks, which are going to have issues. If we’re talking about an operational issue that management is focused on fixing, then we’re willing to take that operational risk as long as we know we have a balance sheet and business model that lends itself to stability. We like limiting the types of risk we take on with each investment.”

The analysts at Sound Shore pay close attention to a company’s valuation, and where it stands compared with its historic norms. They also look at financial performance relative to history. The group actively invests in companies that are in the bottom end of their valuation range to take advantage of mean reversion, an investment approach that suggests prices and returns eventually move back towards the mean or average.

“We also spend a lot of time with primary research sources. We won’t buy a stock until we’ve talked to the management team. We even talk to competing management teams and field consultants—anybody who can give us insight about the company. Finally, we come up with a financial model that helps us see the earning power of a company and the risk/reward value.”

Energy holdings that are exceeding the firm’s expectations include ConocoPhillips Co., which is in the middle of a fairly significant restructuring. The company is expected to sell $15- to $20 billion in assets during the next 24 to 36 months, and Clark expects some of the proceeds will reduce debt and fund share buybacks. Historically, many of the integrated oils have performed well during a restructuring, he points out.

“It’s really an improving return-on-capital story. As the returns on capital move up, it will realize a higher multiple in addition to the earnings growth we should see in the next two to three years. We expect price-to-cash-flow multiples to also expand as they get higher returns.”

Marathon Oil Corp., which is more exposed to refining and marketing, is also a Sound Shore holding. Currently, there’s a lot of confusion on Wall Street about the earnings power of the company, Clark says. It just finished a massive capital-spending period and recently built a large expansion in the Gulf Coast at its Garyville refinery. It also has had some down time in its E&P business, particularly in Equatorial Guinea and Canada.

“We think those assets are going to come back on stream during the second quarter. Off of a very low fourth quarter and first-quarter 2010 in oil production and refining profitability, we expect to see substantially improved earnings power.”

He points to the service industry and shale players as energy subsector winners last year; this year it’s the large integrated majors that have some refining, are doing restructurings and improving financially. Several companies with greater oil exposure were winners for the firm last year, but Sound Shore analysts are reluctant to assume all oil-oriented companies are good investments.

“We still look at investment potential on a company-by-company basis—we’re not invested in Conoco and Marathon for the same reasons. We take the approach that if oil and gas prices and refining margins stayed flat going forward, ‘will this stock outperform?’ We look for a company’s specific drivers that will make the stock go up even if we have a flat commodity environment.”

Value Oriented

Formed in 1997, New-York based Valquest Capital Management LLC is a hedge fund with less than $50 million of assets under management. The firm takes a value-oriented approach to investing, targeting companies that display three key attributes that comprise “The Valquest Winning Footprint.” These companies typically have undergone their own bear markets and been driven down to compelling asset-transfer valuations; have developed an easily benchmarked turnaround strategy; and have the potential to attract a strategic or economic buyer willing to pay a much higher price than the market reflects.

During the past three quarters, Valquest’s cumulative energy exposure has been 21% in the service sector, and 11% in oil producers and major integrateds. About 11.4% of Valquest’s exposure was weighted in small-cap energy companies and 2.3% was in large-cap names.

“The fund has always been a meaningful participant in the energy sector,” says Michael Grotell, president. “The cyclical nature of the sector allows us to accumulate at bottoms within the group’s subsectors and hold long-term, while trading both longs and shorts to actively manage our exposures.

“Our research indicated to us in the early 2000s that energy stocks, which had been out of favor, were likely to outperform. We built an oversized energy weighting up to 25% by 2004, as compared with a 7.2% weighting in the S&P 500. As momentum players began chasing energy stocks and market pundits were quoting $100 a barrel, we felt investor sentiment in the sector was getting frothy. Commodity investing and speculating had moved to the other side of the spectrum from where it was in 2003, and we started bringing down our exposure.”

By year-end 2006, the firm had reduced its net energy weighting to 1.47%, and maintained moderate exposure in 2007 and 2008. When the stock market bottomed out after the global financial meltdown, Valquest began re-accumulating energy stocks in earnest, Grotell says.

“We delight in the opportunities that cyclical industries provide. We find it rewarding and repeatable in that we are able to invest at cycle lows, and to get to know and hold our companies over cycles. We tend to do our buying when companies are beaten up, and then leave the party a little early, usually at about the time the momentum players raid the punchbowl.

