Natural Resources Newsletter Q2 2020

Quarterly Review Q2 2020



Exploration and Production: 2020-2Q Review and Outlook

Energy Prices
When you hit bottom, there is nowhere to go but up. Oil prices crashed in April following the spread of COVID-19 and a price war between Saudi Arabia and Russia. Spot prices even traded as low as negative $37 per barrel. The concept of investors paying another investor to take oil off their hands is perhaps bizarre, explainable when viewed only as a short-term issue of speculators being caught with contracts in their hands and nowhere to dump the contracts with storage fields full. Nevertheless, longer-term contracts followed spot prices downward, if not into the negative range. Oil future contracts going out a month or two fell from prices in the thirties per barrel into prices around $20 per barrel. As expected, the sharp drop in pricing lead to an immediate response. Domestic producers all but eliminated new drilling and Saudi Arabia, Russia and other allies made up (kind of) and agreed to cut supply by 10% through the end of July. Whether the cuts last remains to be seen as there are already reports that several OPEC members are not adhering to reductions. However, current WTI and Brent oil prices, both near $40 per barrel, provide energy companies a lifeline they didn’t have three months ago.

Natural Gas prices fell, albeit not as much as oil prices. Spot prices began the quarter around $1.75 per thousand cubic feet (mcf) and fell as low as $1.38 per mcf, the lowest level in nominal dollars since December 1998. Inventories remain high following a mild winter and demand remains low due to the shut down of the economy. Liquified Natural Gas (LNG) terminals are reporting a decrease in gas exports and the pace of development of new projects is slipping. Production levels are holding steady even as natural gas rig count has decreased.

Energy Stocks
Energy stocks, as measured by the XLE Energy Index, rose 33% in the second quarter. The strong performance generally tracked the rise in oil prices with most of the gain coming at the end of the quarter. Truth be told, however, the gain is primarily due to an improvement in the overall market and not a rise in energy prices. The S&P 500 Composite index rose 26% during the quarter. Both indices were down sharply in the first quarter and the strong performance in the second quarter merely reflects a rebound from the first quarter. Year to date, the XLE is still down some 40%.

The return to oil prices in the forties was welcome news to leveraged energy companies facing negative cash flow and an inability to meet financial obligations. At prices in the forties, companies with a low-cost basis should generate positive cash flow. That said, marginal wells will most likely not be drilled. Of particular interest is whether or not these companies will lock in modest gains by hedging out production. Or, will they view these returns as inadequate to compensate owners for the risks they are taking and continue to roll the dice on the hopes of higher prices? In the end, the outlook for energy prices and energy company stocks has not changed. The outlook will depend on the pace of recovery of global economic conditions and the will of OPEC plus to hold the line on pricing.


Metals & Mining Fourth Quarter & 2019 Review and Outlook

Mining equities outperform the broader market.
During the second quarter of 2020, mining companies (as measured by the XME) gained 31.4% 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 up 59.2% and 76.4%, respectively. During the second quarter, gold futures prices increased 12.8%, while silver futures prices increased 31.3%. With respect to base metals, copper, lead, and zinc futures prices increased 21.5%, 10.5%, and 6.0%, respectively.

Outlook for precious metals remains favorable.
In our view, the outlook for gold remains constructive based on U.S. and global monetary and fiscal policies that support gold as a geopolitical frictions. While silver generally lags gold during periods of rising demand for precious metals, silver finally caught a bid in May and finished the month up almost 24%. At this time, we think silver may offer more immediate upside potential relative to gold.

Base metals should benefit from a rebound in industrial activity.
Following a challenging first quarter, base metals prices, led by copper, responded to a more optimistic industrial demand outlook that was driven by supportive fiscal and monetary policies. Positive demand signals from China, the first country to begin recovering from the negative impacts of COVID-19, rippled across various commodities, including crude oil.

Mining equities provide leverage to rising commodity prices.
In our view, the backdrop is uniquely constructive for both precious and base metals since both are likely to benefit from a rising tide of fiscal and monetary stimulus and their repercussions. Publicly traded equities of mining & metals equities are an attractive way to gain metals exposure due to their leverage to commodity prices.