Natural Resources Newsletter Q4 2020

Quarterly Review Q4 2020



Exploration and Production: 2020-4Q Review and Outlook

Oil Prices
Oil prices continued to rebound from the sharp drop seen in the first quarter as investor enthusiasm about a Coronavirus vaccine pushed prices higher. WTI prices began the quarter in the mid thirties and finished the quarter near $47.50/BBL. Near-month oil futures prices are locked in a narrow range near current spot prices. Prices are still well below beginning-of-the-year prices near $60 per barrel. Interestingly, drilling had not resumed by the end of the year. Baker Hughes reported 351 active rigs in the United States as of December 31, less than half the number from a year ago. Consequently, domestic production has not changed. The U.S. Energy Information Administration (EIA) reports that domestic oil production rose a modest 2.7% between September and November (the last month available) and attributes the increase largely to hurricane-disrupted wells coming back online. We would expect to see production expand in upcoming months with increased drilling.

Natural Gas Prices
Natural Gas prices also rose during the quarter although they have slipped in recent weeks. Recent weakness reflects significantly warmer-than-normal weather. Population-weighted heating degree days were 21% warmer than the 10-year trailing average in the month of November and similar to historical averages in December. As a result of warm weather, natural gas in storage ended the year at all-time high levels for this time of year and 2.6% above the trailing five-year average. Natural gas futures prices show prices rising modestly as the futures curve extends into the spring.

Energy Stocks
Energy stocks, as measured by the XLE Energy Index, rose alongside oil prices climbing 27% during the quarter. The chart below shows that the strength in energy stocks began in November, the exact time that oil prices began to rise. The performance in the quarter far outpaced the overall market. Even with the strong performance in the fourth quarter, however, the energy index was down 38% in 2020. This compares to a 14% rise in the overall market.

The rebound in oil prices came faster than 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. That said, marginal wells will most likely not be drilled, and production growth will be difficult unless we see prices rise back to a level near $60/bbl. and $3.00/mcf. Companies must continue to work to lower costs to adjust to current prices by finetuning drilling techniques.

Our near-term outlook for energy stocks has improved. We expect companies to report favorable results for the next few quarters unless rising production pushes energy prices lower. 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, supply pressure from an increasingly active 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 Fourth Quarter 2020 Review and Outlook

Mining companies outperformed the broader market. During the fourth quarter of 2020, mining companies (as measured by the XME) gained 43.9% compared to 11.7% 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 down 8.0% and 2.0%, respectively. During the fourth quarter, gold futures prices were flat, while silver and palladium futures prices increased 12.4% and 5.6%, respectively. Copper, zinc, and lead futures prices were up 16.0%, 2.5%, and 8.9%, respectively. While it was perhaps a tougher quarter for gold stocks, the GDX and GDXJ were up 23.0% and 28.3% in 2020 with gold and silver prices gaining 22.2% and 46.0%, respectively. We expect strong fourth quarter 2020 financial results among metals producers.

Outlook for precious metals remains constructive. While gold prices benefited in 2020 from investors looking for safety in times of uncertainty; a COVID vaccine, greater clarity with respect to a new Presidential administration, and an expected economic recovery in 2021 tilted the market towards greater risk. With continued low interest rates, an expanding money supply, increasing U.S. debt and a growing federal deficit, we think gold prices will continue to be supported by its appeal as a store of value and hedge against a weaker dollar and inflation. Potential headwinds include a tapering of monetary or fiscal policies and the potential for longer-term interest rates to rise. While cryptocurrencies have emerged as a speculative vehicle of choice for some, they do not have gold's history as a monetary metal and store of value.

Base metals respond to an improving economic outlook. With economic activity expected to rebound in 2021, base metals price have begun to reflect higher demand expectations. Copper, lead, and zinc prices were all up in the fourth quarter, led by copper and zinc prices which were up 25.0% and 19.7%, respectively in 2020. Secular trends associated with a transition to a greener economy, including more electric vehicles and a push toward electrification have elevated investor attention to longer-term supply and demand fundamentals for metals such as copper.

Mining equities provide leverage to commodity price strength. In our view, the environment remains constructive for both precious and base metals although the recovery in precious metals prices has been longer in the making and the outcome of the Georgia Senate race may influence the trajectory and magnitude of stimulative policies. We still think it is early in the game for investors to gain exposure to mining companies given their leverage to commodity prices and our favorable outlook for earnings and cash flow growth.