Industry experience has taught veteran energy investor Bryan Dutt how to win an advantageous position in the sometimes combative search for opportunities in oil and gas. Tactics include well-sharpened, often contrarian viewpoints, as well as a readiness to commit capital—at a price—if an E&P has an urgent need of funds or if a third party wants to exit an illiquid position. The terrain is the small-cap energy sector, where liquidity is at a premium and can vanish in a flash.

“We try to be advantageous in our purchases in the fund,” explained Dutt, who has managed the Ironman Energy Capital fund for the past 15 years. Previously, Dutt was a managing partner at Centennial Energy Partners, another energy-dedicated hedge fund, for four years. This followed 10 years spent with New Orleans-based Howard Weil, during which time he was promoted to supervisory analyst leading the E&P team.

The Ironman Energy fund’s portfolio holdings are comprised predominantly of smaller-cap stocks, as well as a more limited number of micro-cap names, entirely drawn from the energy sector. The bulk of the names are in the E&P and oilfield service sectors, although stocks in other energy subsectors, such as coal and tankers, may also be held.

“All we do is energy,” said Dutt, noting the fund can buy “anything with a hydrocarbon attached to it.”

Because small-cap stocks are often more prone to pitfalls than their large-cap peers, opportunities are there for the taking in the sector, provided you come equipped with a deep knowledge of the individual names, Dutt observed. He sometimes likens the process to “practicing guerilla warfare.”

Frequently, another small-cap holder might have a liquidity issue, for example, or an E&P might be desperately looking to raise capital, according to Dutt.

“When someone needs to move a big block of stock, we’re one of the few purchasers that are able to accommodate large blocks,” he said. “And for the liquidity that we provide, we extract a pretty painful discount. It’s fine to be able to purchase a block of stock in a small company, but it’s just as burdensome on us, too, when we exit.

“We also have probably a much longer-term focus,” he added. “We are not ‘Joe the day trader.’ We don’t think that model fits in the small-cap space, specifically since 2008. It’s even more critical to do your homework today than it was in the past.”

And what are the key investment characteristics sought in the Inronman Energy investment process?

The threefold answer comes back crisply: capable management, high-quality rocks and a strong balance sheet. “Two out of three doesn’t work,” Dutt said. “You have to have all three.”

Assuming these criteria are met, the sizes of the positions in the portfolio vary considerably. Dutt targets five or six core holdings of about 10%, with the remaining 40% to 50% of the portfolio comprised of many smaller positions, scaling down to a 1% position for an occasional “ultra risky” investment.

Once an investment is made, Dutt generally allows ample time for the investment thesis to unfold. “But if management changes its stated goal, or chronically underperforms, that’s when we’ll tend to exit the position,” he said. “We try not to be panic sellers.”

Bryan Dutt, manager of the Ironman Energy Capital fund, seeks the advantage in the combative hunt for opportunities. "When someone needs to move a big block of stock, we're one of the few purchasers that are able to accomodate large blocks."

In terms of crude prices, Dutt is apprehensive about the short-term outlook, with West Texas Intermediate (WTI) prices at the time he was interviewed trending down into the low $90s. Given the backdrop of a faltering world economy, his assumption is that WTI prices in 2015 will average in the mid- to high $80s per barrel and trade at a $6 to $10 or greater differential to Brent crude.

“We think that absent the Middle East turmoil, oil prices would be significantly lower. So right now we are cautious on oil.”

With the shale renaissance driving Lower 48 production growth for at least the next several years—reflecting the very substantial capital raised by E&Ps and their deep inventory of locations to drill—Dutt anticipates an imbalance in domestic crude supply relative to suitable refining capacity, in the absence of significant relaxation of laws banning crude oil exports. Such a move to address crude export policy is, in his view, unlikely in the near term.

“We don’t believe there is the political will to do the right thing in allowing exports,” he said. “We don’t see it in the next 12 months.”

Has the upsurge in U.S. crude production helped calm concerns about how much of a geopolitical risk premium should be factored into the price of oil?

“Psychologically, it comes down to the price paid for the last available molecule of oil, and the swing factors are outside the U.S.,” Dutt said. “To a large extent, we are still held captive to forces in the Middle East for oil. It’s mitigated, but it’s absolutely still there.”

On the outlook for natural gas, Dutt said his views are “probably not as pessimistic as consensus.” In terms of supply expectations, a turning point might come with the delineation of the sweet spots in such prolific plays as the Utica. “We’ve got to define the limits of the acreage and the prolific nature of these wells,” he said. “Once we start to decelerate the productive capacity of some of these plays, that’s when we’ll see the leveling off of supply. That could easily happen next year.”

Top holdings

Gastar Exploration (NYSE: GST) is a top 10 holding for the Ironman Energy fund that exemplifies some of these themes. Gastar recently tested its first Utica well, the Simms U-5, which had an initial 48-hour flow rate of 29.4 million cubic feet per day (MMcf/d) and has helped significantly de-risk the company’s Utica/Point Pleasant assets. Gastar plans one or two additional wells to demonstrate the play’s consistency across its leasehold.

