Deep Pockets

In 1998, energy was not a fun industry to invest in. Iraq had just come back into the market after an eight-year absence, OPEC had raised quota levels, and Asia was in a deep recession. Since then, however, energy prices have skyrocketed. Few funds have fared better in this surge than the Excelsior Energy and Natural Resources Fund (UMESX). The fund, managed by Michael Hoover of U.S. Trust for the past six years, posted a total return of 42.5% last year and 27.3% in 1999. To go along with these impressive returns, the fund has maintained a low expense ratio of 0.97% in a category with an average ratio of 1.77%.

With oil and natural gas prices clocking in at nearly double their 1990 averages, it’s no wonder that a fund with major holdings in companies like ExxonMobil and BP Amoco has posted great numbers.

Since the energy fallout in 1998, you’ve had two years of excellent returns. Why? The period from 1998 to 1999 was energy’s turn at a recession, which resulted from the confluence of three factors. First, Iraq came back into the market for the first time since the Gulf War of 1990, and all of a sudden, you had two million barrels of oil coming back into the market. At the same time, OPEC had raised its quota, thinking that when Iraq came back there would be a quota decrease. Third, Asiawent into recession. Those three things resulted in an oversupply, and oil got down to $11 a barrel. The positive side was that gas prices in certain states got down to $1 per gallon. As a result of the recession in 1998 and 1999, you had a lot of cutbacks in the oil industry and you had significant falloff in drilling expenditures. That’s why we have higher oil and gas prices today. Through the falloff in drilling and continuing depletion of existing oil and gas wells, we’re playing catch-up in trying to produce more oil and gas. OPEC has had a number of production cutbacks, so we’ve had a tight supply/demand balance.

You’ve had a 15% return since inception. How have you managed to do this while keeping your expenses low? When we started the fund, the idea was that it would be for U.S. Trust clients and outside investors, and we’d also market it through an advisor network. We don’t load a lot of overhead on the fund. Basically I pick stocks by visiting companies and listening to presentations. We don’t load a lot of salespeople onto it because we market the fund through various advisor channels. We let the performance speak for itself. Part of our good performance was a function of higher oil prices. Oil averaged $30 per barrel last year and natural gas averaged $4 per MCF (thousand cubic feet). To put that into context, oil in the 1990s averaged between $15 and $20 a barrel and natural gas averaged about $2 per MCF. The fund last year had a significant allocation to the exploration and production companies–companies like Anadarko Petroleum, which is a producer in the upstream of the oil and gas business. With high prices, companies saw their revenues and profits expand significantly. We were also helped by our significant allocation to the oil service sector. Those companies are involved in the business of finding oil and gas for the producers. The producers contract out the drilling to the oil service companies. They benefited because more rigs were getting put back to work and day rates for rigs were going up as capacity increased. We were in the right sectors and commodity prices were up. We also had good representation in the pipelines and utilities with companies like El Paso and Enron.

How do you keep your fund diversified? We divide the fund into various components, so you have the major integrated companies like ExxonMobil and BP Amoco. Being integrated means that they have production capabilities of finding oil and gas and they also refine oil and market the gasoline. They are well balanced in the sense that as oil prices fall, they can offset part of the impact through gasoline sales. Typically, crude oil costs fall faster than gasoline prices at the pump. So their downstream tends to do well in a gradually falling price environment. Over a three- to five-year period, companies like ExxonMobil tend to outperform the S&P through share repurchase and dividend increases. Also, during down times, they make acquisitions. Thus, earnings power significantly increases, so when you come to the upturn, you have a stronger company. By buying Mobil, Exxon has more drilling projects to choose from. Also, BP bought Amoco and Arco during the downturn. You tend to get consolidation during the downturns. Along these lines, we like Chevron and Texaco, which are merging. And Phillips Petroleum is buying Tosco, which is an independent refiner. Currently we have about 21% of the fund in major integrated companies. We have trimmed our exposure in independent producers now, because in April and May, you tend to get a pullback in commodity prices because you don’t need natural gas or fuel oil for heating needs anymore, and you don’t yet need natural gas or fuel oil for the driving season or for running air conditioning. We went from a 19% to 12% weighting in independent producers.

How has the Administration’s push for increasing supply affected your buy/sell decisions? It did have an impact in the sense that we bought a coal company called Massey Energy because the Bush/Cheney platform obviously has roots in the energy industry. They believe fossil fuels such as coal, oil, nuclear, and natural gas will be the most efficient, economical fuels for the next 10 to 15 years. They have no issue with alternative fuels–it’s just that it won’t develop for a while yet and when it does, it will be at higher prices. They are trying to push better exploitation of traditional fuels.