POWERING dOWN

---

INVESTMENT INSIGHTS | March 2015

Powering down Oil’s sharp slide fails to create broad value buys But sparks select energy opportunities

The sharp decline in oil prices and energy stocks at the end of 2014 and beginning of 2015 has many investors looking for buying opportunities in energy stocks. A closer examination of sector fundamentals, however, highlights why Perkins maintains a cautious outlook even at current prices, with the most compelling potential coming from select opportunities to strengthen portfolio quality.

Prices for West Texas Intermediate (WTI) and Brent crude oil have fallen more than 51% and 52%, respectively, since 12/31/2013. $120

$100

$80

$60

WTI Crude Oil

Source: EIA.gov. As of 1/30/2015.

Brent Crude Oil

1/15

12/14

11/14

10/14

9/14

8/14

7/14

6/14

5/14

4/14

3/14

2/14

$40 1/14

Given our cautious outlook on natural gas and crude oil’s fairly tight trading range prior to this recent downdraft, we were relatively defensively positioned. We avoided many of the high-flyers that have driven sector returns post financial crisis, most of which have been painfully punished in recent months, some stocks as much as 80% of their recent highs. Instead, we continued to focus on high-quality companies with strong management teams that have exhibited capital discipline and have lived through both up and down cycles. These companies also possessed attractive valuations and favorable long-term risk/ reward characteristics. Additionally, some of our holdings were in master limited partnerships (MLPs) and general partnerships (GPs), which tend (and proved) to be more defensive than E&P stocks and oil services stocks. Nonetheless, a sell-off of this magnitude would catch the attention of any value investor, but based on our research we believe a cautious view of the energy sector remains warranted. Longer term, crude oil prices

Exhibit 1: Crude oil Prices

12/13

While many believed oil prices had found a permanent home in the $80 to $110 per barrel range (WTI crude oil), we felt there was notable risk that the price of crude oil could dip into the $60s when it was still above $80 during fall 2014. During summer 2014, it had gone as high as $107. However, we did not anticipate the swift, drastic plunge to the current $43 to $54 range (Exhibit 1) and related 28% and 24% year-end tumble in exploration and production (E&P) and oil services stocks, respectively.

will most likely move higher, barring global recession, but when that occurs is anyone’s guess. In the meantime, we expect commodity prices to remain fairly volatile. Our focus is on those companies we are confident will survive this turbulent period.

Price Per Barrel

Further to fall?

As we evaluate investing in energy stocks, we remain concerned about several critical overhangs. Price rebound overconfidence: In our opinion, E&P management teams generally remain too optimistic that this is a short-term oil price decline. Perhaps they are correct and do not need to cut capital expenditures as much as we think is currently warranted. If they are wrong, however, and it becomes a prolonged period of weak prices, many companies may be impaired for years to come without dilutive equity offerings. Similarly, we believe too many investors expect oil prices to soon reach a “V-bottom” and rally closer to $70, but this seems unlikely given the reasons below. Weaker global demand: Outside of the U.S., the global economy remains weak, and thus oil demand growth is lackluster. In our view, the soft global economy is evident not just in crude oil prices, but other economically sensitive commodities, such as copper, down 22% since 2013, and iron ore, off 32% for the 13-month period ending January 31, 2015. A stronger U.S. dollar: The U.S. dollar has continued to move higher, helping to pressure oil prices lower. Admittedly, we are not experts in the movements of currencies, but as countries around the world resort to currency devaluation in an effort to boost local growth, this could continue to weigh on crude oil prices. Lack of OPEC pricing support: This is by far our biggest concern. For the past 16 years, OPEC has supported oil prices by reducing supply when prices weakened, increasing supply when prices strengthened and jawboning the market when needed. However, OPEC, heavily influenced by one of the world’s largest oil producers, Saudi Arabia, has not stepped in to defend oil prices recently and instead appears to have encouraged it. This is possibly to help regain market share and potentially punish what it perceives as bad regimes such as Russia and Iran, both of which have economies very dependent on oil exports and thus high oil prices. There is also the new dynamic of the U.S. shale revolution that could make the U.S. a net exporter of crude in the near future. Consequently, major OPEC players such as Saudi Arabia may see the recent downturn as an opportunity to reestablish their market leadership positions (Exhibit 2).

