Cato Brahde discusses Oceanic Energy Fund's innovative strategies in tapping the growing potential in the energy sector.
Cato Brahde qualified as a naval architect at the University of Newcastle upon Tyne and gained an MSc in Business Administration from Boston University. After a stint in the Norwegian Navy, he spent 11 years at Brown and Root - a subsidiary of US oil services group Halliburton working with marine installations and construction contracts. He joined Tufton Oceanic in 1989 where he managed an in-house shipping investment fund and several private equity projects - including a fleet of 30 offshore support vessels for North Sea use. Cato founded Oceanic Hedge Fund in 2002 and launched Oceanic Energy Fund in 2006.
HW: What is the background to the fund?
CB: In 2002 we established Oceanic Hedge Fund, (OHF) which was launched with USD 4 million. OHF was closed in April with USD 550 million, whilst Oceanic Energy Fund was launched with USD 20 million on 1 March 2006.
OHF was designed to be a medium volatility fund. The relatively smooth performance in the traditionally volatile shipping and energy markets was achieved through judicious diversification within those sectors, as the economic drivers for energy, container shipping, bulk shipping, shipbuilders and cruise are very different. Unfortunately the liquidity in the shipping universe is limited, and several sub-sectors such as container ships and tankers are now being oversupplied. This has been an advantage in that it has enabled OHF to use shipping shorts to balance energy longs, but liquidity tends to decline in a falling market thus making it more difficult to deploy additional funds.
The target return for OEF is 25% though we do expect it to be more volatile than OHF - primarily because of the lower level of diversification.
The team originally consisted of myself, Ted Kalborg, Jonas Andreasson, and Andreas Vergottis. Ted and I had worked together in Brown and Root before Ted founded Tufton in 1984, and Jonas and Andreas had both worked with us for a number of years in their capacity as shipping analysts, though Andreas had left us for a while when he was senior shipping analyst with UBS. More recently the analysis team has been augmented by Bjorn Rise whose career started in the Norwegian oil company Norsk Hydro where he did oil field development analysis and natural gas sales. He changed tack and became an investment analyst, and worked with Tiger Management, SEB Asset Management and Mitsubishi Trust before coming to Tufton. Kashyap Swami who was a petrochemical engineer with Exxon Mobil before gaining his MBA joined the Tufton team last year. We are also in the process of recruiting a senior alternative energy analyst.
HW: Who are your service providers?
CB: OHF uses Bear Sterns as its prime broker, HSBC as administrator, and PWC as auditors, whilst OEF uses Morgan Stanley as prime broker, HSBC as administrator, and KPMG as auditors.
HW: How and where do you distribute the fund? What is your current and targeted client base?
CB: We have appointed DNA Advisors as our third party marketer. DNA has recently been set up with a highly professional marketing team, and this enables the fund management team to focus on running the fund. The marketing is being focused on family offices, HNW individuals, and discretionary managers.
HW: What is the investment process of your fund?
CB: The investment process includes a number of features:
- We start from a bottleneck analysis to identify the main bottlenecks within the industry. For example 2 years ago a major bottleneck was the tanker fleet, however due to an extensive new-building programme, tankers are unlikely to be in short supply for the next few of years. Current bottlenecks are in oil services and refining. We review the sectors in detail each month based on the latest statistics and trends.
- We have detailed models of the companies in our sectors. For example when it comes to the offshore drillers we have details of every drilling rig owned by every public company, including details of its contract status, cost base, area of operations etc. We replace book values with values based on replacement costs, depreciation policies with a standardized policy across the universe and so on. In this way we ensure that we compare companies on an 'apples for apples' basis, and this gives us many opportunities to rotate the stocks within the universe, going long the cheap stocks and shorting the expensive ones.
- Over the past 4 years we have developed a framework for identifying relative valuations between equities and commodities. We often find that equity markets and commodity markets are both efficient and rational - yet the two have different views of the future. These differences give rise to great trading opportunities for investors like us who are comfortable taking positions in both markets.
HW: How do you generate ideas for your fund?
CB: Our internal research, detailed industry knowledge and a wide contact network helps a lot in the idea generation. The best ideas are generated when we have some time to think laterally and kick scenarios around to try to see who the winners and losers will be.
HW: What is your approach to managing risk?
CB: We have a comprehensive risk management approach based on a combination of gross and net exposure limits, diversification rules, stop losses, value at risk and individual position size rules. The main point is to watch your net and gross exposures, and make sure that the various themes that you invest in at any time are not too correlated. Also you need to watch the correlation between your fund and factors such as interest rates, market liquidity, trade flows and commodity prices.
HW: How/against what do you benchmark the performance of your fund?
CB: We are first and foremost interested in absolute return, but we also measure our return against MSCI world index and relevant energy indices.