“Currently, the new M&A cycle we had been forecasting is gaining momentum, with middle-market companies experiencing the greater share of deal flow as expected. Also, transactions and rumors in the energy space abound. This all falls right into Valquest’s sweet spot, and is creating some interesting investment opportunities.”

Valquest often focuses on companies with underpriced assets that the Street is ignoring or valuing differently. It then invests broadly, across market caps and across energy subsectors, he says.

“For example, in the past 12 months oil equipment and services stocks were up 70%, E&P stocks were up 47% and pipelines were up 37%. Some of the smaller stocks that we hold among the producers have risen from 100% to 300%, so we’ve been rotating out of them and into companies that haven’t had the same piling-in of investors.

“Also, the major integrated oils are up only 11%, and some of the larger E&P names have underperformed the smaller companies that survived the meltdown. We’re finding lower risk with good dividends and strong balance sheets and have been redeploying into these larger, more liquid laggards.”

s contrarian investors, Valquest looks for situations in which distressed shareholders create value by dumping their stocks. While some shareholders are forced to sell for a variety of reasons, they’re often not looking at what a company is worth, Grotell says. By the time Valquest invests in such stocks, there is a negative discount imbedded in the price, so the risk of owning them has been significantly reduced.

“As far as potential rewards, quantitative analysis has shown that when reporting a positive earnings surprise, the company that has an imbedded negative expectational discount will reward twice what a company with a positive expectational premium will.”

Two of Valquest’s holdings that have exceeded the firm’s expectations were BJ Services Co. and Smith International Inc. Both companies were acquired during the past year. Brigham Exploration and McMoRan Exploration, two other holdings, have moved up materially based on geology, geography, financial engineering and management vision.

“I give the industry and company managements credit for having become more astute, balance-sheet savvy and more niche focused during each of the last several cycles. This was not the case in prior decades. Currently, and not unlike other areas of the capital markets, fear and abandonment have been replaced by hope, turnaround, and now recovery. Perhaps this is now priced into many of the stocks that have rebounded; they are becoming crowded trades.”

Because of falling gas prices, some investors have shied away from gas-weighted names. Grotell says there are many variables that could affect which way gas prices go. Many E&P companies are not curtailing their drilling plans as quickly as they might otherwise prefer so they don’t forfeit their leases; this could potentially make the price recovery in natural gas slower. Also adding to the current oversupply is the move into shale plays, which is improving the ability to extract gas from rock and may result in a lower cost of production. This could also have a moderating effect on gas prices.

“There are some positives. Lower production costs strengthen natural gas’ future as an energy-source alternative. Also, the historically net short position of institutional speculators in gas futures suggests that sentiment is perhaps pushing bearish extremes. Notwithstanding the current rush to shale, any emerging buy pressure in gas should result in a hefty amount of short covering, so it wouldn’t surprise us to see a rebound in natural gas prices in the coming months.”

By contrast, he notes there has been little abatement of institutional net long positions in crude oil futures since the 2008 highs, which could have the opposite effect on oil prices. His 2010 pricing outlook is $65 to $95 for oil and $3 to $6 for natural gas.

“We think, in addition to the special situations that have not yet run up, the bigger and safer laggards that have been repositioning themselves, but were overlooked because they were not in the hot zone at the time, offer high potential for outperformance.”

Asset Allocators

Based in the heart of Chicago’s financial district and owned by the Bank of Montreal, Harris NA has about $41 billion in assets. The firm’s Harris Private Bank arm provides equity and fixed income management activities and currently has about $30 billion under management. As of April 10, 2010, Harris Bank had a 10.35% weighting to energy relative to the S&P 500. In spite of the financial meltdown last year, the firm didn’t experience major shifts in its energy-investment strategy.

“We’ve generally held pretty firm in our energy weighting, but our investment picks now tend to be a bit more focused on oil as opposed to gas,” says Thomas Lewis, director of research and trading, vice president, and senior equity research analyst for Harris Private Bank.

“It’s not that we don’t want to have natural gas investments—but as we moved into 2010 we knew that gas was liable to have a little bit more of a difficult time.

“We have exposure to some E&Ps that are in the shales, but we don’t play a name just because it’s in a specific area. The company needs to have other positive things going on. I don’t envision our approach to energy investments changing drastically, but we’re capable of tweaking it up or down.”

While Harris has some ownership in each of the energy subsectors, it has a strong interest in mid- to large-cap E&P companies. However, the larger portion of the dollar amount it has invested in energy is in the major integrated oils.