2

Unknown implications for shale-focused companies: Oversupply, due in part to strong U.S. production, has led to weak oil prices before. Both the 1980s and 1990s saw prolonged periods of pricing pain for oil and gas companies, with thousands of jobs shed. This downturn could be similarly painful in that many public E&P companies producing in the new shale plays have only operated in an environment of rising oil prices until now. No one really knows what the future holds – commodity prices are notoriously difficult to predict – but there is enough evidence to suggest that the current falling price trajectory may not recover in a meaningful way any time soon. For that reason, we have been adding slowly to positions and focusing on high-quality names that we remain confident will survive if the current climate turns into a multiyear period of weak prices.

Exhibit 2: Global Crude Oil Market Share Saudi Arabia and other OPEC countries have steadily lost market share to the U.S. 15,000 Total Oil Supply (Thousand Barrels Per Day)

Shaky fundamentals

12,000

9,000

6,000

3,000 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Saudi Arabia

Russia

United States

Source: EIA.gov. As of 12/31/2013.

Negative longer-term implications In addition, the recent fallout in energy prices will likely prove to be a double-edged sword as it relates to equity markets and the broader U.S. economy. Short term, it should provide a boost in consumer spending. Long term, however, the energy complex has been a primary growth driver in U.S.

profits and solvency concerns could easily spread to the broader financial markets (Exhibit 3).

capital expenditures during the past five years, and less E&P activity could negatively affect the earnings of those firms with exposure. Furthermore, the dramatic growth in U.S. shale production has stimulated economic activity in states such as North Dakota and Pennsylvania with high-paying jobs and thriving local economies that have only witnessed rising oil prices and remain untested in down cycles. We have already seen energy companies announce layoffs in the thousands, with more likely to be announced. Energy companies have also been active participants in the debt markets, particularly in high-yield issuance, and risks around substantially squeezed

Clearly, there are winners from lower crude prices, but the collateral damage could appear later. An added variable is the geopolitical consequences of lower oil prices on volatile countries such as Russia, Venezuela and much of the Middle East. These risks seem to be reflected to an extent in current energy stock valuations, but the broader markets continue to march to new highs that might be quickly torpedoed if any mounting unrest starts to roil investors.

Exhibit 3: Higher energy company debt exposure

$200

20%

$150

15%

$100

10%

$50

5%

$0

12/2009

12/2010

12/2011

Secondary Oil/Gas Producers

12/2012 Oil Service

12/2013 Gas Pipelines

12/2014

1/2015

Energy as Percentage of Total High-Yield Issuance

Value of Total Energy High-Yield Issuance (In Billions)

Energy high-yield bonds now represent more than $180 billion, a 245% increase from six years ago.

0%

Miscellaneous

Source: UBS. As of 1/30/2015.

Building on quality We have kept these uncertainties firmly in mind as we have researched and analyzed energy equities in these trying times for the industry. As such, we have maintained a slow, deliberate pace in adding to existing positions and beginning new positions, with a constant emphasis on owning the highquality names. In E&P stocks, we are focusing on companies and managements that have a history of surviving extended downturns and have seen their companies emerge even stronger. We also look for firms with healthy and strong

balance sheets, capital expenditure discipline and quality assets. In our view, there are far too many managements, particularly in the small-cap space, that have only experienced periods of rising commodity prices and appear unprepared to weather a long-term oil price decline under their current capital structures. For example, only one of the 10 largest E&P weightings in the Russell 2000 Value Index generated free cash flow in the last 12 months as of September 30, 2014, and the average capital expenditures of this group was 2.2x cash flow generated, excluding asset sales. These types of thin characteristics may make them more susceptible to steep downturns in difficult markets.

