ENERGY INDUSTRY OUTLOOK

Exploration and Production: 2020-3Q Review and Outlook

Oil prices rebounded faster than expected but have stalled out at $40/BBL
The dismal days of the second quarter and the crash in oil prices are behind us. Still, few people in the energy industry are rejoicing about a return in oil prices to the $40 level. At current levels, thoughts have shifted from trying to survive to making sure operations are cash flow positive.

Natural gas prices rose sharply despite a rise in inventories
Normally, the summer months are quiet for natural gas prices given the seasonal nature of gas demand. Not this year. Surprisingly, the rise in natural gas prices comes despite an increase in gas inventories. Rising gas prices most likely reflect early predictions for a cold winter for most of the country. This is especially true for the highly populated eastern half of the country.

On the other hand, domestic oil production has declined to the reduced drilling. The EIA reports that U.S. crude oil production fell 21% between March and May before gaining half the decline back. Domestic producers have clearly shown an ability to respond quickly to oil price changes and that should dampen any impact that external events might have on oil prices.

Gas Prices
Natural Gas prices followed the trend of oil prices in the spring dropping from a price near $2 per mcf at the beginning of the year to a price under $1.50 by late June. Since then, natural gas prices have started to climb. The current futures price for next month deliveries is a robust $2.47 per mcf. Normally, the summer months are quiet for natural gas prices given the seasonal nature of gas demand. Not this year. Surprisingly, the rise in natural gas prices comes despite an increase in gas inventories. The chart below shows that gas inventories are the highest they have been in the last five years for this time of year. Rising inventories reflect a bounce-back in production and a decrease in liquified natural gas exports. Rising gas prices most likely reflect early predictions for a cold winter for most of the country. This is especially true for the highly populated eastern half of the country. La Nina forecasts call for wetter-than- normal conditions in the northern half of the country that could mean heavy snowfall. The hope is that cold weather will result in increased heating demand for natural gas and will drive down inventory levels this winter.

Energy Stocks
Energy stocks, as measured by the XLE Energy Index, fell 20% in the second quarter compared to a 7% rise in the S&P 500 Composite Index. The September quarter marks the tenth consecutive quarter in which the XLE has underperformed the overall market. Over the last ten years, the XLE has declined 50% versus a 175% increase in the S&P Index. The cause of the underperformance is, of course, lower energy prices. The underperformance also reflects the bull market. Although energy stocks benefit from growing demand associated with strong economic conditions, they also have characteristics of defensive stocks. They generally pay a high dividend yield. In fact, several energy companies such as Exxon Mobile now offer a dividend yield above 10%.

Outlook
The rebound in oil prices came faster than expected but seems to have stalled out at current price levels. A higher oil price 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, and production growth will be difficult. Companies must work to lower costs to adjust to $40 pricing, which is beginning to feel like the new normal for the foreseeable future. However, technology gains that came from applying hydraulic fracking and horizontal drilling to nonconventional formations will be hard to come by. Improvements are still being made by adjusting fracking intervals, viscosity, etc. However, these fine-tuning improvements yield small cost reductions, not the type that lower lifting costs by $10 per barrel.

We believe investors should continue to be wary regarding energy stocks. Investors would be wise to focus energy investment on companies with little to no debt and liquidity to continue to drill. A large hedge position may provide a lifeline. Low lifting costs per barrel remain important. A supportive ownership group with a long investment timeframe is also important. That said, there are compelling values within the group now that individual stock prices have fallen. We continue to believe energy prices will eventually return to higher levels with a return to more normal economic conditions and a supply response by domestic producers. We have adjusted our long-term oil and gas price assumption to $50/bbl and $2.50/mcf respectively, although we believe it may be a year or two before we reach those levels. Our individual stock net asset values and price targets are based off of our long-term energy price assumptions.

Energy stocks continue to fall
They have underperformed the overall index for ten consecutive quarters. Energy stocks, as measured by the XLE Energy Index, fell 20% in the second quarter compared to a 7% rise in the S&P 500 Composite Index. The September quarter marks the tenth consecutive quarter in which the XLE has underperformed the overall market. Over the last ten years, the XLE has declined 50% versus a 175% increase in the S&P Index.

Investors should focus on low-cost producers with good balance sheets
Investors would be wise to focus energy investment on companies with little to no debt and liquidity to continue to drill. A large hedge position may provide a lifeline. Low lifting costs per barrel remain important. A supportive ownership group with a long investment timeframe is also important.

Oil Prices
The dismal days of the second quarter and the crash in oil prices are behind us. Still, few people in the energy industry are rejoicing about a return in oil prices to the $40 level. At current levels, thoughts have shifted from trying to survive to making sure operations are cash flow positive. Managements are less focused on shutting in production or getting out of drilling contracts, but they are still concerned about cutting costs and focusing on the most profitable wells. And throughout it all is a general feeling that $40 per barrel could vanish quickly if anything else negative happened. Could the global economy shut down again if COVID cases accelerate as we enter the winter heating season? Will OPEC Plus members tire of output restrictions and raise production levels? Does the shift towards electric vehicles threaten a key component of oil demand? Will domestic production cost cutting continue to drive down oil prices regardless of supply and demand changes?

METALS AND MINING INDUSTRY OUTLOOK

Metals & Mining 2020-3Q Review and Outlook

Mining companies outperformed the broader market
During the third quarter of 2020, mining companies (as measured by the XME) gained 9.7% compared to 8.5% 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 6.8% and 11.7%, respectively. During the third quarter, gold futures prices increased 4.1%, while silver futures prices increased 26.1%. While gold has retreated from its all-time high in August, it is up 22.2% year-to-date through September 30. With respect to base metals, copper and zinc futures prices increased 11.8% and 18.6%, respectively, while the lead futures price declined 1.9%. Given that most metals built on price gains achieved during the second quarter, we might expect improved third quarter financial results.

Outlook for precious metals remains constructive
With the upcoming U.S. elections, both parties appear to support continued fiscal spending, while the Federal Reserve has already signaled accommodative policies for the foreseeable future. During the third quarter, the U.S. dollar index fell 3.6% and is down 3.0% for the year after peaking in March. While we expect the USD to maintain its status as the world’s reserve currency, we see few catalysts for it to strengthen materially due to continued low interest rates, an expanding money supply, a widening trade deficit, increasing U.S. debt which stood at 135% of GDP at the end of the second quarter, and the Federal Reserve’s inclination to allow inflation to drift above its 2% target.

Base metals could benefit from increased economic activity
We expect base metals to benefit from continued fiscal stimulus and a focus on infrastructure spending. In our view, demand should increase as economic activity improves following the depths of the pandemic’s impact on demand, coupled with the need to rebuild inventories. Additionally, we see demand for metals, including copper, nickel, silver and palladium benefiting from secular themes, including a push toward electrification and green technologies.

Mining equities provide leverage to commodity price strength
In our view, the backdrop remains constructive for both precious and base metals since both are likely to benefit from continued fiscal and monetary stimulus and their repercussions. However, there is a risk of greater regulation of mining in the United States should the Democratic Party sweep the election.

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