Fri, 7 Sep 2012
Despite the drop in natural gas prices, certain firms in the energy sector are showing their value, says Oakmark manager Clyde McGregor.
Shannon Zimmerman: So, let's talk about the equity part of Oakmark Equity in Income. We were talking before we began taping this segment, and the fund does have a pretty substantial exposure to industrials, overall more of a cyclical bent than a defensive cast right now.
I understand that shopwide Oakmark managers are not making any kind of top-down calls. They're not looking at sector allocations per se in the way you back in to your sector allocations through the bottom-up process, the stocks that you find most attractive. At the end of that process though, the result among many, one result is that you do have sector allocations that can be out of whack, or out of sync relative to the index.
Clyde McGregor: To the benchmark. Sure.
Zimmerman: Exactly. How do you think about risk in that context? For instance, given the fund's substantial industrials exposure right now, the next industrials name that seems attractive to you, will it become less attractive because you already have such a significant allocation there?
McGregor: As we've often said, every asset in the portfolio and in all of our portfolios has to compete with every other asset for space in that portfolio, and any new asset will also have to compete on that basis. If it is the case that we decide we want to add another industrial to the portfolio, it would obviously have to be a name that on its own, we'd want to own the entire company at its current price if we could never sell it again.
So if it meets that kind of basic understanding, then we move to the issue of portfolio construction and how does it fit into the portfolio at this point in time. I will say it doesn't have to be an industrial, but in another sector where we have a fairly large exposure. Today, actually I am cutting back one issue and adding to another issue in the portfolio, both for valuation reasons and in one case for a tax-reduction issue, as well.
So, we do think about that issue, but it's not primary. Again, as you mentioned, things percolate up from the bottom. The value decision ultimately trumps everything else. We find out that we have sector overweights after a while when we realize that we have been adding to the health-care space, or to the industrials space, or the energy space, and find out that we have overweights versus the index. We're benchmark-agnostic, but we do find out from people like you that we have overweights in such sectors.
Zimmerman: From your shareholders, as well, when the fund is more volatile than it might otherwise be?
McGregor: Yes. Although, today the fund is more volatile relative to other balanced funds because of the equity allocation rather than because of the sector weights.
Zimmerman: Right, because you are close to the top of what you can be invested in equities?
McGregor: Yeah, correct.
Zimmerman: 75% is max for Equity and Income?
Zimmerman: I won't spend all of our time on Equity and Income, but given the current environment for fixed income, do you have any thoughts on revisiting the prospectus maximum in terms of equities exposure, at least temporarily, and say the opportunities are much more plentiful on the equities side than on the fixed-income side?
McGregor: Well, there have been very light discussions of that, but nothing coherent or intentional. Occasionally, we ruminate about how bad bonds are and make such statements, but it hasn't been more directive than that.
Zimmerman: It seems like that rumination sort of industrywide has been going on for several years now. I keep waiting for the first shoe to drop, but it hasn't happened as yet.
Another area of the market that the fund is substantially exposed to is energy, and I know that from your most recent shareholder letter you picked up a new energy issue, Devon Energy. Can you talk a little bit about that company, but in the context of the overall process that you use at the Equity and Income fund and at the Global fund and that Oakmark uses shopwide?
McGregor: Well, one of the things that we love to do in learning about any business is to get checks from other companies in the industry that affirm our original concept of why the particular company is well-managed and an effective company. And we have had exposure to the Canadian tar sands sometime through our holding of Cenovus that was carved out of Encana a while ago and Cenovus management in passing noted to our analysts a while back that Devon had a parcel near theirs, and in Cenovus' opinion Devon was the best manager in the tar sands aside from themselves of course. And that kind of piqued our interest because this is a secondary or a tertiary business really for Devon.
We also noted over the years that Devon had gotten out of areas that we felt did not make much sense for them. For example, in the Gulf of Mexico, they sold a large amount of assets. They had focused on mainland North America and had a reputation for being a good driller. So we did more work on it and found that their asset pool like many exploration and production companies was quite undervalued in our estimation anyway. And we now had the combination of a management team that was acting in their shareholders' interests by managing their capital effectively and a cheap stock. So, we felt that this was one that rose to the level of forcing its way into the portfolio.
Zimmerman: So the natural gas line is a tertiary business for Devon as you mentioned. A company like that that has a fairly complex structure, the business model is not so complex, but the way it could be far-flung might be complex. What's the approach to valuation that you take for a company like Devon?
McGregor: Well, for a natural-resources company we're looking at transactions that have occurred in similar basins and applying it to the resources that have been audited and admitted into their statements. So, a natural-resources company is different from one where we evaluate it entirely on earnings. Yes, we look at earnings, we pay attention to earnings, and you don't ignore them. You look at dividends, all the standard characteristics, but for a natural-resources company, whether it's a copper company or a natural gas company or an energy company in totality, you're looking at transactions and trying to make sense of them.
Now it does happen occasionally that a business will have seen some very high price transactions and those no longer make sense because the price of coal or oil or whatever has gone down. We have to be wary of that. Obviously, we can't use old data that is quite out-of-date because of current market realities.
