Crescat Capital’s investor letter for the fourth quarter ended December 31, 2015.
With pockets of weakness being exposed in the financial markets, Crescat’s three strategies have delivered strong performance year to date. Through 11/30/15, our Global Macro Fund was up 15.3% net, Long/Short Fund was up 8.3% net, and Large Cap was up 3.3% net. Emerging market dislocations, including a currency devaluation in China, plunging oil and gas prices, poor stock market breadth, and trouble in the high yield credit market have each contributed to losses for money managers this year. Fortunately, Crescat has been on the right side of these and other trades in 2015. In addition to having several prescient macro themes and solid positioning around them, we have managed risk well in these choppy markets through a combination of hedging, diversification, and exposure constraints within our conditional value-at-risk model.
Unlike many money managers and hedge funds that make large concentrated bets, we spread our exposure across a diverse set of well-developed macro themes and positions in all our strategies. In our global macro hedge fund, we held an average of 127 different securities—long and short—at any point in time during 2015, and we had exposure to 16 macro themes in total (14 of which are still active as of this writing). We made money in 12 out of 16 of these themes so far this year, a high 75% hit ratio as shown in the table below:
Crescat Capital – China Currency and Credit Bubble
Since we have written extensively about the overvaluation of China’s currency and its suspect totalitarian economic model in our prior quarterly letters, we will provide just a brief summary here. China Currency and Credit Bubble remains one of our highest conviction macro themes. What we believe will be the inevitable bursting of the China economic bubble has significant ramifications for the global financial markets. A mere 3% devaluation of the yuan in August this year took the markets by surprise and led to a 6% down month for the S&P 500. Thanks to our yuan put options, other China-related shorts, and other positions that served as S&P 500 hedges, Crescat Global Macro Fund was up 4.8% net that month. We believe China’s currency remains extraordinarily overvalued. We think the August devaluation was only the beginning of a much further decline. After years of world record money printing, inefficient centrally planned capital allocation, extreme currency overvaluation, and ongoing capital flight, we believe China is in the beginning phases of a hard landing. In our Global Macro Fund, we have significant exposure to a yuan devaluation with minimal risk through put options. In both of our hedge funds, we remain short China equities.
New Oil and Gas Resources
New Oil and Gas Resources has been the strongest performing theme for Crescat’s hedge funds for the past two years. The theme relates to increased production of oil and gas in the U.S. from the shale basins. As part of this theme, we profited from a spread trade (long natural gas and short crude oil futures) in our Global Macro Fund from 2012 to 2014 as a record energy-equivalent differential (the BTU spread) between oil and natural gas prices narrowed. We also profited in the early days of this theme from long positions in pipeline and oil service companies. However, as the price of oil began collapsing in 2014, we seized the opportunity to short oil and gas exploration and production (E&P or upstream) companies in both of our hedge funds. Our fundamental equity model helped us identify these shorts based on excessive debt, negative free cash flow, and high valuations. We correctly predicted dividend cuts and capitalized on short positions in E&P master limited partnerships (MLPs): Breitburn Energy (BBEP), Linn Energy (LINE), Atlas (ATLS), Legacy Reserves (LGCY), and Memorial Products (MEMP). We capitalized on many other upstream short positions over the last 18 months, including Carrizo Oil and Gas (CRZO), Gulfport Energy (GPOR), Laredo Petroleum (LPI), Oasis Petroleum (OAS), Petrobras (PBR), Penn Virginia (PVA), Whiting Petroleum (WLL), Pioneer Natural Resources (PXD), Continental Resources (CLR), Concho Resources (CXO), and the SPDR Oil & Gas ETF (XOP).
This year, in addition to maintaining the E&P shorts at reduced exposure levels, we began shorting midstream (pipeline) MLPs. Short positions in Plains All-American (PAA), Energy Transfer Equity (ETE), Kinder Morgan (KMI), SemGroup (SEMG), Genesis (GEL), Enbridge (ENB), and Markwest (MWE), and MPLX LP (MPLX) have all been highly successful midstream short positions for our hedge funds year to date. The graph below illustrates our positioning in the energy space over the past two years.
Crescat warned of the energy MLP bubble in our July 2014 quarterly letter. At that point, oil and gas MLPs had been bid up for years by unseasoned investors hungry for yield and tax advantages. Wall Street investment bankers were happy to oblige and greatly expanded the formerly small MLP corner of the energy market. The problem is that the oil and gas sector operates in classic boom and bust fashion. Even the pipeline companies that were touted as “toll roads” are susceptible to the swings of the industry. As production increases during boom times and spreads out from core areas, midstream companies respond by providing expanded infrastructure. The past several years of $90+ per barrel oil saw billions invested in oil and gas pipelines to facilitate the rapid increase in production. These investments were justified by assuming continued high levels of oil and gas output growth, often in regions far from existing infrastructure. As recently as late-2014, very optimistic 5-year US production growth scenarios were commonly seen in midstream company presentations. For example, in December 2014, Plains All-American projected 40% oil production growth in the US and Canada from year end 2013 through year end 2018. With the collapse in the price of oil and gas, these production growth scenarios are no longer realistic for the pipeline operators.
When production slows compared to pipeline capacity, less product needs to get to market, and pipeline utilization decreases. Declines in crude pipeline utilization have already been seen in many regions. The graph below shows total Permian Basin takeaway capacity already exceeding production this year as Plains All-American’s (PAA) Cactus Pipeline came online. The Enterprise Products (EPD) Midland Sealy pipeline is slated to begin flowing in 2017, creating more excess capacity. The Permian is arguably the healthiest shale basin in the country. Other areas have seen similar overbuilding.
Plains All-American Pipeline (PAA) CEO, Greg Armstrong, admitted on the company’s Q3 conference call “We’ve got a lot of excess capacity …we’ve got capital spend and not revenue, so it’s dragging on the aggregate results.” Also on the call, PAA executives noted that 3/4ths of their volume