Q&A Interview: Riding the Commodity Rollercoaster

by Dan Wiener | April 3, 2012 11:45 am

[1]The price of a barrel of oil is approaching $110, and the average gallon of gasoline now costs more than $4. Yet the price of the “other” fuel, natural gas, is at multi year lows. Who better to make heads and tails of this situation than Karl Bandtel, 45, a 20+ year Wellington Management veteran and lead manager on Energy?

Bandtel learned his craft under the tutelage of one of Wellington’s great investors, Ernst Hans von Metzsch, and was handed Energy’s reins in 2003 upon von Metzsch’s retirement. We spoke in late March.

Q: Karl, Energy has been both a volatile fund and a volatile sector to invest in over time. Yet, the long-term returns are quite strong, if you can stomach the painful periods. What’s your background, first, and then, why have you gravitated to the energy sector?

A: My background had nothing to do with energy before I joined Wellington. I started working with the prior manager on the Vanguard fund, Ernst von Metzsch, in 1990 or 1991 because he needed help and my personality was a good fit. And it’s true what you say: Sector funds are volatile, and energy is more volatile than some sectors because you not only have the typical volatility of equities, but on top of that, you have commodity volatility. To some extent, that volatility has helped the industry to be a good place to earn money over time, as it can affect your investment decisions.

Q: You often say that “supply” is the key to energy prices and, I would guess, the prices of the stocks you invest in. There seems to be two scenarios for the current oil price that we are hearing: (1) Israel and Iran go to war and oil prices rise, so traders are getting ahead of this, or (2) the global economy continues to recover and oil prices rise. Is there a scenario where oil prices fall?  If so, what does it look like?

A: As you know, with any commodity—and certainly this is true with oil—it is always supply and demand. We don’t think supply is more important than demand, but the idea that the ability to increase supply meaningfully—in the short run or the long run—is reasonably challenged and requires a lot of capital is an underpinning of the industry. If it wasn’t true, it would really affect returns.

With natural gas there has been the ability, in recent years, to add to supply faster than demand growth. Therefore returns have shrunk to nothing, and the industry is not making any money. Whereas in oil, supply growth has been challenged, and demand continues to basically creep up over time. Supply hasn’t been able to get in front of that demand growth enough to create a cushion. So there is very little excess capacity in the world oil market. Whether oil prices go up a lot or down a lot depends on whether that cushion goes completely away or builds.

The scenario where it builds is similar to 2008, where you have a demand surprise—a real demand contraction, where the excess capacity builds up and the price of oil can drop. These other scenarios, like Iran or an issue of higher demand than expected due to the economy, will just add pressure to the oil market and lead to a higher price.

We don’t make any predictions about what will happen, nor do we invest on one scenario. We look at a range of reasonable oil prices and make our investment decision on the range—neither a collapse in price nor a price that has moved up above a sustainable level.

Q: Does this then lead you to exploration and production (E&P) companies over major oils? Or would there be a scenario that would lead to the major oils over, say, E&P?

A: We have always owned both majors and E&P companies. The relative attractiveness is often a function of their recent price moves. If the majors have outperformed, then we might find the group that has underperformed more attractive, and we might look to add to those. We have always looked to maintain a reasonably balanced portfolio. Recognizing it’s a sector fund, we try to maintain some balance across subsectors and other investment characteristics. We always have had a good percentage of the portfolio which is more total-return orientated, where the companies offer a very good yield but very modest growth, than other parts of the portfolio, which are much more growth-oriented but with little current income.

Q: Gasoline prices are rising, and we’re nowhere near Memorial Day, the traditional start of the driving—and rising price—season. How high will gasoline go, or is there something the popular press is missing that will drive gasoline prices lower before summer’s start?

A: The biggest predictor of gasoline prices is the price of oil. The spread varies, but it’s a reasonably tight relationship. The price of gasoline relative to oil often peaks before the driving season gets started, like a signal for the companies to begin producing more gasoline.

Q: Would a release from the Strategic Petroleum Reserves be anything more than a very temporary fix? Also, the Saudis came out with a comment about trying to keep the price low. Would that supercede any need to get into the SPR?