Zimmerman: Right, so it's almost private market estimations or looking at comparable deals in other parts of the industry and applying that to your own scenario with the company you're examining.
McGregor: Yes, both.
Zimmerman: In your responses then, you talked about Devon management's decision to pull out of an operation in the Gulf of Mexico and to focus more closely on its core businesses here onshore. Talk a little bit about that as a specific example of the way you vet management teams, and there's the question of are they shareholder-aligned? How do you answer that? What are proxies for that? And then in terms of their skill as capital allocators, how do you get a sense, and how do you get comfortable with the management team in that role?
McGregor: Well, again the Gulf of Mexico assets were mature assets that further expansion of them was going to be very expensive. Devon is kind of midsized energy company; it's not of the scale of a Shell or an Exxon, and to try to compete with the [larger-scale firms] in ever-deeper and more difficult spaces is a highly risky decision for a company of that scale. They got something on the order of $6 billion in sale of these assets for which they are able to apply a much less risky shale development. That's the odd thing about the energy space today is that there is rarely dry hole. There might be an uneconomic hole today, but they are not dry holes.
Devon had learned how to do the horizontal drilling and how to make this work. So they took the capital out of the Gulf of Mexico, moved it into the onshore space, and were able to leverage their position there. From our perspective, it made a lot of sense, and it also narrowed their range of management skills or whatever. They did not have to be as far-flung--to use a term you used before--and we felt that this concentration made sense, particularly at this time.
Now, of course, what hasn't made sense in the meantime is because of the great success that the E&P companies have had in exploiting the shale fields, the price of natural gas has come down a lot, which has harmed the prices of natural gas producers. And that created part of the opportunity for us to buy Devon, and we were buying it at least more than a third off of the high rate it had a couple of years ago.
Zimmerman: I want to ask you about that, because you also talked about it in your summer commentary, a natural gas glut, which has been a persistent glut for several years now. Two questions really, how much of the revenue is derived from gas? And how long do you expect it will take for the investment thesis that you have for that company to play out given the glut of natural gas?
McGregor: Value mangers I think, generally, are not very good on timing and such things in terms of when things are going to work out. So, I will say I don't know relative to that. The majority of the revenues today are coming from oil. Devon produces less oil in terms of BTUs than they do gas in terms of BTUs. But the price of gas and oil are so out of whack with each other that the smaller oil component overwhelms the gas component. We expect that to continue for some time.
When we value businesses, when we value properties that a company like Devon has, we do use the futures curve in terms of trying to justify the prices that people are paying, and the futures prices show some decline in oil, some rise in natural gas. We think that those are reasonable, but there are many people who feel that natural gas prices should become more at BTU equivalents with oil.
Well, we don't see that happening. Natural gas is more of a stranded asset until we develop the export facilities to be able to send it off to Japan or other markets that pay very high prices for natural gas. It's a very curious situation where natural gas in the United States is roughly $3 per million BTUs, and in Japan it's oftentimes over $16. It's an advantage for our manufacturing companies versus Japanese companies or European companies, but it's a disadvantage for our native producers of natural gas because they can't get it from here to there very easily.
Zimmerman: So, why the big press or big push within the industry to find more and more opportunities to mine natural gas so to speak?
McGregor: Well, recognize that the big push, to use your term, was used several years ago before the price of natural gas had come down so much, and it became sort of a competitive aspect to get leases in place. And Chesapeake was one company that became rather renowned for this and took on a very large amount of leaseholds. What happens when you take on the lease position, you have to show at least a minimal amount of drilling within a certain time frame in order to hold the lease. And so, the number of gas rigs has come down over 2012. We expect that to continue if the price of gas does not revive some.
It doesn't say that you can't be a successful company in this environment even at current prices. We own some Range Resources shares in the fund, and Range actually drills in my old homeland. I grew up in Western Pennsylvania. And Range has had some great success in the Marcellus Shale in Western Pennsylvania, and their cost per million BTUs is at a level that is still profitable for them to produce natural gas. Other companies have issues where they not only don't have the same cost structures, but they don't have the transportation facilities to get it out either. And so they have much higher costs. It's very company-specific.
Zimmerman: Sure. The portfolio I think has about 12% as of the end of June allocated to energy right now. So not necessarily about Devon, but when you think about energy and the share-price performance of all those companies to some degree is going to be affected by its tether to the price of a commodity. I know that Oakmark, there's a requirement of a very steep discount to your estimate of business value or intrinsic value, 40% is sometimes the number that Oakmark managers refer to. Is there a greater discount that you require for energy companies because of the very difficult nature of forecasting what normalized earnings going forward will be?
McGregor: Well, again we use the futures curves to help us come up with those forecasts. So, it doesn't mean the futures curves will be correct, but it does mean that a business person could buy a company and sell-out for the next five or six years depending on the length of the curve at any point in time and be able to pay for his or her investment through doing that.
So, we think that it is a discipline that makes sense over the long term, and it has worked for us over many years. You may recall that XTO Energy was a very significant holding for the fund. It was a great success. Burlington Resources [was another]. We are trying to repeat past glories or something like that, but we do believe that this is a space where our way of seeing adds some of value in terms of finding value.