3

On the oil service side, we continue to focus on companies with distinct competitive advantages, market niches and strong balance sheets. We are also looking for those companies that are trading at something close to trough valuations given the uncertain market the companies face in 2015 and possibly for far longer. In the supermajors, our portfolios continue to own companies with the most defensive balance sheets that have positioned themselves to weather the turmoil in oil prices and quite possibly come out of this downturn as stronger companies. This group has had challenges in the recent past with heavy spending on higher cost, elephant projects, but we think the firms that we own have moved past the bulk of these expenses, with management teams refocusing on driving higher returns and profitable growth. They also have defensive downstream and midstream businesses that could potentially benefit from declining crude oil prices. Moreover, these holdings continue to provide attractive, relatively safe dividends while we wait for improving fundamentals and a more stable macro environment. MLPs have remained an extensive part of our energy holdings for many years, but we recently have significantly reduced or eliminated exposure to the group across our portfolios. Our focus has always been on high fixed-fee midstream businesses with stable, visible cash flows and strong coverage ratios. If this is the early stages of a prolonged weak environment for crude oil and natural gas prices, distribution growth should slow, perhaps not in 2015 but certainly in 2016 and 2017. We do not believe this slower growth profile is reflected in current valuations. MLPs have also generally outperformed the rest of the energy complex (Exhibit 4), and we have opportunistically taken advantage of this relative outperformance to significantly reduce our exposure and reinvest some of the proceeds into more beaten down, high-quality stocks in the energy space.

4

The common theme across these positions is Perkins’ constant emphasis on seeking to protect assets against downside risk first and foremost, and then considering upside potential. In the current climate, this has allowed us to further strengthen portfolio quality in our energy holdings by taking advantage of select buying opportunities while remaining moderately defensive in our positioning. Exhibit 4: Energy industry stock performance 12/31/2013 - 1/30/2015 Relative subsector performance has been varied, with more defensive subsectors like MLPs holding up better. 10%

0% Industry Relative Performance

We are also paying close attention to credit market views of the companies we own or are interested in, as this can provide an added layer of protective insights if debt markets are signaling potential distress.

-10%

-20%

-30%

-40%

-50%

Super Major Basket

MLPs

E&Ps

Oil Services

WTI Crude Oil

Super Major Basket (Exxon, Chevron, Total SA, Royal Dutch Shell, BP PLC) MLPs (AMZ) – Alerian MLP Index E&Ps (EPX) – Philadelphia Stock Exchange SIG Oil Exploration & Production Index Oil Services (OSX) – Philadelphia Stock Exchange Oil Service Sector Index

Source: Bloomberg. As of 1/30/2015.

Conclusion We believe the key takeaway from the current energy stock sell-off is that not all price declines are immediate buying opportunities. There are numerous macro and fundamental headwinds that could continue to pressure sector performance and escalate downside risk, especially short term. While there are certainly attractive risk/reward valuations in the current market, these appear primarily to be in select high-quality stocks. At a time like this, caution can be the biggest driver of potential long-term gains. The best way to avoid unnecessary risk is to focus on energy holdings that may be down, but definitely not out, for the long term.

This publication is for investors and investment consultants interested in the institutional products and services available through Janus Capital Management LLC and its affiliates. Various account minimums or other eligibility qualifications apply depending on the investment strategy or vehicle. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value. The views presented are as of the date published. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or market sector. No forecasts can be guaranteed. The opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. It is not intended to indicate or imply in any manner that any illustration/example mentioned is now or was ever held in any Janus portfolio, or that current or past results are indicative of future profitability or expectations. As with all investments, there are inherent risks to be considered. Perkins Investment Management LLC is an indirect subsidiary of Janus Capital Group Inc. and serves as the sub-adviser on certain products. Janus Distributors LLC 151 Detroit St. Denver, CO 80206 Janus and Perkins are registered trademarks of Janus International Holding LLC. © Janus International Holding LLC.

Perkins Investment Management 311 S. Wacker Drive, Suite 6000, Chicago, IL 60606 www.perkinsinvestmentmanagement.com

C-0315-83539 04-30-16

For More Information Contact Janus Capital Group 151 Detroit Street, Denver, CO 80206 www.janusinstitutional.com

388-15-30051 02-15