After a steep slide in the back half of 2018, crude oil is experiencing a measured rebound in the early weeks of 2019. New U.S. sanctions on Venezuela and recent supply cuts pledged by Saudi Arabia are placing upward pressure on prices, but the picture is far from clear. Trump’s tenuous footing with China and other factors like Iranian import waivers threaten to stymy lasting price momentum.
SumZero sat down with Derren Geiger and the team at Cornerstone Acquisition & Management Co. to elaborate on the subject.
Drawing on deep expertise in oil & gas, Geiger explains key global catalysts and the firm’s private energy strategy, Caritas Royalty Fund. With over 15 years of experience in the space, Caritas offers a uniquely liquid approach to private energy through oil & gas royalty interests and has emerged as an outperformer during some of the industry’s most challenging years.
Avery Pagan, SumZero: To get us started, how would you describe Cornerstone's investment strategy and what makes the fund’s approach to energy assets unique?
Derren Geiger, Caritas Royalty Fund: Cornerstone’s investment philosophy is to provide investors a conservative and intelligent way to gain private energy exposure in a relatively liquid investment vehicle. Cornerstone’s Caritas Royalty Funds provide consistent yield with an underlying portfolio of oil and natural gas royalty interests that has the ability to appreciate over time. In addition, Cornerstone has historically augmented return through a very active hedging program that has reduced volatility of returns and correlation to other asset classes while generating alpha.
Caritas investors receive steady monthly cash flow from the production and sale of oil and natural gas in addition to a fair market valuation of the portfolio on a semi-annual basis. Valuation utilizes independent expertise and is levered to long-term oil and natural gas futures strip pricing rather than volatile spot prices.
Caritas allows exposure to this unique facet of the energy space without locking up capital for several years such as our competitors in private equity and with lower volatility, correlation and contagion embedded in other publicly-traded options. The Caritas Royalty Funds allow quarterly entry/semi-annual exit, which is as liquid as one could reasonably expect investing in private assets. We really match the liquidity of the Funds to that of the assets.
Cornerstone launched the Caritas Royalty Funds in 2004, generating 15% net annualized returns over a nearly 15-year time horizon. Equally commendable is Caritas’ 1.63 Sharpe Ratio over that time horizon. Our investment philosophy is relatively simple. During perceived peaks, we aim to lock in attractive pricing via hedging forward production and/or divest assets at/near peak FMV. Conversely, at perceived troughs our goal is to aggressively acquire quality assets at a relative discount to FMV.
We tend to be very patient, opportunistic and disciplined, waiting for the market to come to us rather than chasing assets and compromising return. In fact, some of Caritas’ best results were in difficult energy years, such as 2008 (+20.7%) and 2014 (+30.5%).
AP: Why the focus on oil & gas royalties?
DG: Royalties are an ideal way to gain the most conservative approach to private energy investing. Royalty investors own a fixed percentage of revenue generated from E&P-operated wells, without incurring any operating expenses or bearing any legal and environmental exposure. Unlike other royalty varieties, oil and gas royalties are not subject to expiration and generally run until the wells fully deplete, which can span decades.
While oil and gas royalties are definitely specialized, they possess a very robust secondary market, which allows Caritas to provide enhanced liquidity. Cornerstone focuses exclusively on assets located 100% onshore in the Continental U.S. in proven long-life, low (production) decline basins, and tend to augment those assets with established high-growth upside locations. We are never a first-mover in any given new play and literally need to see several years of what the production profile looks like before confident forecasting output and return.
Royalties also tend to resonate with investors that transcend across several investment strategies. Caritas attracts allocators focusing on fixed income, alternative credit, energy-specific, real asset and niche specialties.
AP: What metrics do you use to value oil and gas royalties and what are your views on valuations today?
DG: Cornerstone utilizes a multi-faceted and regimented approach to our investment opportunities, with the anticipation of meeting targeted 10-12% net annualized returns in any commodity price environment. We initially focus on the geographic location of the assets, the financial viability of the E&P operators, our conviction of the historic production profile and the upside (additional wells) potential. We engage a top-tier independent petroleum engineering firm to assess the production profile and ultimate recoverable reserves to assist in our financial forecasts. Our modeling analyzes numerous oil and gas metrics, including price/BOE (PDP/PUD), price/producing BOEPD, present value of expected future cash flow, other cash flow metrics, mineral acreage pricing, existing and trending permitting, offset drilling activity and yield generation thresholds.
