Interview with BP Capital's Toby Loftin

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BP Capital

Q&As and Interviews

Interview with BP Capital's Toby Loftin

Shauna O'Brien Dec 18, 2014

Insights From Toby Loftin

Toby Loftin: In our opinion, investors should not approach the energy sector the same way that they have in decades past, where the focus has been mostly on upstream and oilfield services—the supply side. Much has changed in the North American energy landscape, resulting in an abundance of supply, particularly natural gas (NG) and natural gas liquids (NGLs). As a natural consequence, investors would be wise to consider the whole value chain—particularly the demand side.

The BP Capital TwinLine™ Energy Fund incorporates the demand side—end-user companies who will benefit from the dislocation between energy prices both geographically (US vs. non-US) and by product (NG and NGLs vs. oil and oil liquids on an energy equivalent basis). This also balances the portfolio when the overall price of energy declines. We ask the question, “Who is going to benefit from a decline in oil prices as an input into their costs?” It’s not our only investment criterion, but it is an important one.

As oil prices have dropped in recent months, our team’s deep expertise in commodity fundamentals, combined with bottom-up analysis, played a large role in our decision to reduce exposure to the upstream category in the Energy Fund. Our team’s approach yielded the desired result—reduced downside capture. The BP Capital TwinLine™ Energy Fund experienced less drawdown relative to other funds who are primarily invested in upstream companies, and benefited our shareholders, outperforming its peers in the Morningstar Equity Energy category. Where do you see oil prices heading in the next 12-18 months, and if your outlook is cautious do you expect to reweight your holdings deeper towards chemicals and other basic material names?

Tody Loftin: The BP Capital TwinLine™ Funds’ investment team is integrated. That is, the team members who manage the commodity hedge fund also co-manage the TwinLine™ Funds. We believe this integration gives us an advantage as we begin our investment process with a top-down macro view of each energy commodity. Clearly, the direction of oil prices is one of the most important variables influencing the performance of energy-related equities. The relationship between oil, NG and NGLs pricing is also important. The recent decrease in oil prices was not a surprise to our team. We reduced exposure to upstream and moved more to cash and to the end-user category well in advance of the selloff. The flexibility to traverse the full spectrum of the energy value chain (including end users) proved invaluable as the TwinLine™ Energy Fund (BPEIX, BPEAX) has outperformed typical energy funds who do not.

In addition, we use bottom-up fundamental analysis to rank-order the companies we filter according to our evaluation of reward (upside) vs risk (downside). We ask ourselves “Based on our analysis, how are these companies valued relative to what the market is pricing into the stock?” As an example, we may think oil prices are going lower, but still buy a company with oil exposure because we believe that its valuation is attractive based on earnings growth, asset quality and geography, key contracts, balance sheet profile, talking to company management, and other fundamental metrics.

Specifically regarding crude oil prices, we believe that there has been too much focus on the supply side of the equation as the culprit for the most recent selloff. However, we would argue that it is primarily due to erosion of demand in regions like Japan, China and Europe, coupled with robust U.S. supply growth (due to unconventional drilling). We believe that just as the selloff in oil prices is attributable to eroding demand, oil price strength will be preceded by a recovery in demand. But nothing happens in a vacuum, so recovery in demand is somewhat dependent on the supply response. As producers respond to lower oil prices, production will likely decelerate, the result of which will take some time to be evident in inventory, and ultimately the price of oil. On the margin, we’ve already seen a reduction in the U.S. oil rig count, and the general tone from producers during the most recent quarterly earnings session has been to rein in capex.

Near-term oversupply in oil markets is masking long-term implications of a weak investment climate in the Middle East. Global and regional inventories of crude are not abnormally higher the five-year average. Global and especially US crack spreads remain slightly above five-year norms, all of which should lead to sustained refined product production (i.e., demand for crude by refineries). In our opinion, the “supply glut” should not be too onerous to clean up. We believe that oil prices will likely remain relatively low during the first half of 2015, with an increasing chance of price strength into the second half of the year.