“We wanted to get into a more conservative, defensive posture with respect to where energy prices were going last year. We envisioned a relatively stable environment for crude pricing between late last year and early 2010, and we thought we might see some stalling in the economy. Because of that, we thought energy investors might get a bit more defensively oriented, with a focus on the large-cap, dividend-paying companies with the most consistent returns.”

Lewis is cautiously optimistic about commodity prices. He says crude will probably continue to trend in the low to mid-$80s, higher than what people generally expected. He expects gas to get as high as $4.25 to $4.50.

“Gas is tough right now but long-term, it’s a great commodity to be involved in. If the economy moves in a more positive direction, it will perk up demand, which will drive prices higher. If events push crude prices higher, this will pick up gas prices no matter what else is going on.”

When Harris evaluates potential investments, Lewis says it’s critical to look at a stock from all angles, from the management team to the interaction of various investment metrics over a period of time. This includes a number of different variables—interest rates, inflation, etc.—that go back for decades, which helps the firm develop reasonable assumptions of risks and returns.

“A good management team is going to be able to capitalize on quality assets and ensure that growth remains in place going forward. They’ll make sure returns stay high. There’s also a lot of emphasis on finding and development costs and repeatability of good results.

“If you’re in cycles where you’re having a tremendous uptick in energy prices, you’re going to get the most bang for your buck if you go with somebody who’s highly leveraged to the commodity. But when the cycles are moving in the other direction, people want a strong balance sheet, stable cash flows and a yield on the dividends.”

Before it was sold to Exxon Mobil, XTO Energy was a top E&P stock at Harris. Lewis considers the XTO management team a seasoned group that can repeat results. “They had a good asset base that they grew wisely through regular acquisitions. They never lost focus in terms of their geographic areas of expertise. And they never went too far trying to hit a home run; instead, they consistently hit singles and doubles and the stock paid for itself.”

Another winner for Harris has been Newfield Exploration Co. Though it has had challenges at times, “trying to find out exactly what it was,” Lewis says the newer players leading the company are helping potential investors see it as more of a quality E&P player.

“People that were invested in XTO are now looking for a name to replace it. Newfield is one of the companies investors are looking at to fit the bill.”

Going forward, Lewis favors exposure to quality, globally diverse service names and E&P companies. He also likes the refining sector as an early-year play.

One of Harris Private Bank’s strengths is as an asset allocator, Lewis says. During the recent market downturn, Harris continually reviewed its investment strategy and adjusted it where necessary. “The key to any approach is flexibility,” Lewis says, and “we have it.”

“Our firm was providing tactical overlays on a strategic framework when the concept was sort of taboo. Other shops may place client assets into a strategic weighting and move straight to the security analysis, but we add a degree of technical allocation as well. That provides management on many different levels: strategic allocation, asset-class biases and securities selections within each of the classes.

We knew there could be rough patches in performance last year, but our investment philosophy was solid and we maintained it.”

Long-term View

RoundRock Capital Management in Dallas handles about $40 million in assets through its long-short, energy-only hedge fund, RoundRock Capital Onshore. RoundRock Capital Management also advises a larger hedge fund on the energy segment of its portfolio.

The firm differentiates itself from other buyside entities largely by its executives’ background in E&P and the way they generate 85% of their ideas through internal research.

“We only invest in equities,” says Peter Vig, managing director of RoundRock Capital Management. He, Wade Suki and Ben Vig are responsible for its portfolios. “While we invest across the energy spectrum, our focus has been on E&Ps and oilfield-service names.

“We’re value investors, so in looking at E&P stocks we pay attention to where a stock is selling relative to net asset value. We also look at the price per flowing barrel of oil equivalent, acreage, oil vs. gas leverage, and balance sheets. In oil-service names we look at enterprise multiples (enterprise value/earnings before interest, taxes, depreciation and amortization); the price-to-earnings ratio relative to peers and the balance sheet. Last, but not least, is our assessment of management.”

RoundRock analysts are bottoms-up stock pickers. During the past 18 months the firm has been positive on oil prices and negative on gas prices. Accordingly, it emphasized companies leveraged to oil, condensate and NGLs. It took the same approach to its oil-service stock picks.

“We make our best returns when we take advantage of having a view that is different from consensus. Also, Wall Street is often too focused on near-term negatives as opposed to the long-term view. For example, in mid-February, analysts lowered their rating on EOG Resources Inc. when the company reported fourth-quarter 2009 earnings and didn’t elaborate on its ‘stealth’ oil plays. The stock traded under $90 and we added to our position; today the stock is above $110.”