Valuations fluctuate based upon commodity prices, however the allure of oil and gas royalties as an investment has grown significantly over the past decade as the global hunt for yield intensifies. There have been a number of new entrants in the royalty space, albeit managing the assets in a different structure than Caritas. These new participants have generally strengthened valuations over time as the positives we observed in 2004 are even more distinguishable today. Technological advances made in the oil and gas industry over the last 10-15 years are almost unparalleled by any other industry. Royalty owners directly benefit by participating in this upside (stacked pay zones, higher commodity extraction rates, pad drilling efficiencies, etc.) without any cash flow outlays. There is definitely a call optionality aspect of royalties in certain geographic locations.
AP: In the wake of the Dec 7 OPEC meeting and announced supply cuts, do you think Saudi Arabia has established itself as a swing producer, responding too impulsively to market dynamics and political pressures?
DG: Saudi Arabia has always been the world’s swing producer, although that influence has waned over the last several years due to the rapid rise of U.S. production. This is why you now have “OPEC+”, which includes Russia in the production quota decision-making process. Combined, Saudi Arabia and Russia account for nearly 22MM barrels/day of production, which provides more pricing power to decisions. Including Russia into the mix also commits a primary competitor to a known output schedule – assuming the Russians adhere.
We don’t feel Saudi Arabia is acting too impulsively. The Saudis are doing what they always do…trying to maintain prices in a band that is economic for producers (or balances internal budgets), yet not overly taxing on the consumer. If anything, Saudi Arabia appeared to buckle politically earlier in 2018 as discussed next. The Dec. 7th agreement was a first step toward balancing the market and a counter to the Iranian import waivers granted by President Trump.
AP: Picking up that last point, Trump unexpectedly issued import waivers to eight of Iran’s key trade partners after promising otherwise. How do you characterize his decision?
DG: Let’s back up a bit prior to the waivers. Saudi Arabia had ramped up production in anticipation of Iranian production coming offline due to re-implementation of sanctions by the U.S. After the Jamal Khashoggi murder, Saudi Arabia was desperate to gain a global ally and found one in President Trump – at a cost. Trump’s demand was to keep the pedal on production in order to keep oil (gasoline) prices contained heading into the U.S. mid-term elections. Leverage flipped from U.S. reliance on Saudi Arabia to the other way around once it was known that the Saudis were responsible for Khashoggi’s death.
We feel the 11th-hour waiver decision was short-sighted. First, it impaired the credibility of the Administration which, as you stated, promised otherwise. Questions remain as to whether the Saudis were caught off-guard by the decision. More importantly, it led to large position unwinds and delta-hedging pressures in a temporarily over-supplied market. Finally, oil prices at sub-$50/barrel severely weakens U.S. E&P financial viability. Shale production is driven not only by technology but by credit, which is why you saw a complete cessation of activity in 2015 as bond markets shut down, concurrent with a drop in the oil price. My point is that U.S. development is highly levered and prices in the $40's garner the credit market’s attention, leading to forced selling by levered players to strategic buyers like Cornerstone. Moderately lower gasoline prices at the peril of the U.S. E&P sector is a net negative to the domestic economy in our view.
AP: As the US continues to push Iran down “the path to zero”, will Iran’s traditional trade partners find ways to circumvent US sanctions and preserve lucrative deals with Iran, such as India’s lease on the Chabahar Port?
DG: The current U.S. Administration clearly wants regime change in Iran. To that end, it is unreasonable to believe that current waivers will be extended much beyond the initial 180-day term. Even so, those that currently buy Iranian oil legally must pay through escrow accounts, with the proceeds only allowed to be used for essentials (food, medicine and other non-sanctioned goods).