However, in addition to Gastar’s success in the Utica, as well as its Hunton play in Oklahoma, Dutt acquired his Gastar position for the company’s underappreciated exposure to the Midcontinent “Stack play,” often associated with Newfield Exploration. Gastar has more than 1,000 gross acres exposed to the Woodford and Meramec intervals, offering more than 500 potential drilling locations. It estimates a resource potential of 46 million barrels of oil equivalent (MMboe) in the play, assuming only 120 net locations are drilled.

Importantly, Dutt also waited to buy the stock upon a 17-million-share offering completed shortly after Gastar’s successful Utica well announcement. The shares were priced at $6.25/share, an 18% discount to Gastar’s share price at the time the offering was announced.

“We’d been looking for a cheap way to play the Stack, and we thought this came with a huge discount,” recalled Dutt. “Energy is not in favor now, so we think it was an advantageous buy. We think the Stack will eventually garner much more attention.”

Dutt bases his E&P stock analysis on a combination of net asset value (NAV) and multiples of cash flow or EBITDA (earnings before interest, taxes, depreciation and amortization).

Another E&P recently purchased by Dutt is Callon Petroleum (NYSE: CPE), a pure play in the Permian Basin. Although admitting to being nervous about Midland differentials far into the future, Dutt said he was attracted to the stock based on a discount to NAV, again in the wake of a stock offering. The company’s September offering of 12.5 million common shares was priced at $9/share, down more than 10% from Callon’s closing price just two trading days earlier.

“Callon was too cheap to pass up on the offering,” Dutt said.

The Eagle Ford is another favored area for the Ironman Energy fund, which holds several substantial operators active in the play—Sanchez Energy Corp. (NYSE: SN), SM Energy Co. (NYSE: SM) and Penn Virginia Corp. (NYSE: PVA), as well as micro-cap stocks Lucas Energy (NYSE: LEI) and Lonestar Energy (OTC: LNREF).

“The Eagle Ford is generally regarded as the most economic of the large oily, liquids-rich shale plays,” commented portfolio manager John Bishop, who works with Dutt on the fund.

In oilfield service, Dutt owns Tesco (NASDAQ: TESO), which specializes in tubular services and derives some 60% of its revenues from outside North America. Tubular services include running casing, which improves safety, well integrity and rig efficiency. Dutt likes the stock for its “tremendous” free cash flow generation, its stock buyback program and the potential for the company to gain material market share from one of its main competitors that has had “serious management issues.” The stock began the year at $6.27/share and closed August above $10/share.

Another service company owned by Dutt is Weatherford International (NYSE: WFT), a position added as the company continues its transformation through selling noncore assets, while also dealing with a variety of accounting issues and settling litigation under the Foreign Corrupt Practices Act. Core operations after the restructuring will include well construction, artificial lift and formation evaluation. With a cost basis of around $16/share, the stock has since moved up to the low to mid-$20s.

Internationally, Dutt is playing the Vaca Muerta Basin in Argentina by way of Americas Petrogas on the TSX Venture Exchange in Canada. The basin offers shale as good as any in the world, according to Dutt, with the tradeoff being between “de minimis” geologic risk and “high” political risk.

As with many portfolios, there have been disappointments. The position with the steepest loss to date this year for Dutt has been American Eagle Energy (NYSE: AMZG), a stock that “has never got a multiple” due to production issues and its recent visits to the capital markets. However, at recent levels of slightly over $4/share, Dutt said he is “more a buyer than a seller,” suggesting the E&P’s management will eventually sell its Bakken position in Divide Country, North Dakota. Calgary-based Crescent Point Energy (NYSE: CPG) is cited by Dutt as “a voracious buyer” of nearby properties and a possible acquirer.

Another stock yet to play out as expected is Resolute Energy (NYSE: REN). The Resolute management team had won a following in its prior role leading HS Resources, but was dealing with a “stretched” balance sheet at Resolute and had signaled a major deleveraging event, or possibly an outright sale of the company, Dutt said. “We think there is tremendous value there on a NAV basis, but they’re on the verge of squandering a lot of very good political capital with investors if they can’t get their deleveraging event done soon.”

Ironman Energy portfolio manager John Bishop said the Eagle Ford is generally regarded as the most economic of the large oily, liquids-rich shale plays.

Overall, the Ironman Energy portfolio has a long bias, but it does take selective short positions where it deems appropriate. Unlike the practice of many hedge funds, long and short positions are not matched in “pair trades.” Rather, short positions are taken that are highly specific to a company, typically seeking to exploit weaknesses of poor management teams and what are perceived to be fundamental flaws in business plans.

As an example, Dutt cited an offshore driller that is “financially stressed and we believe will go bankrupt in the next two years.”Another is a short position in a service company “with rampant insider selling and questionable management.” Although Dutt said such collective short positions made up only a relatively small percentage of the fund, roughly half of the short positions had a target price of zero—a target that several short positions had attained in the past.

The biggest short position that the Ironman Energy fund has put on—and still owns—was made in WTI crude in late August 2013, when WTI spiked to $110. The rationale was that if WTI pushed much higher, it would not last long, because of its negative impact on the economy.

“We put on a full short position in crude. It was a natural hedge for our portfolio and was one of our easiest investment decisions,” Dutt said.

Was Dutt surprised by the sharpness of the pullback in crude during the third quarter of this year?

“I think it’s a matter of technology trading. We better get used to the speed of trading in both crude and, especially, small-cap stocks, because it’s not going to slow down.”

Comments