A: The SPR, by definition, is a short-term fix. You are taking oil from inventories; it is not a permanent change in supply or demand.

The Saudis may have a different idea of what a low oil price is than the current administration does. And they may have different issues that they are trying to deal with. I don’t have any strong or good sense of what the current administration is wanting, other than to be reelected.

As for the Saudis, their history is of producing more oil when the price is at the high end of what’s comfortable—and that’s probably where we are now. They have a history of cutting back production after the price has fallen. Over the last several years or decade, the price at which they have been willing to cut back production has been moving up. We think the price that is probably too low for them is $70 to $80 a barrel. I don’t have a strong sense of what price is too high, but they have been making some statements lately.

Whether they have enough spare capacity to bring the price down is a question. Some of that depends on how robust world demand is over the next several months. And it also depends on the supply situation in other major producing countries. One reason the price of oil has been elevated, aside from concern about Iran, is you have supply issues in other countries like Libya and southern Sudan. These are putting more pressure on Saudi Arabia to produce more.

Q: Jeremy Grantham says anyone with a brain should be figuring out a way to make money off of the ridiculously low levels of natural gas prices. Do you agree, and if so how do you figure to do so, and what is the catalyst that will drive natural gas higher?

A: I suspect what Mr. Grantham is talking about is actual end-use of natural gas—that as a chemical company you should use cheap natural gas for your feedstock. I think that’s definitely true. If you are trying to figure out the future direction in commodity prices, the best thing for a rising price going forward is a very low current price. The low prices of oil in the ’80s and ’90s led to the development of the SUV industry and complacency on the part of consumers, and has now led to the rise of oil prices over the last decade. You can paint the same picture for natural gas today. The price is at a level that is discouraging supply and encouraging demand. Eventually demand will catch up with supply and the price will rise.

With the Energy fund, the way to try to make money off of that likelihood is to own the producers that mostly produce natural gas. They are currently profit-challenged and are having to cut back their growth. But they will benefit if and when the natural gas price rebounds. If it doesn’t, then the natural gas stocks will continue to languish. The energy industry, or predicting anything, is always far from certain.

Q: In August 2009, with natural gas at about $3.50, you said that supply  and demand would re balance as rigs were taken out of service and prices “could” double. They actually dropped, then rose about 66% before peaking in Jan. 2010 and starting their long, long slide. Do you have a prediction today?

A: The price is very low. I think something similar is possible. We have seen the rig count drop, and it’ll probably continue to drop. A lot of it depends on weather. If next winter is more normal in terms of the weather and the rig count is low leading up to it, then there’s a chance natural gas could double or even triple from the current level.

Q: Last August you warned investors to be cautious on energy going forward, at least in the short term. In hindsight that caution was warranted.  What’s your recommendation?

A: Well, I’m sure I would always say that. I like to think I am always cautiously optimistic. That’s the way we positioned the fund. It’s a portfolio of at least 50 names [in the Wellington portion of the fund] with different characteristics. We try to position it so that enough names are relatively defensive and can hold up through the bad times and strengthen their position in the down cycle. And yet we still want to have exposure in the portfolio to companies that are more aggressive so that if we are too cautious and times are very good, they can really benefit the shareholders. I am not a portfolio manager who one month is really optimistic, and really pessimistic the next. But when stocks have moved up as they have the last six months, I tend to get more cautious. And when they have corrected, I can feel a little more optimistic or hopeful.

Right now it’s kind of in-between because the price of oil is high and energy stocks have done well. And yet other areas, like natural gas, are cyclically depressed, and the stocks are languishing. So the portfolio has some areas with a little more risk and others with more cyclical opportunity.

Q: Who should own the Energy fund?

A: I think whether it’s an individual or an institution, as with most sector funds, you either buy when they have really underperformed, or you buy and hold them as part of a diversified strategy to have representation in very important sectors. Clients recognize energy is an industry that can do well when other things aren’t. Or they are looking for a cyclical opportunity. You either own it for the cyclical opportunity or for the long term.

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