Natural Resources Newsletter Q1 2021

Quarterly Review Q1 2021



Exploration and Production: 2021-1Q Review and Outlook

Oil Prices
Oil prices continued their upward trend in the first quarter with WTI prices reaching mid-sixties in early March before closing the quarter closer to $60/bbl. Brent oil prices are trading approximately 5% above WTI prices. Improving global economic trends have improved the outlook for oil demand. OPEC, which initiated supply reductions last year, has maintained those reductions despite the improved demand outlook. Near-term, temporary events such as cold weather and the blockage of the SUEZ canal have helped keep spot prices high. The oil future curve is flat with longer-term pricing just below $60/bbl.

Meanwhile, domestic producers have been slow to react to higher oil prices. There are slightly more than half the number of active oil rigs in the United States versus this time last year (324 verses 624) and only 25% of the rigs operating at peak (1600). Note in the graph below how WTI oil prices began rising in the fall of 2020, but the rig count barely responded. International rig counts show a similar story. We are somewhat at a loss to explain the slow supply reaction to higher prices. Perhaps COVID issues are making it difficult to man the crews needed to run rigs. Perhaps producers are wary of supply bottlenecks that pushed oil prices into negative levels last fall. Perhaps producers believe OPEC will punish U.S. producers that expand when prices cross $50/bbl. by opening up supply and driving prices back down below $40/bbl. Whatever the reason, the lack of a supply response has the effect of keeping oil prices above the levels we believe would occur when supply and demand are in balance.

Natural Gas Prices
Natural gas prices followed oil prices up in January and February due to much-publicized cold fronts across the Midwest. The May contract peaked at $3.22/mcf on February 16th. However, prices fell in March when warmer weather took over. Current prices are near $2.60/mcf, close to where they began the quarter. Natural gas futures rise modestly as they stretch into the fall approaching $2.75/mcf. There were 92 gas drilling rigs in operation as of March 26th down from 102 rigs a year ago.
The recent decline in natural gas prices mirrors what can be seen in the natural gas storage numbers. Storage began the winter near full capacity but has fallen sharply in January and February due to cold weather. At current levels, storage is near 5-year averages. As we enter the end of the heating season, there is little chance that levels will move away from average levels.

Energy Stocks
Energy stocks, as measured by the XLE Energy Index, rose alongside oil prices climbing 32% during the quarter. The chart below shows that the performance of energy stocks in comparison to the S&P Composite Index.

The rebound in oil prices came faster than expected and is staying higher than we would have expected. We have been adjusting our models to reflect higher prices but are maintaining our long-term oil price forecast of $50 per barrel and $2.50 per mcf. Energy companies should start reporting positive cash flow at these prices and increasing drilling budgets.

Our near-term outlook for energy stocks remains positive. We expect companies to report favorable results for the next few quarters. Longer-term, we have concern that oil demand will be constrained by power generation competition from renewable energy and decreased demand for gasoline and diesel due to a growth in electric vehicles. At the same time, increased supply from OPEC and continued drilling productivity will mean lower energy prices. We recommend investors stay focused on energy companies with solid balance sheets, low operating costs and protected prices.


Metals & Mining First Quarter 2021 Review and Outlook

Mining companies outperformed the broader market
During the first quarter of 2021, mining companies (as measured by the XME) gained 19.4% compared to 5.8% for the broader market as measured by the S&P 500 index. During the first quarter, copper, lead, and zinc futures prices were up 13.4%, 9.9%, and 2.2%, respectively. The VanEck Vectors Gold Miners (GDX) and Junior Gold Miners (GDXJ) ETFs were down 9.8% and 17.0%, respectively, reflecting 9.6% and 7.6% respective declines in gold and silver futures prices. While silver and gold outperformed in 2020, base metals have taken the lead in 2021 as markets recover and economic growth accelerates.

Base metals supported by cyclical and secular themes
Demand for base metals will likely benefit from global economic growth and infrastructure spending. Additionally, secular themes, including trends toward electrification, favor metals used in electric vehicle batteries, charging stations, and solar and renewable power technologies.

Outlook for precious metals remains constructive
While precious metals, notably gold, worked as a flight to safety play in 2020, gold prices have given some ground this year and have yet to signal deep concern about inflation despite record monetary and fiscal stimulus. Another headwind for gold has been a strong U.S. dollar. Despite falling 6.7% in 2020, the U.S. Dollar Index has risen 3.7% since the end of 2020 to finish at 92.31 on March 31. While the Federal Reserve likely has the tools necessary to combat a sharp rise in inflation, interest rates are likely to remain relatively lower for longer, and gold’s value could be supported as investors seek it as a store of value. Sentiment could also be influenced by the market's confidence in the government's ability to fund spending programs and manage a growing debt balance.

Diversification benefits
Investors should consider adding base metals mining stocks to their portfolios to benefit from growing demand as global economic growth accelerates. Infrastructure spending and secular trends bode well for metals linked to the theme of electrification. Allocations to precious metals and associated equities make sense as a precaution against unexpected events that could materialize, including misjudgment by the Fed, a broad sell-off of equities, or any other events that increase uncertainty and angst among investors.