World Energy Fund Commentary
The Fund’s Institutional share class returned -35.46% during the quarter, compared with -19.60% and -44.61% for the Fund’s benchmarks, the S&P 500 Index and the MSCI World Energy Index1, respectively.
What factors affected the energy markets during the quarter?
World energy markets suffered through a dramatically painful quarter. At the same time that an oil price war erupted between Organization of Petroleum Exporting Countries (OPEC)1 and Russia, the global economy began to reel from a forced shutdown caused by the coronavirus pandemic. The failure of Organization of Petroleum Exporting Countries1 and Russia to extend and expand their previous commitment to curtail production led Saudi Arabia to flood the market with crude oil. This occurred while oil demand was drying up globally: air travel was grounded almost overnight, and hundreds of millions of people around the world began to work from home.
U.S. oil producers will likely face an existential crisis as the combination of demand and supply shocks continue to create a stiff headwind to pricing. The U.S. oil rig count has already declined from 835 a year ago to 624 rigs at quarterend, and we expect it to continue to shrink substantially. Meanwhile, global oil storage is rising as the futures curve is “in contango.” This means that lower short-term prices and higher longer-dated prices provide an incentive to buy oil now, sell it forward in the futures market, and store it in the meantime until delivery for that sale. Power demand is also shrinking globally as factories shut down alongside many offices, schools, restaurants and other retail businesses.
With all of these trends converging, it is difficult to predict how many months, quarters, or years it might take to absorb excess oil inventories and excess production from OPEC and Russia. As U.S. production declines, we expect that many exploration and production (E&P) and services companies will go bankrupt, particularly those with leveraged balance sheets and limited hedging programs.
In general, we see dark days ahead for oil prices. Though prices are likely to remain low, a global coordinated cut between OPEC, Russia, and other world producers would keep prices from falling even further. Barring a substantial reduction in supply, we would expect Brent oil prices below $30 and West Texas Intermediate (WTI) below $20 to let market forces clear the market of excess supply. A coordinated supply cut among producers would likely change that outlook substantially- breathing life back into the sector.
What factors influenced the Fund’s relative performance?
During the quarter, small-cap energy stocks continued to trail large caps, with the Russell 2000® Energy Index1 returning -58.58% versus the Russell 1000® Energy Index’s1 -51.22% return.
The Fund’s quarterly returns outperformed those of the MSCI World Energy Index. Relative returns were aided by greatly increasing the Fund’s allocation to cash and fixed income holdings earlier in the quarter while reducing its equity exposure, particularly to the most oil price-sensitive areas. Late in the quarter, we reduced our fixed income exposure and added back somewhat to our alternative energy and refining positions where we see the potential for share price recovery as the pandemic subsides.** The critical aspect of Fund positioning was to sharply reduce allocation to traditional fossil fuel companies, including integrated oil, oil field services and equipment, and exploration and production companies. In total, the Fund had 20% of assets in these three industries at quarterend versus 76% in the Russell 3000® Energy Index1.**
We do have some exposure to integrated oil and gas companies, particularly those with what we feel are adequate balance sheets and opportunities to acquire assets when some U.S. shale companies inevitably fail. Meanwhile, we have minimal exposure to the fossil fuel-leveraged stocks that are closely associated with traditional oil price volatility. Because integrated oil companies are also more sensitive to oil prices than refining and midstream assets, we have just 13% of the portfolio in integrated stocks compared with nearly 50% in the MSCI World Energy Index.**
Our refiner holdings performed poorly during the quarter, hurt by concerns around demand for refined product. Relative to the Russell 3000® Energy Index, we ended the quarter overweight refiners (15% of assets), with a focus on those that we believe could benefit from differentials in the price of Brent and WTI crude oil. We believe that despite reduced demand, these companies have balance sheets that can withstand the downturn. Refining fundamentals may continue to decline in the near term, but, in our opinion their normalized earnings power should remain robust, making them attractive long-term investments.** The Fund’s alternative energy performance was mixed, although we maintain our belief in the strong fundamentals of the space in the intermediate to long term. At period-end, the Fund had 24% allocated to alternative energy stocks, with an ongoing emphasis on electric vehicles, wind and solar. We have confidence in secular growth in this area of the market as developed economies generally continue to reduce fossil fuel use. The companies’ valuations became much more attractive, in our view, during the first quarter as stock prices fell.**
We were also overweight storage and transportation stocks as we see market gluts creating a greater need for crude oil storage in the months ahead.
Finally, we remain conservatively positioned in the Fund. At quarter end, we had an unusually high amount in cash and fixed income, ending the period at 20% of Fund assets because of our negative outlook for the sector. This positioning could change should we see meaningful improvements in demand coupled with substantial supply cuts.**
What is your outlook for the energy sector?
With the global economy essentially closed for business, we’ll have to see a combination of events occur before investors return to risk assets: First, we need to see a leveling off of new U.S. coronavirus cases, which is unlikely to happen for at least another month. Additionally, we’ll need positive developments in the treatment of COVID-19– whether it be from a vaccine or from post-infection treatment medicine–that can reduce the global fear of catching the disease.
Concerning oil, without a truce in the Saudi-Russian price war, we believe there is limited upside to oil prices, even from the current low levels. Energy firm bankruptcies, which are likely to occur in greater numbers over the next few months, should reduce supply. Meanwhile, with the oil glut, storage assets could benefit. As China turns its economy back on, we will be watching for no new hot spots for coronavirus in China, demand for petrochemicals rebounding in China, and continued investment in alternative energy, including solar power, wind, and electric vehicles.**
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