Some U.S. Fund Managers Still Bet on Oil

Mutual fund managers who believed the slump in oil prices would be short-lived have been taking it on the chin, but some are not giving up, betting that the market will bounce back and they will have the last laugh.

The FPA Capital Fund, the Towle Deep Value Fund and the Mount Lucas US Focus Equity fund are among several that are still plowing money into oil exploration and production companies, even as their performance numbers sank to the bottom 5 percent this year, according to Morningstar (MORN). (Graphic: http://link.reuters.com/nup45w)

Their reason for buying oil stocks even as crude prices are tanking again after a tentative second-quarter recovery? A bet that U.S. production will retreat sharply over the next 12 months, setting the stage for a rebound towards $65-70 per barrel that would allow most U.S. shale oil producers to stay profitable in the longer term.

U.S. crude hit 6-1/2 year lows below $41 a barrel on Wednesday, weighed down by oversupply concerns, swelling stockpiles and fears that China's slowing economy will sap global demand.

"We're setting ourselves up for the next cycle," said Dennis Bryan, co-portfolio manager of the $950 million FPA Capital Fund. The fund has about a fifth of its portfolio in oil-related stocks, according to Lipper data.

Bryan, who points to surveys that estimate that U.S. oil companies have cut their capital expenditures by 35 percent this year, expects the supply glut to ease by the end of this year.

His view is rosier than that of a growing number of executives and analysts who are bracing for "lower for longer" oil prices, predicting a relatively small dent in U.S. production and new supplies from Iran. The International Energy Agency expects global oil supply to outstrip demand until at least the third quarter of 2016. The deepening pessimism pushed energy sector stocks in the S&P 500 down nearly 13 percent this year, compared with a 3.3 percent rise in the main index.

Bryan's fund is down 8.4 percent and investors have pulled $237 million from it over the past 12 months, according to Lipper data. In all, the 10 diversified US equity funds with the largest energy allocations saw nearly $900 million in outflows, shrinking to $3.2 billion over the past 12 months.

BETTING ON REBOUND

In contrast, funds that threw in the towel on energy over the last year have outperformed. The $17.5 million Tanaka Growth fund, for instance, slashed its energy holdings from 17.2 percent of assets to just 1.2 percent over the past 12 months, according to Lipper. The fund has returned 14.7 percent this year landing in the top 1 percent of mid-cap funds tracked by Morningstar.

Yet some oil analysts think that crude will bottom out soon. Paul Horsnell, head of commodities at Standard Chartered (SCBFF), told clients in a note on Monday that he expected a "sharp rise in prices next year." Raymond James analysts, meanwhile, see oil staying below $60 per barrel in 2016, but significantly rebounding in 2017.

Timothy Rudderow, co-portfolio manager of the $53.9 million Mount Lucas US Focused Equity fund, said that he has boosted oil exposure following his fund's model that suggests oil stocks will rebound over the next 12 months. The fund now has 30.2 percent of its assets in energy, compared with 7.3 percent a year ago, according to Lipper data.

Among Rudderow's picks are companies such as Diamond Offshore Drilling Inc, whose latest quarterly earnings handily beat analyst's forecasts, and Transocean Partners LLC , which also beat estimates after what it called "near fanatical" cost-cutting.

Even so, shares of both companies are down by nearly a quarter or more so far this year, one reason why Rudderow's fund is down 2.2 percent for the year.

"When oil started falling people sold everything that wasn't nailed to the floor," Rudderow said. "We're willing to take some short-term pain to outperform over the long run."

Craig Hodges, co-portfolio manager of the $2.1 billion Hodges Small Cap fund, managed to stay in the black despite the downdraft even with 7 percent invested in energy, roughly double the average for among small-cap funds tracked by Morningstar.

His secret? Selective stock-picking and a bit of hedging.

As oil prices started to slide in the second half of last year, Hodges consolidated his position, putting the money that he had spread out across 10 energy stocks into the five companies he thought had the strongest balance sheets and positioning to weather the downturn. He sold companies including U.S. Silica Holdings Inc, which makes proppants used in shale drilling, and Sanchez Energy Corp, a fracking company located mostly in the Gulf Coast. He held on to companies such as Matador Resources Co, RSP Permian Inc , and Diamondback Energy Inc, which operate low-cost shale oil fields in Texas.

At the same time, Hodges began raising stakes in companies that could benefit from cheaper oil, such as American Airlines Group Inc, concrete maker Eagle Materials Inc and discount retailer Shoe Carnival Inc.

The fund is up 3.3 percent for the year, which puts it in the top third of its category.

"We want to focus on the survivors and those that have the balance sheets to withstand much lower oil prices," he said. "At the same time, cheaper energy is a net positive for the economy as a whole, and we're trying to tap into that."

Reporting by David Randall