HW: Has your performance been as per budget and expectations? Do you expect your performance or style to change going forward?
CB: For OHF the target at start up was annual return of 20% with a Sharpe ratio of 2.0. The actual performance to date was 24% in 2003, 18% in 2004 and 24% in 2005.
The investment themes obviously change from time to time, and whilst 3 years ago we were long most shipping sectors and short energy, the opposite is now the case. We have tried to remain true to our style, but with increasing size we tend to trade less than we used to, and we now tend to use exchange traded funds as a means to increase or reduce our sectoral exposures without trading individual positions. As long as there is volatility and a differential outlook for our sectors there should be no reason why the performance can not be maintained.
For OEF the target annual return is 25% with a Sharpe ratio 1.5. We have been cautious in scaling exposures and positions over the first 2 months, but now feel that we have a portfolio that will perform on a risk adjusted basis.
HW: What opportunities are you looking at right now?
CB: We consider that the energy universe is still at the beginning of a long upturn; oil demand is increasing as the world industrialises, and if China is to continue on its current trend of development it will reach the kind of per capita oil consumption in 25 years time that South Korea enjoys today. This would lead to a near doubling of the world's oil consumption by 2030. A similar increase in demand occurred in the 1970s because of the growth in private car ownership in Japan and Europe. The oil crisis in the 1970s was precipitated by the fact that oil production in the US peaked - much to the surprise of most forecasters at the time. In the 1970s the world economy was saved by vast new oil producing areas being found and developed such as the Gulf of Mexico, Mexico, Alaska, North Sea and Russia and that Saudi Arabia was able to increase its production from 3 million barrels to 10 million barrels per day. Given the lack of cheaply available supplies, this kind of growth is simply not possible today, and it will be a major challenge for the world economy to replace the aging oil fields currently being depleted and at the same time to cater for Asian demand growth. The portion of the world's GDP which will need to be allocated to meet its energy needs to increase dramatically and there is little risk of general investors becoming over allocated in energy in the foreseeable future.
HW: What events do you expect to see in your sector in the year ahead?
CB: It is clear that over the past couple of years the right investment mode in energy has been the long only mode rather than through a hedgefund, and this is because the utilization of the world's energy supply capacity has been steadily increasing leading to higher prices and profit margins. However the high utilization gives both higher prices and higher volatility, and this is where a good hedgefund comes into its own. Last October many energy funds corrected by between 20 and 35% due to fears that demand was slowing with the high energy prices, whilst OHF which has a 50% energy weighting, only experienced a drawdown of 2.5% due to a combination of hedges and natural shorts in our portfolio. We expect significant volatility going forward, and this will provide plenty of opportunities to test the hedging strategies, and our thesis that a hedged approach is now more appropriate than an outright long approach going forward.
HW: How will these changes/future events impact on your own portfolio?
CB: Energy is in one of those fascinating periods of change from a staid cyclical industry to a growth industry, with new solutions and new technologies appearing virtually every day. We see the alternative energy universe for example as a truly exciting part of the fund's future. The world toyed around with energy conservation and alternative energy in the 1970s and early 80s, only to abort the efforts when hydrocarbons got cheaper again. This time it is for real, and all the ingenuity of the human mind will be required to supply the energy needs in a rapidly developing world aspiring to the standard of living and freedom of travel that Europe and North America now enjoys. No single source of energy has the capacity to do that, and there will be a multitude of opportunities for developing whole new industries based on energy supply and demand management. This places a great demand on fund managers to understand the dynamics of change as well as the fundamental factors that do not change.
HW: What differentiates you from other managers in your sector?
CB: The team consists of energy industry veterans, having worked in the energy industry before becoming investors; this gives us an innate understanding of current and potential bottlenecks, of promising technologies and of required investment flows for the future.
Over the past few years we have developed a robust framework for evaluating inefficiencies that frequently arise between the equity and commodity universe. Not many investors are comfortable executing relative value trades between the commodities and the equities space, and this inevitably makes the risk adjusted returns more attractive for those investors who can identify and trade on such discrepancies.
By having a good fundamental valuation framework we can readily compare valuations across different regions, companies and sectors, and this has enabled us to focus our resources in the right places. Many energy funds tend to be US centric, and although the US energy companies are good value at the moment, one should not lose sight of the fact that 97% of the World's oil reserves are located outside the US
HW: Do you have any plans for similar/other product launches in the near future?
CB: There is a limited universe of investible companies in some of the more exciting sectors at the moment, and we plan to launch a new fund to help fund some of the smaller cap companies in this space. This will focus on small cap and pre-IPO opportunities within our area of expertise - building on our extensive experience of private equity deals and fund management.
(Cato Brahde was interviewed on 5 May 2006)