September was a bad month all over for the Black Diamond Energy fund. Clint Carlson’s multi-billion Carlson Capital Black Diamond Energy Long/Short fund generated a return of 2.14% for clients net of fees during the second quarter, bringing year-to-date returns to 4.49%. The fund was up 7.7% prior to August but volatility around the OPEC Algiers meeting curbed gains for the year, that’s according to the fund’s quarterly letter, a copy of which has been reviewed by ValueWalk.

Two key short positions moved in the wrong direction, costing 2.01%. One short position was taken over by a peer and another benefited from ‘media hype’ around a natural gas discovery (Carlson believes this to be a transitional anomaly). For the short book as a whole, returns were -2.97% during the month of September. For the year to October 14 however, the short book is up 5.92%.

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After the oil sector bloodbath of early 2016, Carlson’s quarterly letter speculates that fundamentals are beginning to emerge as a factor that is reflective in stock performance once again. Over July and August  momentum and energy beta were the dominant theme, but heading into the fourth quarter Carlson’s analysts expect companies will have to provide 2017 outlooks which should bring the re-emergence of fundamentals as the dominant driver of stock price performance.

Carlson Capital’s Black Diamond Energy Up 2.14% For Quarter

Large-cap E&P producers were the best performers in Carlson’s portfolio for the quarter just gone according to the letter. The fund’s analysts believe restructuring large-cap E&P companies are some “of the most mispriced securities in energy”. Companies such as Anadarko Petroleum (APC), which continues “to trade at some of the cheapest multiples (5.2X 2018 EV/EBITDA at $60 crude) and widest discounts to NAV’s in the energy space, which is interesting given they have some of the best assets in E&P globally.” The letter goes on, “the market has an obsession with select small and mid-cap E&P but is overlooking the value proposition large cap E&P is presenting.”

Outside of the large-cap global E&P space Carlson likes large-cap Permian plays like Pioneer Natural Resources (PXD) where the “evolution of completion techniques is improving capital efficiency and economic production growth profiles.” As well as these companies Carlson likes a number of companies that operate in the SCOOP and STACK plays of Oklahoma. Although these stocks did not outperform in the third quarter relative to their Permian peers, Carlson believes “the value proposition has not changed and is only improving.”

Big Short Bets Against E&Ps Ahead Of Bankruptcy

Conversely, Carlson is short E&P stocks that destroy capital when crude is trading in the region of $50-$55 a barrel. The fund is also short one large cap, which as mentioned above, saw its stock price increase during the quarter of the back of a new discovery in West Texas. The fund does not mention which company it is short directly in the letter but all the signs point to Apache (APA). At the beginning of September Apache announced that it had uncovered a huge shale oil discovery in West Texas, named “Alpine High,” estimated to contain three billion barrels of crude. Carlson has other ideas:

“We were also short one large E&P company which has very poor asset quality, yet it trades at the highest multiples I have seen in my career on the mistaken market perception that they have discovered a new oilfield in West Texas. It is actually a natural gas and NGL field where the size of the field will be smaller than the initial estimates and the economics are going to be challenged. However, in this beta chase energy market, there seems to be little focus on the fundamentals at present making the short side of the book challenging.”

Additionally, the hedge fund announces:

In the quarter our largest short position, Spectra Energy (SE), was subject to a takeover by Enbridge (ENB) paying 15.5 times 2016 EBITDA, a material premium to GP Peers. Not only did the valuation [not] make limited sense, the project backlog was at severe risk and the asset performance has been weak such that Spectra was not covering its dividend payments within cash flow and issuing equity in order to support its capex and dividend obligations. We believed that this set-up had similar characteristics to KMI during 2015, hence our short position.

The hedge fund has another short idea:

We are now also initiating short positions in select Asian refiners given China has moved from a product importer to a product exporter and there is significant new refining capacity coming on line in the Asian region that will significantly reduce the profitability of select Korean export and distillate heavy refiners.

Other long positions are select Delaware basin plays where M&A activity is currently at “fever pitch” with asset values topping the $40,000 per acre mark. Carlson is long several companies like WPX Energy (WPX) and Cimarex Energy (XEC), which have already established positions in the region and are not purchasing assets at these inflated values.

The fund also likes NRG stating:

NRG Energy (NRG) is an $11 stock that will produce $8 per share in free cash flow over 2017 and 2018 which is essentially contracted and has a renewable business in NYLD, which is expanding and represents $4 per share of value in NRG. Thus, an investor would get the entire Texas generation and electric retail business for free as well as generating assets in California and the Midwest.With a constructive view on Gulf Coast gas prices over 2017-2018, Texas power prices are positioned to move higher.While we understand NRG is a more complex asset set than other utility companies, the market is not appropriately valuing this equity especially given the changing dynamics of the Texas power market.We expect this to normalize in the coming quarters.

Carlson Capital Bullish After 08/09 Crash For Energy

Black Diamond Energy believes the oil world is only just starting to understand the Delaware basin. It is “far more geologically complex versus other onshore basins, but has the potential of 7 to 10 zones in the core part of the basin being productive. That type of stacked play opportunity is truly unique and not understood or priced by the market.”