Vig also points to Pioneer Natural Resources Co. and Carbo Ceramics as winners in the firm’s portfolio.

“Pioneer has cleaned up its balance sheet and sharpened its focus. The majority of its capital expenditures are going to the Sprayberry formation in West Texas and the 300,000 acres it holds in the Eagle Ford shale in South Texas, where they are likely to bring in a joint-venture partner. The stock is up threefold since we bought it.

“As for Carbo Ceramics, the company is a beneficiary of horizontal drilling, especially for oil. The company is sold out for 2010, is bringing on new capacity in the fourth quarter of this year, and the board recently approved a second capacity addition.”

Vig likes certain segments of the oilfield-services group as potential outperformers this year, especially those tied to horizontal drilling. Pressure-pumping activity is expected to approach the record levels of 2008 with revenues up 30% to 40%, he says. RoundRock owns stock in both Halliburton and Calfrac Well Services Ltd., a smaller North American pressure-pumping company. The firm also recently initiated a position in Cathedral Energy Services Ltd., a small directional drilling firm active in the U.S. and Canada.

Overall, RoundRock is bullish on oil and gas investments, Vig says. “While stock prices have moved up, valuations are still reasonable. Oil should average $80 per barrel or higher in 2010, while gas could average $4.75 or less.”

Opportunistic Investor

As a part of BNY Mellon Asset Management in Boston, The Boston Company Asset Management’s small-cap growth team manages microcap, small-cap and mid-cap portfolios. Though its energy weighting varies by portfolio, the team’s managers have had an active interest in the energy sector for the past five years. While several buysiders were reducing their energy exposure in 2009, the firm’s energy position actually increased.

“When oil went down we thought it was an interesting investment opportunity, and we increased our positions in several companies with oil-leveraged business models,” says Todd Wakefield, portfolio manager. “I like oil because the market is slowly tightening and OPEC’s spare capacity is going to slowly shrink over the next 18 months. This should be a driver to keep oil prices at current levels, if not higher. We had less interest in companies with business models heavily leveraged to natural gas prices.”

During the past 12 months there were substantial opportunities to buy into all kinds of energy companies at attractive levels, especially if they had balance-sheet risk, he adds.

“Our style isn’t necessarily to take on a lot of balance-sheet risk, but during that period the market’s worries created opportunities to buy terrific companies at exceptional values.

“I expected more mergers and acquisitions during the downturn. Companies with strong balance sheets were hoping to buy companies with poor balance sheets, getting quality assets at distressed prices. However, the capital markets cooperated and most companies avoided selling assets at distressed prices.”

Wakefield’s investment-evaluation process starts with developing valuation targets, and determining downside and upside potential. If the potential isn’t promising, the analysis ends. If the stock has a strong risk-reward profile, the process moves into a review of the management team and very bottoms-up, fundamentally based analysis.

“In developing our energy-investment framework, we try to identify themes that have strong tailwinds behind them. This helps us determine which subsectors we want to focus on. During the last few years there were definitely times when we wanted to focus on oil versus natural gas, or services versus producers. Once we determine what area of energy is attractive, based on the dynamics of the market, we then focus on bottoms-up analysis.”
A theme that is still prevalent today is to identify new or improving resource plays and the companies that will benefit as the plays get de-risked.

When Wakefield was covering energy a decade ago, he says it seemed like the majority of the value made from an investment was tied to “getting the commodity right. But now you can make money in stocks that are being revalued based on their asset positions. Investors didn’t have to get the gas call entirely right if they correctly forecasted the de-risking of the Fayetteville or Marcellus resource plays. However, going forward, I want to get the commodity direction calls right as best we can.”

He likes oil producers over oil-service companies because from 2004 to 2008, service-capacity additions were up more than producers’ capex. Thus, he expects the pricing cycle for service to be more muted than it’s been in the past. It’s another reason why the producers offer better value right now with a positive commodity outlook for oil, he says.

“The bottom line is the oil market is tightening because demand is increasing faster than supply. As for the natural gas market, demand is increasing, but so is supply. It’s easier for the market to throttle-up supply in natural gas compared with oil.

“I’m expecting crude to stay in the range of $75 to $100 this year; for gas my expected range is $4 to $6 on strip pricing. Institutional investors have embraced the economic recovery, and they’re buying stock across the energy subsectors. Energy hasn’t been a leading sector in recent quarters but it certainly hasn’t been left behind.”