There will always be some sort of cheating to the sanctions in place. Unfortunately for Iran, their largest supporters either do not need their oil (Russia) or do not want to risk too much in a trying trade dispute with the U.S. (China). That being said, we have witnessed variations of cheating, from turning off tanker transponders to attempts to pay in gold, etc. We feel most nations that wish to have a trading relationship with the U.S. will revert to other suppliers for their crude demand. It simply isn’t worth it to be on the wrong side of this issue, especially with prices still trading down by 30% since early October 2018.
From the Iranians point of view, they will also be monitoring U.S. politics as the race to the 2020 U.S. Presidential election heats up. A Trump re-election would be disastrous for the current Iranian regime whereas a defeat could lead back to an Obama-like relations reset attempt.
AP: In Caritas' November 2018 investor letter, you outline the fund’s proactive response to the crude oil downturn. Can you briefly describe how the Caritas Royalty Fund portfolio is strategically positioned to handle extreme market volatility?
DG: The majority of the current Caritas portfolio was acquired during the significant downturn in 2015 and 2016 …after Cornerstone negotiated the sale of nearly all prior Caritas assets at the 2014 peak so the initial price point was quite favorable. The portfolio is attractively weighted between oil and natural gas production, which allows for a balancing effect if/when one commodity underperforms relative to the other (which we witnessed during Q4 2018). Furthermore, the portfolio’s yield generation is very strong, and Caritas remains completely unlevered, allowing for the benefit of patience and dry powder for accretive acquisitions. We are generally aggressive on the hedging front and are constantly monitoring opportunities to lock in attractive pricing. Again, we wait for the market to come to us, including outlier events that heavily impact the futures curve temporarily. Historically, we have hedged up to four years forward at extremes (Hurricanes Katrina/Rita in 2005, peak oil prices in 2008, Arab Spring, etc.).
It should be noted that Caritas has never been forced to sell assets to meet redemptions or gate investor capital. In fact, some of Caritas’ best years were in difficult energy years, such as 2008 (+20.7%) and 2014 (+30.5%).
AP: How diversified is the Caritas portfolio?
DG: Caritas currently holds interests in over 15,000 wells spread throughout 18 states and 275 counties. We receive monthly payments from more than 400 E&P companies on the assets. The portfolio has no undue concentration risk in terms of individual wells, E&P operator or geographic location. On a cash flow basis, approximately 65% is generated from oil production while the remainder is from natural gas (and related products).
New wells are consistently drilled on existing leases, with thousands of non-producing mineral acres available to promote future upside.
AP: In the same letter, you make some assumptions about catalysts driving up oil prices, such as the expiration of Iranian import waivers, the easing of US/China trade tensions, and stable global oil demand. With crude oil up by over 20% since the end of 2018, have these trends started to take shape and do you expect this price rally to last?
DG: The most immediate remedy in 2019 has been the near elimination of the financial aspect of the rout, which we spoke at length about. Once the waivers were announced and the crude sell-off gained momentum, large position unwinds and delta hedging pressures by E&P lenders/hedging counter-parties compounded the price descent. That has largely run its course. The other perceived headwinds are also starting to moderate and we remain bullish on the oil market in 2019.
The other oil price catalysts and supporting initiatives are working and have more room to go. The OPEC+ 1.2MM barrels/day production cut is being implemented, with high adherence. We are less than a month into this material production cut. Venezuela’s demise is adding to this cut by the month. The Iranian waivers (accounting for greater than 1MM barrels/day) have been fully absorbed by the market and are expected to expire in May. The U.S. and China appear to be playing nice in the trade talk sandbox, however the clock is ticking. With the unpredictable nature of President Trump, this is probably the most difficult to gauge.
Global oil demand growth last year was right in line with the post-financial crisis annual average of +1.5MM barrels/day. We do not see demand growth materially moving away from that figure. Finally, don’t discount the effect of the Fed and the U.S. Dollar. The Fed is on pause and the USD is weakening – both provide a tailwind to oil prices that really has yet to be felt.
AP: What does Qatar's recent departure from OPEC mean for the organization and diplomatic tensions within?
