Barron’s | Hedge Funds Now Play the Nuances of Energy

After crude surged last year, some funds were able to recoup their losses. Now, with oil around $50 a barrel, they have to be more discriminating.

For hedge fund managers who hang their hats on market drama, the energy sector never seems to disappoint. Yet the past couple of years have offered more than their share of plot twists.

Things started getting interesting in June 2014, when U.S. benchmark crude prices began their slide from more than $100 a barrel to half as much by the end of that year. Many hedge funds had waded in early and paid the price. Energy continued to suffer in 2015, and by January 2016 prices had plunged to below $27 a barrel.

“Anyone who was overallocated to energy saw drawdowns of 10% to 20%,” says Mark Doherty, the director of research at PivotalPath, which advises institutional clients on how to manage hedge fund assets. While there were no big calamities during the downturn, many of the larger firms laid off their energy specialists. Now, he says, they’re hiring again.

THERE’S NO DOUBT that energy turned around quickly last spring, with crude prices gaining 13% in the month of March alone. Among go-anywhere hedge fund managers with long exposures to energy, last spring was the time to recoup losses and move on.

“In the first quarter of 2016, when energy was quite low, they went in heavily,” says Pavle Sabic, head of market development for S&P Global Market Intelligence, which tracks 10 of the largest high-conviction equity hedge funds, including Viking Global Investors, Lone Pine Capital, and Icahn Capital. Those managers have since trimmed their energy stakes, which were 6% of their collective portfolios in the fourth quarter of 2016, down from 8% in the previous quarter.

Yet managers who stayed in energy were among the top performers for 2016. Hedge funds tracked by HFR that invested in energy and basic materials were leaders, with the HFRI Energy/Basic Materials Index up more than 18% in 2016 and nearly 2% in January.

The next chapter isn’t about whether oil prices move lower or higher—though hedge funds recently had record net long positions in derivative contracts tied to crude oil. It’s about nuance. “As long as crude hangs around $50, there will be a lot of dispersion,” says Doherty, noting that stockpickers do best when there are stark differences between winners and losers. “Now it’s really more about what companies are executing well and making good allocation decisions.”

While crude prices are a barometer of what’s happening in energy, there are many ways to play this sector. On the equity side, investors can pinpoint where they want to be in the production cycle, whether it’s upstream, midstream, or downstream. They can make regional plays, from the popular Permian Basin to smaller areas such as the Piceance Basin in Colorado. There is the fixed-income side of energy, from high-yield bonds to bank loans. Finally, there are master limited partnerships, or MLPs—publicly traded limited partnerships that own pipelines, processing facilities, and storage depots and collect fees based on the volume of oil and gas they handle.

At Dallas-based Highland Capital Management, which manages more than $15 billion in alternative assets, energy has long been a big theme. It found opportunities in dislocated energy credit in 2016 and is looking at energy-related bank loans, which haven’t rallied as much as high-yield bonds. The firm is also focusing on the shares of companies in lesser-known shale basins, as well as undervalued equities, such as Enterprise Products Partners (ticker: EPD), Targa Resources (TRGP), and the Energy Transfer complex, which includes Energy Transfer Equity (ETE), Energy Transfer Partners (ETP), and Sunoco Logistics Partners (SXL).

“The big questions are whether OPEC will continue the production quota and how fast shale will perform,” says Jon Poglitsch, a managing director at Highland, referring to OPEC’s commitment to limit oil supplies. While an oversupply of oil was previously a concern, there is now the possibility of “a market that is undersupplied, with demand growing into it,” Poglitsch says.

WITH THE ENERGY SECTOR on more-solid ground, some of the largest hedge funds turned their attention to the information-technology, industrial, and financial sectors starting late last year. “This the first time that we have seen three net-buy sectors over $1 billion each since 2015,” says Sabic at S&P Global Market Intelligence.

In the case of financials, the last quarter of 2016 marked the first time in two years that the sector ranked as a top buy among the firms he tracks. Based on 13F filings, the heavy hitters scooped up Bank of America (BAC), JPMorgan Chase (JPM), and Charles Schwab (SCHW), among others.

This renewed interest in financials may not be fleeting. “I think it’s going to be a good opportunity for hedge funds,” says PivotalPath’s Doherty, adding that hedge funds have for years been underallocated to the sector. “I haven’t had people ask about pure-play financial funds in years, and now I’m getting inquiries.”

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Ruozhou Wang