Natural Resources Newsletter Q1 2020

Quarterly Review Q1 2020



Exploration and Production: 2020-1Q Review and Outlook

Energy investors looking for relief in 2020 drilled a dry hole. The dual impact of the Coronavirus and a Saudi Arabia oil price war sent oil prices crashing down and with them, energy stocks. The XLE Energy Index fell 52% in the quarter ending March 31, far outpacing a 22% decline for the S&P 500 Index. West Texas Intermediate (WTI) oil prices for the May 2020 futures contract began the year at $61.18 per barrel and finished the quarter at $20.13 per barrel, down 67%. Henry Hub natural gas prices for the May 2020 futures contract fared a bit better dropping 25% to a level of $1.60 per thousand cubic feet (mcf).

The Coronavirus and its resulting global economic slowdown will undoubtedly lead to a decrease in the demand for oil. Highways are empty, airlines are shutting down and factories are closing. Estimates for the impact range from a decline of 2.5 million barrels of oil per day (MBOE/d) to 12 MBOE/d. The upper end of the range would represent a 12% reduction in demand from pre-virus levels near 80 MBOE/d. This is demand that will be gone forever, not just pushed back into future quarters.

Complicating issues is the fact that Saudi Arabia and Russia are flooding the market with excess oil. On March 6th, the bottom fell out when OPEC and Russia failed to agree to a production cut, and Saudi Arabia signaled it might ramp up production. WTI prices fell $10.15 per barrel, or 24.59% to a level near $30 per barrel. The decline marked the second biggest one-day decline on record and the largest since 1991. Since March 6th, oil prices have continued to slide as the Energy Information Administration (EIA) reports a growing stock of crude oil in storage.

Needless to say, oil prices in the twenties is disastrous for domestic energy companies. Many companies claim to be able to break even at oil prices in the forties. However, none claim to be able to do so at prices in the twenties. We have said in the past that U.S. producers have become the producers on margin. They will be the first to react to changes in oil prices by adjusting drilling. Already, many companies have announced that they have cancelled their drilling programs.

The United States has grown to become the largest producer of oil at 11 MBOE/d. It has done so through horizontal drilling and fracking that accelerates initial production rates. These techniques, however, also lead to sharper declines if new wells are not drilled. Without new drilling, U.S. production could quickly slip back towards the 6 MBOE/day level of just ten years ago.

What is most disturbing about the recent drop in oil prices is that the market does not view the drop as temporary. Looking at future month contracts, prices rise very slowly. That means that the market believes Saudi Arabia is not bluffing about raising production and that OPEC and Russia won’t reach an agreement to cut production. It also means the market believes the impact of the Coronavirus may continue well into the future. It also means the market does not believe that there will be a quick supply response by U.S. producers.

U.S. producers can withstand temporary dips into the forties, thirties or even twenties. Many companies hedged part of their production when oil prices rose last year. Two years of oil prices below $40 would be another story. Companies have operating and financial costs to consider. Companies that have tapped their lines of credit could see that credit reduced or eliminated leaving management with few options now that energy stock prices have fallen. Without an improvement in oil prices, many U.S. producers could be headed towards bankruptcy at a rate similar to what happened in 2016.


Metals & Mining Fourth Quarter & 2019 Review and Outlook

During the first quarter of 2020, mining companies (as measured by the XME) fell 44.9% compared to 20.0% for the broader market as measured by the S&P 500 index. The VanEck Vectors Gold Miners (GDX) and Junior Gold Miners (GDXJ) ETFs were down 21.3% and 33.5%, respectively. During the first quarter, gold futures prices increased 4.4%, while silver futures prices declined 21.1%. With respect to base metals, copper, lead and zinc futures prices were down 20.9%, 9.0% and 16.2%, respectively. Concerns about economic growth, compounded by the impact of the coronavirus, negatively impacted the demand and price outlook for base metals. The broad market sell-off in March also weighed on gold, normally perceived as a safe haven, as investors sold positions to raise cash, deleverage and/or offset other losses.

In our view, a combination of fiscal and monetary stimulus, rising U.S. government deficits, debt and lower-for-longer interest rates are supportive of gold prices. Investors typically buy gold as a store of value and with interest rates expected to remain low for the foreseeable future and negative-yielding debt in some countries, investors may increase their exposure to precious metals. Additionally, while stimulus is required to mitigate the coronavirus’ negative impact on global economies, it could lead to inflationary pressures down the road. Increasing government deficits and debt could act as a drag on economic growth, support lower interest rates and eventually weaken the U.S. dollar.

Growing silver demand for use in solar panels, electronics and medical applications gives silver versatility as both a monetary and industrial metal. Silver's role as an industrial metal may explain why the historical gold-to-silver price ratio has widened during the past few years. However, we expect investment demand for silver to increase as investors consider the wide discount between the two metals and silver's upside potential. Silver generally lags gold during periods of rising demand for precious metals. Silver prices could also benefit from tighter supplies. A significant source of silver production is as a by-product of base metals production. If demand for base metals slows and production declines, the supply of silver could be negatively impacted. Additionally, current silver prices provide producers with little incentive to expand production capacity.

Due to the outlook for slower economic growth both in the United States and globally, the short-term outlook for base metals is uninspiring. Longer-term, we think the outlook is favorable, particularly for copper, which should benefit from growing demand related to electric vehicle and other industrial applications. We note that for copper, the International Copper Study Group (ICSG) recently released preliminary data for December 2019. The data indicates that world mine production declined by 0.7% in 2019. World refined production was down 0.6%, while the world refined copper balance for 2019 indicated a deficit of 340,000 tonnes. Investor interest in base metals-oriented companies could grow as the market begins to assess longer-term supply/demand and pricing trends for metals such as copper.