DG: It’s no secret that Qatar and Saudi Arabia are relatively hostile neighbors. Qatar’s exit is really a non-event as they are a much larger natural gas producer than oil. Their oil output, at approximately 600,000 barrels/day, accounts for only 2% of OPEC’s total output. Qatar has a lot to do on the natural gas side in potentially de-linking natural gas contract prices to oil.
Middle East politics revolve around perpetual strife, yet OPEC has endured. It may further evolve, but we do not see a looming threat to its existence.
AP: Qatar also announced a 42% increase in natural gas production and the U.S. is now a net exporter of natural gas for the first time in 60 years. Why the steep uptick in natural gas production, especially U.S. LNG?
DG: Qatar sees itself as a global leader in natural gas, which is the obvious preferred bridge fuel. With the global anti-coal movement, natural gas has a strong growth outlook in capturing that power-generation market-share over years…perhaps decades.
Here is another example of recent politics heavily influencing decision-making. Qatar was listening when President Trump lectured Merkel on a Russian-German natural gas pipeline and supply deals. While Trump was promoting U.S. LNG, Qatar is a natural diversifier for European countries seeking to reduce reliance on Russian gas.
The U.S. will continue to ramp up LNG export volumes in addition to increasing pipeline exports to Mexico. Domestic gas production is ramping up in unison with what we have witnessed regarding oil production…often as associated gas or a by-product. Again, climate concerns rise every year, with coal in the crosshairs. This will intensify with the U.S., given its massive reserves, cheap price and reliable supplier status, in the driver’s seat.
AP: With nearly 15 years in the oil & gas space, how has Cornerstone built its reputation and cultivated valuable industry contacts?
DG: Given our firm’s long duration, Cornerstone’s reputation has been paramount within the industry as well as with our investor base (Caritas). Starting with the oil and gas industry – reputation is everything. The U.S. oil and gas upstream sector is a relatively small network of professionals, with a heavy emphasis on doing business with those you know and trust. We position Cornerstone as an ongoing partner to E&Ps looking to divest non-core assets in order to raise capital for other needs. Since we are not an E&P operator, we are not viewed as a competitor. Cornerstone possesses the expertise to quickly analyze assets and always has funds secured prior to making a fair offer. Once we agree to terms, we follow through. As a seller, we take the same professional tact. With diversified oil and gas royalty portfolios, there are months of necessary reconciliation of production and cash flow post-closing so it is essential you have a trustworthy counter-party.
We also host an invite-only, three-day annual event geared entirely toward networking and enhancing deal flow opportunities. This event alone has provided several non-marketed acquisition opportunities that we wouldn’t otherwise see.
On the investment side, we are exceptionally disciplined on the assets we acquire, and the price were willing to pay. We also make it a priority to communicate regularly with our investor base. Given Caritas’ performance over such a long time-frame, I believe our reputation and management of the Funds speaks for itself.
AP: What do you see in the oil sector that the sell-side doesn’t understand?
DG: Traditional sell side research has historically "counted barrels" worldwide and from that fundamental research, combined with a consistent 2-2.5% global growth rate, derived a price for crude oil. In the world we live in now, technology has almost instantaneously made significant production viable in marginal basins all over the globe, particularly in those regions which might enjoy a currency advantage. Therefore, barrel flows are no longer simply driven by traditional geo-politics and, as such, both opportunities and risks are presenting themselves in ways we have never seen.
AP: Any other salient thoughts to share on the industry as we move into 2019? Where do you see the biggest opportunities in the markets today outside of oil?
DG: Some of the opportunities lie in spreads/differentials domestically that can be captured via strategic acquisitions designed to take advantage of short to medium term dislocations. We will also see more a shift from pipeline (takeaway) bottlenecks to oil terminal export obstacles. While there are numerous projects in the works, only one export terminal presently allows for the direct loading of VLCC tankers (those with 2MM barrel capacity).
In this challenging environment, we have witnessed numerous energy-fund closures over the past year. Cornerstone has always viewed these challenges as opportunities, outperforming on a relative and absolute basis. In addition to bucking the trend in the trying years of 2008 and 2014, you can add 2018 to the list. Caritas generated a net return of 9.1% while most energy, equity indices, and fixed income investments were decidedly negative.