Meanwhile, we expect NG prices to remain low throughout 2015 and 2016 as demand shows up slowly but surely through structural changes—liquefied natural gas (LNG) exports, NG exports to Mexico, power generation and industrial demand. We also think that ethane will remain plentiful as we await the arrival of additional cracking capacity on the Gulf Coast. In looking at your other fund, BP Capital TwinLine™ MLP (BPMIX, BPMAX), the results there have been a bit more steady. Do you expect investors looking for energy exposure to push more towards yield-centric funds that focus on the MLP niche?

Toby Loftin: First, the BP Capital TwinLine™ Funds invest in proven management teams operating attractive assets with a favorable cash flow profile. Some of those companies are structured as master limited partnerships (EPD, e.g.) while others are C-corporations (KMI, e.g.). The MLP asset class has never enjoyed a clearer picture of needed projects, and, in turn, potential distribution growth, which we believe creates an enduring tailwind for midstream assets. Earlier this year, IHS CERA published its estimated capital spend required to re-plumb America’s energy infrastructure at $1.2 trillion from 2010 thru 2025. Our team believes that the peak-year spending has been “pushed out” beyond 2021 (previously 2019, according to IHS) as additional large-scale projects have been announced by large MLPs and infrastructure C-corps.

The BP Capital TwinLine™ MLP Fund seeks to take advantage of those trends by focusing on what our team calls the “core midstream fairway” marked by visible distribution growth and lower debt leverage than the benchmark. We typically trend away from upstream or variable-rate MLPs that do not fit into that core fairway.

We believe investor allocation to energy infrastructure corps/MLPs will continue to grow, even as we’ve seen significant growth over the past several years and strong returns in the sector. MLPs are yield vehicles, and in a yield-starved environment and relaxed monetary policy from central banks, they have been attractive to baby boomers and others searching for yield. Given the dearth of yield alternatives, we believe investor interest will continue. There was some recent commentary in regards to solar energy prices, with one analyst saying solar costs will basically be free in the next 20 years. If that scenario does indeed come to fruition, how does that play out for many of the well-known energy names that investors are holding today?

Toby Loftin: Mr. Pickens and our team are recognized as thought leaders in the energy industry. As such, we’ve designed the funds to be flexible so that we can invest in the most attractive areas of the energy value chain. While we are perpetually conscious of the entire energy landscape, we focus the deployment of our capital into the timely investment themes that we can measure today. Our typical investment horizon as we enter and exit a name is six months to five years. In contrast, 20 years is a really long time. Fossil fuels will continue to play an important role in our future. As Boone often says, “you can’t move an 18-wheeler with solar.” Certainly, the well-known energy companies will be affected as solar becomes a viable option on a large scale, but they too are constantly adapting to the changing energy landscape. Besides solar, are there other energy technologies investors should be paying attention to?

Toby Loftin: The “other energy technologies” we believe investors should consider are actually in play right now. Instead of focusing on “alternative energy” solutions, the BP Capital TwinLine™ Funds are taking advantage of new technologies such as horizontal drilling and completion techniques that have revolutionized how we extract our existing natural resources from the ground. Our “traditional” energy sources are now being harvested in nontraditional ways. The results are meaningful. For example:

• Better economies of scale: with the increase in unconventional drilling, it is common to have eight to 16 producing wellbores from one pad site, as opposed to one conventional producing well per site
• Increased drilling capability: currently, the length of horizontal laterals typically ranges between 3,000 to 9,000 feet while remaining within the “pay zone,” which in some cases is a relatively thin corridor.
• Improved drilling efficiency: The pre-2005 U.S. rig profile is vastly different than that of today. There are now more active horizontal than vertical rigs, which has resulted in significantly higher recovery rates. In addition, drillers are making other improvements which often results in significant reduction in “days to drill.”

Mr. Pickens has long been an advocate for “cleaner, cheaper, and domestic” energy. Solar, wind, and other alternative fuels fit into that thesis and undoubtedly will play a role in the future. But currently, natural gas is the most abundant, reliable, economic and realistic alternative to oil. Here we sit with $4/mcf (thousand cubic feet) NG, as Asia’s price hovers around $16/mcf. We at BP Capital Fund Advisors believe we don’t need to go search for the “next thing.” We have it right here in our backyard, and the TwinLine™ Funds seek to capitalize on opportunities offered by natural gas and other energy sources as the American Energy and Industrial Renaissance continues to unfold.

The Bottom Line

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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