Josh Young: Transition Can Deliver Value in E&Ps
Author: George Mack (Energy Report)
Posted: April 12, 2011
Portfolio Manager and Founder Josh Young of Young Capital Management (YCM) looks for value in oil and gas exploration and production (E&P) companies. In this exclusive interview with The Energy Report, Josh discusses some of his best ideas—strategies that could well deliver the significant upside and reduced risk investors might not expect from natural gas producers.
The Energy Report: Are you overweighted to natural gas right now?
Josh Young: Yes, at the moment, I am. It’s challenging right now because natural gas prices are low, so companies aren’t making a lot of money drilling for gas. In such an environment, there are strong incentives for nat gas companies to diversify their product mix and improve margins by drilling for oil; and the market is rewarding companies that manage to increase oil production and improve their margins with substantially higher stock prices. As gas companies have transitioned a portion of their production to oil, their stocks have outperformed significantly; in fact, they’ve been the highest-performing stocks across this space over the last year or two. And, generally, the ones that have transitioned have retained their upside potential from exposure to gas prices, which, historically, are cheap versus other energy sources like oil. That is part of what has driven their stock price outperformance.
TER: I hate to overuse the term “value,” but I’m guessing that your investment theory here is that gas is a value-rich universe.
JY: Yes. Actually, it’s sort of interesting because there’s been a bifurcation in valuation based upon the size of the company. The larger companies that are followed closely and are better understood have started pricing in fairly high natural gas prices, and that correction is already priced in. The market is already expecting gas at $5–$6 per thousand cubic feet (tcf)—and higher in some cases, depending on the stock. So, for me, it’s almost like getting a free ride on the backs of smart, large investment funds that are bidding up the stocks of these big companies based on expectations of the natural gas curve. Typically, these large investment firms can’t invest in the smaller companies that I follow.
Smaller investors have been slow to follow this investment trend, so the shares of smaller natural gas companies haven’t gotten bid up in a same way similar to the larger ones. That’s part of what’s created this tremendous, and I think temporary, dislocation. Also, despite superior performance versus the market and other larger hedge funds, it is a very challenging time for small funds to raise capital—especially in the oil and gas (O&G) space.
As capital has flowed to larger funds, it has been deployed to buy stock in larger-cap companies. This has helped feed the current valuation discrepancy. It has been a temporary phenomenon, as allocators to funds are beginning to overcome their inhibitions toward investing in smaller funds in favor of the (generally) higher returns and lower risk available in those funds. Between additional funds flowing into smaller funds that invest in smaller companies, and larger funds “stretching” and starting to buy stock in smaller-cap companies, there is the chance for a substantial correction in this valuation gap. Of course, many of the companies I’m invested in are going through a transition process, which should drive substantial value creation and share price improvement regardless of fund flows into the space.
