Quarterly Report - March 31, 2010
April 21, 2010
The Fund continued to do well this quarter largely reflecting the strong oil prices and an economy
that has been performing better than generally expected by most forecasters. However, while we
remain positive on the overall outlook for energy stocks, we do anticipate near term volatility
which necessitates heavy emphasis on portfolio asset allocation and micro managing undervalued
stock selections and hedging. The Fund's diversification was particularly important in the first
quarter with the energy and construction (E&C) and energy industrial sectors' strength offsetting
the price consolidation in exploration and production, oil service, and master limited partnerships
(MLPs) after excellent performances in 2009.
The current negative industry concern is the significant decline in natural gas prices to $4 mmbtu. The industry consensus is that most producers need $5 mmbtu to generate a positive economic return. However, many companies have continued to drill in order to hold onto acreage by producing so that it will not be lost and this has contributed to the over supply problem. It has been estimated that as much as half of shale drilling is non-voluntary, but rather to hold onto leases. Positively, many of these agreements are scheduled to expire by 2011, and, when coupled with a strengthening economy we believe that gas prices should eventually rebound from current low levels. Therefore, although we could be early, we are looking for opportunities to increase our gas E&P exposure, especially in situations where stock prices have corrected significantly off recent highs. This was similar to our strategy with selected E&P and service companies and MLPs in 2009.
We continue to be bullish on the overall energy outlook. Developing and delivering various energy sources to end users are expected to provide many opportunities for profitable investment. As the global standard of living continues to increase, all forms of energy supplies will be necessary to fulfill the increasing demand. This has been particularly obvious in developing countries such as China and India. The United States, with only about 5% of the world's population, accounts for about 25% of global energy consumption. Consequently, huge opportunities lie with rising energy consumption of developing countries that comprise the 95% balance of the world's population.
As noted, we moved into oil related stocks more aggressively last year as concerns began to rise regarding the long-term availability of total proven reserves in OPEC (about 76%) and an additional 10% in the former Soviet Union. Continuing access to these reserves is a major concern, as the increase in exploration moves off shore, particularly in deep water and harsh environments. Also much of the world's oil reserves are located in areas where the geopolitical risks are very high. In contrast, our decision to reduce the Fund's positions in natural gas was based largely on the breakthroughs in expanding supplies beyond current and longer term forecasts of demand, largely because of new technology breakthroughs such as horizontal drilling that opened up access to huge new unconventional reserves including shale and coal seam methane.
We continue to favor the MLP stocks since they, on average, are generating total returns of at least 8% - 10% with some as high as 10% - 15% in 2010. Natural gas liquid margins remain high on an historic and absolute basis. We also added to the infrastructure E&C and industrial spaces 2 because the valuations were very compelling and backlogs and profitability are showing signs of improvement with some companies beginning to derive benefit from the Federal stimulus money.
During the first quarter we added a number of new companies to the portfolio such as Forest Oil and Denbury Resources, and increased positions in Noble Energy and Petrohawk Energy. Nevertheless, given the volatility that always is associated with energy investment, especially over the near term, we are doing more pair trades, i.e. going long in a stock and offsetting the investment with a short that we believe reduces risk. We also manage the volatility in a number of ways, including increasing and/or decreasing the amount of puts in the portfolio.
In summary, we remain optimistic regarding our positioning in 2010, but also expect volatility and periodic corrections. Given our generally positive longer term outlook, we often view such developments as buying opportunities.
Certain statements contained herein may contain "forward-looking statements" within the meaning of the Private Securities and Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Fund to be materially different from any future results, performance or achievements expressed or implied by such forward- looking statements. Such factors include, among others, risks and uncertainties associated with the timing and costs of energy sector production, the demand for and prices of oil/gas products, the timing and amount of capital spending in the nation and world wide, and general economic factors. This report is not a recommendation to either buy or sell any securities mentioned.
About ELCO Management, LLC
Established in 1995 and based in New York, ELCO Management (www.elcomanagement.com) offers investment solutions to high net worth individuals and institutions. ELCO also manages two highly specialized energy funds: the ELCO Energy Fund, L.P. and the ELCO Select Fund L.P.