Investors see silver lining in energy sector

Updated with correction

Investors are stepping back into energy, but this time they are looking to capitalize on the industry's distress.

This year alone, the $104 billion Washington State Investment Board, Olympia; $29.1 billion Indiana Public Retirement System, Indianapolis; and $20 billion San Francisco City & County Employees' Retirement System have all invested in energy.

Energy has been a thrill ride for investors, reaching amazing heights only to crash as little as a year later. And until recently, investors were staying off the ride.

In 2015, energy investments reported by the largest managers of U.S. institutional tax-exempt assets dropped 28.3% and investments in another energy-related investment strategy, master limited partnerships, fell 6%. Just a year earlier, managers' energy investments grew 41%, the most of any alternative investment asset class, and MLPs showed double-digit growth, according to Pensions & Investments' data.

Energy is one of the major industries where investment managers expect to see increasing amounts of distress in the next year or two, industry insiders say.

There are many ways to invest in energy including distress, long-short bets to take advantage of the discrepancies in the price of energy assets, and investing in MLPs, said Timothy C. Ng, chief investment officer of outsourced CIO firm Clearbrook Global Advisors LLC, New York.

“Midstream MLPs are companies that are in the business of transporting, storing and acquiring oil,” Mr. Ng said. “The U.S. has a lot of storage needs because there are an estimated 500 million barrels of oil out there.” Companies offering storage services are still earning cash flow, providing as much as 7% to 9% annual yield, he said.

Clearbrook does not directly manage money, but advises on and constructs portfolio strategies using independent managers.

“Disorder and chaos is the place distressed debt likes to play,” said Jamie Lewin, head of product strategy and performance management at BNY Mellon Investment Management, New York.

Much of the distressed investment opportunities in the U.S. are in energy, where the drop in price of oil and gas has wreaked havoc on the industry.

“Distress is a contrarian trade. You buy distress on the theory that you can realize value and that the assets are priced inaccurately to what they are intrinsically worth,” Mr. Lewin said.

Investors are accessing energy in two ways — through infrastructure and private equity allocations, said Monte Brem, CEO of La Jolla, Calif.-based consultant and money manager StepStone Group LP.

Investments such as pipelines that have existing contracts but are under stress fit into investors' infrastructure allocation, while the majority of the opportunistic investments are in private equity, Mr. Brem explained.

So far this year, institutional investors tracked by Pensions & Investments committed roughly $1.1 billion to energy strategies, mostly focusing on dislocation.

But one, Orange County Employees Retirement System, Santa Ana, Calif., started its energy dislocation investment strategy last year. Last September, OCERS committed $100 million to a separately managed account with Kayne Anderson Capital Advisors LP for midstream energy, said Robert Kinsler, spokesman for the $12.5 billion pension fund in an e-mail.

Girard Miller, OCERS chief investment officer said that after a rocky period, OCERS' MLP portfolio with Kayne Anderson is now the firm's best performing account and OCERS' portfolio with Brigade Capital Management LP, a hedge fund that makes energy plays, is doing very well.

“We still have dry powder, as it's been hard to get good properties cheap .... So discipline and patience is essential,” Mr. Miller said “The irony is that we'll do better in the long run if prices wash out a second time and we get the remaining capital deployed more favorably.”

OCERS official are not “wedded to hydrocarbons,” he added. They will be exploring renewable energy such as wind and solar as well as senior debt or preferred equity in the midstream energy space as part of an exploratory RFP launched May 26 for alternative income managers.

“But we will be very picky about those now; we got a great deal on some Western Gas preferreds that popped over 50% on us from the day we underwrote them when there was still a lot of fear in the market, and I don't expect to see that again,” he said.

Thaddeus I. Gray, managing director in the New York office of private equity fund-of-funds firm Abbott Capital Management LLC, said he expects to see more deals like one earlier this year in which private equity firms acquired preferred equity in a master limited partnership, taking advantage of the drop in MLP stock prices. In January, EnCap Investments LP, EnCap Flatrock Midstream, The Energy Minerals Group, Kayne Anderson Capital and First Reserve Advisors LLC together bought Plains All American Pipeline LP, an MLP, for $1.5 billion.

“It's a vote of confidence by knowledgeable energy investors that large, diversified pipelines are the place to be,” Mr. Gray said.

It is also a bet that oil and gas prices will rebound.

“But no one expects prices to go to where they were two or three years ago,” Mr. Gray said. “A more reasonable projection might be $55 to $65 per barrel in the next 12 to 18 months.”

Marietta Moshiashvili, managing director, energy and infrastructure, in the New York office of TIAA Global Asset Management, agreed that the prevailing feeling among investors is that the energy cycle hit bottom in price terms. The exploration and production sector “has seen clear winners and losers based on the level of leverage and quality of the resource and management teams,” she said. “There are now oil and gas opportunities from distressed and bankrupt sellers, and expansion opportunities of proven resource plays.”

Private equity investments in MLPs also are helping with the continued growth in the midstream sector, she said.

Still, investors need to take care.

“The lesson of past cycles is that the damage is broad and deep, and it can take longer to recover than people think, especially when geopolitical forces are at work,” Mr. Gray said.

Some managers already have mistimed the energy investment opportunity.

A few hedge funds started buying distressed debt of energy companies 18 months to 24 months ago, Clearbrook's Mr. Ng said. He declined to name any.

It turns out they were too early.

Oil prices fell to an average around $43 a barrel by April down from nearly $100 a barrel in July 2014, when many hedge funds began investing in the debt. “So the discounted paper took another leg down,” Mr. Ng said.

Private equity titan The Carlyle Group LP, Washington, has been busy amassing capital for energy. In the past 18 months Carlyle raised $2.5 billion for Carlyle International Energy Partners — its first international energy fund and the largest first-time fund in the firm's history — and the $1.5 billion Carlyle Power Partners II, targeting power generation assets.

Oaktree Capital Management LP; GSO Capital Management Partners, Blackstone Group LP's credit business; ArcLight Capital Partners LLC; Crestview Partners; and Global Infrastructure Partners all are raising energy funds as well, according to Pensions & Investments data.

People saw the price of crude oil drop and thought it was a fairly significant investment opportunity, said Kevin Campbell, managing director, private markets, at fund-of-funds money manager DuPont Capital Management Corp., Wilmington, Del.

“The big question is: Did people truly run in when others were rushing away or did they get in a trap?” Mr. Campbell said. “There will be a lot of LPs (limited partners) two to three to four years from now paying a lot of attention to when their private equity partners re-entered the energy space.”

Meanwhile, DuPont Capital executives are biding their time before re-investing in energy, he said. There are too many questions around whether the stability in the price of oil is short-lived.

“Patience has proven to be pretty valuable,” Mr. Campbell said.