‘Sticky’ Money Investors Return to Oil Sector They Once Shunned

(Bloomberg) -- Energy companies long-spurned by institutional investors are crawling back into favor.

After declining for most of the past decade, energy made up just 6.4 percent of institutional investors’ holdings at the end of the first quarter, Royal Bank of Canada analysts wrote in a May note, citing company filings. That’s beginning to turn around with U.S. benchmark crude up 23 percent this year.

But while so-called sticky money is returning to the energy sector, more specialized funds are shying away from some Permian Basin explorers on concerns that pipeline bottlenecks in the region will force a slowdown in growth. It may take signs that producers are delaying well completions and idling rigs to bring back investors, according to analysts at Goldman Sachs Group Inc. and Tudor Pickering Holt & Co.

"Energy had become just a rounding error in broader indices and benchmarks, but we’re seeing some renewed interest now, especially with strong performance in the first half of the year," said Rob Thummel, managing director at Tortoise, which handles $16 billion in energy-related assets. "However, the Permian infrastructure constraints are real and will persist for at least 18 months, so investors need to be selective."

Stronger returns compared to other sectors, changes in management incentives that move towards better profitability and higher forward oil prices have all attracted investment. Another factor: better discipline. When oil first slumped in 2014, firms produced below breakeven costs, which helped pressure prices to near 13-year lows.

U.S. benchmark crude reached $75 a barrel this week, the highest since 2014. Energy companies are the third-best performer this year in the S&P 500 index, lagging only consumer discretionary and technology sectors.

Even as Permian production soars, a shortage of transport options among pipelines, rail and trucking has caused local prices to dive. Investors have been shy to commit new money to the region, with a number of Permian-focused producers like Parsley Energy Inc. lagging peers that have assets in the SCOOP/STACK or even the Bakken.

Cutting Back

Goldman Sachs analysts said in a report June 8 that there’s more discussion among investors about Permian producers deferring completions and well tie-ins or reducing rig counts. "If we see this, it could be a catalyst for investors to consider buying some stocks that have lagged relative to their exposure," the analysts said.

Tudor Pickering analysts said June 11 that clients are now generally convinced that activity cuts are a matter of “when” and not “if”. Long-only funds and hedge funds "are unwilling to step in on stocks until broader industry cuts are announced," the Tudor analysts said.

Some of that is already happening. Marathon Oil announced plans to reduce its rig count in the Delaware Basin, while Halcon Resources said it would scale back oil drilling in the area to cope with the regional glut.

To be sure, some companies with the best Permian land still trade at lofty levels. Pioneer Natural Resources Co. is trading at more than nine times earnings before interest, taxes, depreciation and amortization, according to analysts’ estimates compiled by Bloomberg. Meanwhile, Oasis Petroleum Inc., which focuses on the Bakken, is trading at six times EBITDA and Chesapeake Energy Corp., with acreage across six states, is at seven times.

Management Incentives

About half of the exploration and production companies have altered their management incentives to include payouts linked to corporate-level returns and debt-adjusted per share production growth, according to Goldman Sachs. Previously, only 10 percent had them. Other metrics that companies are adding include return on capital employed, proved-reserve replacement and underlying costs.

The market also looks better. With lower upstream investment and growing demand, some analysts are forecasting that oil could even reach $90 or higher in the next two years.

"Energy is in a situation now where it went from bad to good," said Ryan Kelley, a portfolio manager at Hennessy Funds. "The trajectory forward looks pretty positive for reasons including lower cost structure, higher crude oil prices and a more rationalized business model."

Still, while the market is better than it was, investors are still cautious as they digest all the recent moves. According to Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, U.S. investors are just "starting to wake up" to energy again, but they will need to see longer-term results.

"We’re still in early innings to what’s going on," said Calvasina, adding that upward revision in revenue-growth expectations among energy companies has been a strong incentive. "In the next reporting season, investors will want to see higher beat rates. That’s how they’ll really win institutional investors back."

To contact the reporter on this story: Catherine Ngai in New York at cngai16@bloomberg.net

To contact the editors responsible for this story: David Marino at dmarino4@bloomberg.net, Steve Stroth

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