Natural Resources Newsletter Q4 2019

Quarterly Review Q4 2019



Exploration and Production: 2019 Review and Outlook

Exploration and production companies were glad to see the ball drop on 2019 and close out a frustrating year. A strong performance in the fourth quarter (XLE E&P index rose 6.9%) offset declines in the second and third quarter and left the index in the green (up 1.8%) for the year. Of course, this performance paled in comparison to the annual returns of the broader market (S&P 500 up 26.7% and the Russell 2000 up 18.7%). As expected, the performance of the XLE mirrored oil prices, which rose in the first quarter, fell in the second and third, and then rose again in the fourth. The rise in the February 2020 oil contract rose from $54 per barrel to $62/BBL in the fourth quarter in response to an improved global economic outlook and growing tension in the Middle East.
The market seems to be dismissing the long-term impact of the president’s political saber rattling with Iran. We would note that future oil prices are below the current spot price. Clearly the market has grown weary of the constant threats of war by both countries and discounts the probability of war. Or, as we have discussed in the past, the market realizes the diminished role OPEC and the Middle East now have on West Texas Intermediate oil pricing.

When companies report December quarter and year-end results next month, we expect most management to report an increase in their hedge position and an increase in their drilling budgets. Most energy companies still set capital expenditures to stay within their operating cash flow but are anxious to turn on the spigots. With higher prices and cash flow, look for modest increases in drilling.

If energy investors are looking away from oil for relief, they won’t get any help from gas producers. The February Henry Hub natural gas contract began the year near $3.00 per thousand cubic feet (mcf) and closed the year at $2.19 per mcf. The year’s decline was largely felt in the last two months of the year when the contract fell $0.67 in response to mild weather.

As we look towards the new year, the outlook for energy stocks is improved but not yet positive. We continue to believe that oil prices are essentially locked in a range of $50-$65 per barrel. Any movement outside that range will cause domestic producers to react by increasing/decreasing drilling and thus production which will eventually move prices back into the range. We view the current movement to the upper end of the range as driven largely by political events and thus temporary.

Unfortunately, at prices within the $50-$65 range, most small energy companies are struggling to operate within free cash flow. They have cut operating costs, restructured debt, and focused on only the most profitable areas of production. Those with high leverage are vulnerable to line of credit downgrades that could create financial strain.

We favor energy companies with a large portfolio of drilling prospects and a strong balance sheet to fund future drilling or other expenditures. We believe energy companies with strong financial positions could begin to consider share repurchases in 2020 if energy prices remain strong and stock prices have not responded. While too early to become positive on the group, we believe investors should maintain a modest exposure to energy stocks as a way to play any potential rise in energy prices.


Metals & Mining Fourth Quarter & 2019 Review and Outlook

In 2019, mining companies (as measured by the XME) appreciated 11.8% compared to 28.9% for the broader market as measured by the S&P 500 index. During the fourth quarter, the XME outpaced the broader market and rose 15.1% versus 8.5% for the S&P 500. For the full year, gold and silver futures prices rose 16.0% and 13.4%, respectively, while copper increased 5.7%. We note that copper futures prices rose 8.5% during the fourth quarter and outpaced both silver and gold. In 2019, precious metals prices reacted to changes in monetary policy, economic growth and geopolitical expectations. For base metals, the key catalysts were economic growth expectations and issues around trade.

As we move into the new year, the outlook for precious metals remains favorable in our view. Increasing geopolitical tensions, notably in the Middle East, increased risk of equity market volatility and a modest interest rate environment along with the potential for higher inflation may cause investors to increase allocations to precious metals for their defensive characteristics in a diversified portfolio.

Central banks have increased gold reserves. According to the World Gold Council, reported 2019 net central bank purchases amounted to 562 tonnes through October 2019 which brought reported global gold reserves to 34,500.8 tonnes.

In 2019, exchanged traded products were a popular vehicle for investment exposure to gold. While 2019 global gold-backed ETF flows were a significant driver of gold demand, U.S. Mint sales of American Eagle gold bullion declined to 152,000 ounces in 2019 compared to 245,500 ounces in 2018. We think publicly-traded equities of metals producers offer an attractive way to invest given the disproportionate percentage impact higher commodity prices may have on a company's bottom line and valuation for a given percentage increase in the commodity itself.

With respect to base metals, economic growth expectations and issues around trade will influence pricing. While the theme of "electrification" gained attention in 2019, sources and supplies of metals needed to support development of electric vehicles and green technologies will likely come into focus in 2020. As a result, 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, zinc, cobalt and manganese. We note that for copper, the International Copper Study Group (ICSG) recently released preliminary data for September 2019. The data indicates that world mine production declined by 0.4% in the first nine months of 2019 due to reduced output in major producing countries such as Chile. World refined production was unchanged, while world refined copper balance in the first nine months of 2019 was a deficit of 390,000 tonnes.

In our view, mining stocks are an attractive way to gain exposure to metals given their leverage to strengthening metals prices. Precious metals equities may provide a hedge against volatility in the equity markets and offer diversification benefits.