World Energy Fund Commentary
The Fund’s Institutional share class returned 7.53% during the quarter, compared with 9.07% and 5.22% for the Fund’s benchmarks, the S&P 500 Index1 and the MSCI World Energy Index1, respectively.
What factors affected the energy markets during the quarter?
World energy markets rebounded in the fourth quarter as almost all risk assets benefited from accommodative central bank policy and the announcement of a Phase One U.S.- China trade deal. A number of factors combined to support the energy market: constrained supply partly because of the Organization of Petroleum Exporting Countries1 and Russia agreement from December 2018, sanction-related declines in Iranian oil exports, and the risk of Iran-Saudi conflicts in the Persian Gulf and Straits of Hormuz, which could disrupt supplies and cause oil prices to spike. The number of U.S. oil rigs declined from 885 to 670 through the course of 2019 as U.S. producers reduce production growth rates.
On the negative side, the energy sector underperformed the overall equity market with the weakest returns in the S&P 500 Index for the full year, though only modestly lagging the index for the quarter. Over the past seven years, the U.S. energy sector has underperformed the overall market in all but one year. Over that time, management teams have lacked discipline in their capital decisions, investing excess cash flow to generate additional growth despite poor returns. Compounding this, private equity has poured capital into energy, providing competition for assets and reducing returns for public equity. In addition to China’s economic slowdown this year, the Saudi Aramco initial public offering (IPO), launched in the fourth quarter, could result in an oversupply of energy stocks.
As a result, we see West Texas Intermediate (WTI) oil prices as likely range-bound from $45 to $65, with the global economic slowdown offsetting the potential upside demand demand from International Maritime Organization’s (IMO) 2020 regulations. Geopolitics remains a wildcard that could result in prices moving above this range temporarily.
What factors influenced the Fund’s relative performance
During the quarter, small-cap energy stocks trailed large caps by a slim margin, with the Russell 2000® Energy Index1 returning 5.15% versus the 5.69% gain for the Russell 1000® Energy Index1.
The Fund’s quarterly returns outpaced those of the MSCI World Energy Index. Relative returns were aided by strong stock selection in the exploration and production (E&P) space, and positive results in companies related to the electric vehicle supply chain, including firms that sell chips and technology into the electrical components of these vehicles. Conversely, weighing down overall returns were fixed income holdings that had low yields relative to stock returns during an equity rally, along with relatively weak performance from utilities, as defensive stocks underperformed.**
The Fund has a 10% allocation to integrated oil and gas stocks versus 43% in the Russell 3000® Energy Index1. We continue to significantly underweight this group because we see attractive opportunities for investment in alternative energy and refiners. We are also underweight the E&P industry, focusing on companies with low unit costs and companies where management has shown commitment to returning cash to shareholders. We are focused on companies that are expected to generate free cash flow in the next year.**
We are equal weight the storage and transportation companies with a focus on the Permian basin and Canada, where we see opportunities for returns based on production increases. The Fund has a 21% weighting in alternative energy stocks, where companies continue to trade below our view of intrinsic value. These companies offer attractive long-term opportunities as global economies focus on more environmentally friendly energy production and usage. We remain focused on electric vehicle makers, whose valuations we view favorably, and we added to existing positions within alternative energy during the quarter.**
We remain overweight refiners to benefit from the price differentials between Brent and WTI crude oil as well as discounted crude that’s likely to be found throughout the U.S. because of pipeline constraints. We also are focused on refineries that we expect will benefit from the IMO 2020 rules requiring marine ships to use lower-sulfur fuel. These rules should drive increased demand and higher prices for marine diesel. Refiners remain well capitalized with strong cash flow yields, and they should continue to benefit from wider discounts for WTI relative to Brent based on excess amounts of local light, sweet crude.**
What is your outlook for the energy sector?
With an easing of U.S.-China trade tensions and a possible resolution, we see improved prospects for the energy sector. If trade tensions are resolved, we would expect oil prices to rebound on expectations for increased demand. Brent crude prices could be held within a range of $55 to $70 based on the likelihood that OPEC+1 would reduce its supply cuts in the event of a price increase.
A U.S.-China trade settlement would be bullish for cyclical energy businesses. The Phase One trade agreement has already led us to increase our investment in alternative energy and refineries, particularly with IMO 2020 as a catalyst, while reducing our position in fixed income and cash to fund expanding opportunities in alternatives and refiners. We see some relative value in mid- and small-cap E&P companies and services, but we expect investors to wait to see whether management will remain disciplined. The issues of oversupplied services and an overcapitalized industry as a result of excess prior-year investments remain.**
Past performance does not guarantee future results. The performance data quoted represents past performance and current returns may be lower or higher. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. To obtain performance information current to the most recent month end, call 800-762-7085 or visit us at www.cavanalhillfunds.com.
S&P 500 Index is regarded as a gauge of the U.S. equities market, this index includes 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 focuses on the large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market. MSCI World Energy Index is designed to capture the large- and mid-cap segments across 23 Developed Markets (DM) countries. Developed Markets countries include: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK and the US. All securities in the index are classified in the Energy sector as per the Global Industry Classification Standard (GICS®). Russell 3000®, 2000® and 1000® Energy Indexes are designed to represent the performance of companies within specific sectors of the Russell 3000, 2000 and 1000 Indexes. Methodology equally weights securities within each sector, mitigating security specific risk and offering balanced exposure to particular sectors. These indexes are unmanaged and do not reflect the fees and expenses associated with a mutual fund. An investor cannot invest directly in an index. Organization of Petroleum Exporting Countries (OPEC) is a permanent intergovernmental organization of 14 oil-exporting developing nations that coordinates and unifies the petroleum policies of its Member Countries.
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