ENERGY INDUSTRY OUTLOOK

Exploration and production stocks (as measured by the XLE) fell 6.7% in the first quarter of 2018 despite higher crude oil prices. Crude oil futures prices rose 7.5% to finish the quarter at $64.94/Bbl, while natural gas futures declined by an equal amount to finish at $2.73/Mcf. The XLE underperformed the broader S&P Index, which fell 1.2%, during the same time period. Despite strong performance in January, two straight down months pushed the S&P 500 into negative territory for the quarter. Crude oil futures are in backwardation with future prices moving back toward the $55 range in 2020. Natural gas prices appear range-bound into 2020. While we think global economic conditions are supportive of current energy prices, recession fears in the United States and/or globally could send prices lower. Additionally, US producers have become much more efficient and can operate profitably at lower prices, which increases the likelihood that US production will continue to expand. With that in mind, there is the ever present worry that higher US production could lead OPEC to throw in the towel on production restraint and decide to reclaim market share.

However, we think the near-term supply/demand outlook is supported by firm crude oil demand driven by favorable global economic conditions and the impact of OPEC production cuts on reducing global inventories. Additionally, continued geopolitical uncertainty is supportive of crude oil prices.

In the U.S., producers have access to an immense unconventional resource base and the ingenuity and technology to exploit it. Even though the downturn in U.S. energy markets was severe and many companies were forced to restructure, the industry has quickly recovered and production growth has surprised to the upside. While investors are becoming more focused on returns than production growth, the industry still needs more capital spending discipline, which could lead to a more durable path forward for the industry. While we remain cautious, we think there are attractive opportunities for patient investors who are willing to endure the inevitable volatility.

METALS AND MINING INDUSTRY OUTLOOK

Mining companies (as measured by the XME) declined 6.4% during the March quarter. While the price of gold rose 1.4%, silver declined 5.1%. The gold/silver price ratio at the end of the quarter was 81.6x versus a 15-year average of 62.6x. Given that the current ratio lies above one standard deviation from the mean, silver is arguably undervalued relative to gold. During the same time frame, the ratio reached a low of 32.0x in April 2011 and a high of 84.4x in October 2008.

We continue to have a favorable view of the precious metals & mining sector. We think favorable economic conditions will continue to support industrial demand for silver. Furthermore, potential inflationary pressure keeping real interest rates subdued, rising geopolitical uncertainty, the potential for a weaker dollar and equity market volatility could encourage investors to look to both silver and gold for investment. However, silver prices could be more sensitive to negative changes in the economic outlook (e.g., fear of a recession) although the steep discount to gold could provide a floor on pricing.

Following several years of underinvestment in precious metals exploration and development, supply growth could be constrained. Given that demand for coins and bullion was down sharply in 2017, resurgence in investment demand could put upward pressure on precious metals prices. Given that silver is trading at steep discount to gold, we think more upside exists in silver in the event both metals experience a surge in demand. We favor companies with high-quality reserves and resources, brownfield exploration potential, a favorable cost structure and the ability to quickly respond to market conditions.