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Alternative energies and investment strategies

The last decade saw major structural changes in the publicly-quoted energy sector. Since 2004 the ten major oil companies’ market capitalization has fallen from about 70 percent of the MSCI Energy index to less than half. Over the same period the biggest companies’ market value trailed the rest of the sector as the number of …


The last decade saw major structural changes in the publicly-quoted energy sector. Since 2004 the ten major oil companies’ market capitalization has fallen from about 70 percent of the MSCI Energy index to less than half. Over the same period the biggest companies’ market value trailed the rest of the sector as the number of firms almost doubled.

This has created a far more fragmented industry. At the start of the 1990s, just 20 exploration and production companies were listed with a total public float of over $100 million. By 2004, the number of firms had swollen almost five-fold and today there are more than 200 exploration and production businesses.

This has multiplied the number of investment opportunities throughout a range of sub-sectors, demanding more specialized expertise. Armed only with the standard valuation toolbox of ratios, the traditional investor will be lost in a world where it is essential to analyze the probable net present value of an exploration portfolio. Investors now need a more industrial approach than in the past married with classic financial analysis.

These changes have been accompanied by the evolution of alternative investment strategies. Larger and more mature oil companies can become a source for extracting cash through a short selling strategy, which in turn can be judiciously invested in a portfolio of smaller exploration and production firms. The range of exploratory activities among these businesses gives investors a range of possibilities. A $2 billion market-cap company that discovers 100 million barrels of oil may see its share price surge while a similar discovery by Chevron or Total goes virtually unnoticed. Such a broad universe of securities also increases the dispersion of returns between investments.

A greater range of companies within the sector has also spurred greater issuance of bonds and hybrid securities such as convertible bonds. We recently concluded, for example, that a company’s exploration portfolio was fully valued in the market. However, since that portfolio contained "high risk/high reward" assets we chose to invest in the convertible bond issued by the company, giving a floor value for our investment while maintaining exposure to any drilling successes.

The high-yield debt market is another example. The recent financial crisis has opened new investment opportunities after the partial withdrawal of credit from some banking institutions. These investments allow for attractive returns while limiting the volatility of a portfolio. Investors with in-depth knowledge of the exploration and production sector have developed sophisticated ways of looking at industrial value as a function of assets, such as a floating drilling rig. Furthermore, investments such as these have benefitted from two strong sources of performance: the fall in corporate lending rates throughout 2010 and sporadic acquisition of these assets by companies with a superior rating.

Investing in the energy sector today demands a sharp change in investment approaches combining industrial knowledge and financial analysis with an expertise applicable across multiple asset classes. The lesson of the industry’s expansion over the last few years is clear; applying innovative equity and debt strategies within the same fund lets investors maximize performance while minimizing portfolio volatility.

Pascal Mengès is the Head of Energy Research at Lombard Odier Investment Managers. This article was written exclusively for Daily News Egypt.

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