ENERGY INDUSTRY OUTLOOK

INDEPENDENT EXPLORATION AND PRODUCTION

It was a difficult quarter for energy stocks as prices fell in response to falling energy prices. Energy stocks, as measured by the XLE Energy Select Sector SPDR Fund, fell 5.1% over the three months ended June 30, 2019. The decline stands in contrast to a 2.6% increase in the S&P 500 Composite Index over the same time period. Both oil and natural gas prices declined during the most recent quarter. Oil prices, as measured by the WTI August 2019 future price, declined 5.4% from $61.81 per barrel to $58.47 per barrel. Natural gas prices, as measured by Henry Hub August 2019 futures, declined even more significantly, falling 14.0% from $2.68 per thousand cubic feet to $2.308.

The decline in oil prices corresponds to rising inventories with the EIA reporting consolidated oil stocks of approximately 2 million BBLS (as of 6/21), up 4.6% from a year ago. Oil imports continue to decline even as the export of petroleum products grows. Domestic production of oil continues to grow. The spread between North Sea Brent oil prices and WTI oil price has widened from $5.23 per barrel to $8.04 per barrel in response to increased domestic production. The oil futures curve is relatively flat with prices rising towards $60 over the next few months but then falling to $57 next summer and $55 the year thereafter. We believe the decline reflects a belief that near-term prices are artificially inflated by political tension in the Mideast and perhaps a feeling that long-term global expansion may be getting old in the tooth.

The decline in natural gas prices, on the other hand, is due to domestic issues. The EIA reports natural gas storage of 2.3 trillion cubic feet (as of June 21, 2019), up 11.4% from the same time last year. After several months of being near five-year lows, storage levels have returned to historical averages. The rise in storage has been most pronounced in the Midwest where weather was abnormally mild in April and May. At the same time, domestic gas production has continued to grow, at least until reported for April. It should be noted that natural gas prices began their sharp decline in May and June. We suspect domestic production in May and June will show a decline when reported in response to lower prices.

The current outlook for the energy sector is somewhat negative. The euphoria of merger activity in previous quarters has dissipated. We have noticed an increase of bankruptcy filings among marginal energy companies this quarter. The rise in international oil prices due to political unrest seems destined to be short-lived. Other energy future prices are low. Storage levels are high. Undoubtedly, companies will respond to low prices by cutting back drilling, which will reduce production and the storage glut. Until companies begin reporting such cutbacks, we would encourage investors to be cautious regarding the energy sector.

METALS AND MINING INDUSTRY OUTLOOK

Mining companies (as measured by the XME) declined 4.4% during the June quarter versus a 3.8% increase in the S&P 500 Index. Notably, after posting 2.9% and 15.4% declines in April and May, the XME rose 16.3% in June on the back of higher gold prices which rose 8.0%. During the first half of 2019, the XME was up 8.4% but still lagged the S&P 500 Index which appreciated 17.4%. During the second quarter, the price of gold increased 9.1%, while silver increased 1.3%. Futures suggest gold above $1,400 an ounce in 2020, with silver prices in the mid- $15 range. The gold/silver ratio was 92.0x at the close of the quarter and we still maintain our view that silver is undervalued relative to gold and thus could represent greater long-term price appreciation potential.

Among base metals, copper and lead fell 7.8% and 5.3% during the second quarter, while zinc eked out a 1.3% gain. During the first half of 2019, gold was up 9.9%, silver declined 0.9%, copper rose 3.0%, lead fell 4.7% and zinc was down 0.9%. What can investors expect for the remainder of 2019?

A few of the key contributors to gold’s strength in June included a rather dovish posture from the Federal Reserve Open Markets Committee when it decided to maintain the target range for federal funds rate and suggested the potential for the
future rate cuts by mentioning in its release that it could “act as appropriate to sustain the expansion.” Accommodation by the Fed could send the dollar lower which would be supportive of precious metals. Second, trade concerns, particularly with
China, helped sustain gold’s rally along with increasing geopolitical tensions, most notably with Iran. Interestingly though, second quarter sales of gold bullion by the U.S. Mint totaled a modest 19,000 ounces, compared to 90,000 ounces during the first quarter and 77,000 ounces during the prior year period, which implies that the June rally was likely driven by the purchase of gold-backed exchange-traded products rather than physical coin investment. We generally view physical buying
as an indicator of the breadth of such rallies. For example, the U.S. Mint has been challenged in past years to keep up with demand when prices were rising.

In our view, monetary policy, geopolitical risk and trade will most likely drive movements in gold for the remainder of the year. While fears of a global or U.S. recession appear to have been deferred for the moment, they have not faded, in our view. Underscoring concerns about economic growth, a more dovish posture by the U.S. Federal Reserve and other Central Banks, including the European Central Bank and Bank of Japan, may strengthen gold's appeal, especially when one considers that real interest rates are negative in some countries. We note that, according to the World Gold Council, first quarter global gold demand increased 7% on a year over-year basis with Central Bank purchases representing the largest since the first quarter of 2013, China and Russia have been buyers as they have sought to diversify away from the U.S. dollar.

With respect to base metals, issues around trade and economic growth will continue to influence demand expectations. While these will influence near and intermediate prices for copper, we are very constructive on the long-term outlook due to growing sources of demand that include components for electric vehicles, charging stations and electronics and support investment in new sources of supply.