Beyond Bulls & Bears

Equity

Implications of the Coronavirus for Natural Resource Investors

The coronavirus and the impact of containment efforts on global economic growth and oil demand is influencing investor sentiment and behavior, according to Franklin Equity Group’s Fred Fromm. Despite the outbreak’s near-term impact on commodity prices and natural resources stocks, he explains why he thinks the situation is likely to be manageable for most companies in the long run.

There’s no question the Novel Coronavirus has brought suffering to many people, and we certainly don’t wish to downplay the seriousness of the situation. It also has caused a sense of panic among investors globally, as we’ve seen some volatile market reactions in the wake of the virus’s spread. One prime example surfaced on February 3, when China’s commodity markets tumbled after re-opening following the Lunar New Year holiday. The question is whether the markets’ often panicky short-term reactions to these types of shocks are justified.

Although concerns related to the potential economic damage from the coronavirus and its containment efforts have weighed on commodity prices and related equity values, as we examine the situation through an investment lens, we believe the long-term fundamental trends in place prior to reports of the outbreak are unlikely to change meaningfully. Recent economic reports have further supported signs of a recovery, and governments are likely to provide further monetary stimulus to help offset the virus’s downstream effects on economic activity. In addition, lower commodity prices can act as a form of stimulus by lowering costs to consumers, particularly for transportation fuel.

Quarantines in China, along with the government’s targeted closures of businesses and mass transit in regional hot spots, will influence commodity demand, but we believe the negative consequences should be short-lived as weather warms into the spring, the spread of the virus wanes and vaccinations and drug treatment regimens are developed. While the situation remains fluid, if history and the 2003 SARS (Severe Acute Respiratory Syndrome) epidemic are any guides, markets will recover—and perhaps strongly—once the virus is decoded and contained.

Meanwhile, the People’s Bank of China recently announced significant capital injections into the country’s banking system to help offset its slumping domestic equity market. However, concerns have lingered over the threat the Novel Coronavirus poses to global oil demand. The virus’s economic fallout is also tied to a range of other industrial commodities used in transportation and manufacturing. As the contagion spreads, commodity traders continually reassessed the impact of shutdowns in the world’s biggest energy user and producer of steel, coal, refined copper and other base metals.

China is the world’s largest oil importer and second-largest oil consumer—it currently uses roughly 13.5 million barrels of crude oil daily (mb/d), or nearly 10 mb/d more than it produces.1 Attempts to contain the coronavirus have crippled regional travel at a time when fuel stockpiles typically build on a seasonal basis. In this environment, the specter of oversupply has made crude oil extremely sensitive to demand concerns, even if viewed as short term in nature.

Global oil markets experienced some relief when the Organization of Petroleum Exporting Countries consortium (OPEC+), including Russia, announced a joint technical committee meeting to discuss the virus’s short-term impact on oil demand. In our view, OPEC could recommend temporary production curtailments, though Russia has been slow to confirm their position on the matter, which has raised some questions as to whether such a reduction will take place, furthering pressure on crude oil prices.

Investment Implications

At the company and industry level, trends remain positive for many natural resource companies in the energy and materials sectors, with a focus on cost control and capital spending discipline. This should set the stage for better returns and growing cash flow generation that can be used to improve balance sheets and return cash to shareholders. With the fourth-quarter 2019 earnings season well under way, so far most natural resource companies have reported financial results and forward-looking views that have met or exceeded analysts’ consensus expectations.

We believe a combination of factors—including those mentioned above—will begin to attract more investors who are rightfully skeptical following several years of weak returns within commodities-driven industries. In the energy sector, previously poor returns were due, in part, to investments made during the peak of the last cycle when development opportunities were limited and costs were relatively high. Conversely, the investment environment over the past couple of years has provided ample opportunities to pursue projects with much stronger and durable return profiles.

More recently, the prevalence of weak returns in the oil and gas exploration and production industry can be chalked up to the early stages of development for unconventional US resources, also known as shale or tight rock. Rather than see it in this light, as one might view an early-stage technology company, many short-sighted investors have concluded that the resource type is simply not economically viable, a view we do not share.

For example, management of Chevron, one of the largest and oldest energy producers in the Permian Basin of Texas, stated on their latest earnings call that they expect to achieve return on capital employed (ROCE) in the Permian of 20% on an “all-in” basis, which includes all acquisition, development and production costs. This, in turn, is expected to boost Chevron’s current companywide ROCE of 7%, as their Permian shale production grows to over 20% of total production.2

Similarly, we expect returns and cash generation to improve for select small- and medium-sized producers as they mature and gain economies of scale, which should be recognized by investors and, if not, by other producers seeking to grow their resource base through acquisitions.

While we obviously can’t predict the full ramifications of the coronavirus, commodities were generally viewed as highly susceptible to potential demand weakness. Related natural resource equities were overly punished by investors, in our view, particularly when compared to the broader market. During a time when sentiment and momentum dominate market action, stocks that have performed poorly are easy targets for raising cash, and we think this could create a potential opportunity to invest in energy and materials equities where longer-term fundamentals remain solid.

Many natural resource stocks have completely retraced their fourth-quarter 2019 rallies and are once again trading near multi-decade and, in some cases, all-time lows. In the current environment, we are therefore comfortable adding back to core holdings, with a particular focus on higher-quality companies with robust balance sheets that have previously appeared fully valued to us.

 

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What Are the Risks?

Franklin Natural Resources Fund

All investments involve risks, including possible loss of principal. Investing in a fund concentrating in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Growth stock prices may fall dramatically if the company fails to meet projections of earnings or revenue; their prices may be more volatile than other securities, particularly over the short term. Smaller companies can be particularly sensitive to changes in economic conditions and have less certain growth prospects than larger, more established companies and can be volatile, especially over the short term. The fund may also invest in foreign companies, which involve special risks, including currency fluctuations and political uncertainty. These and other risks are described more fully in the fund’s prospectus.

Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. Download a prospectus, which contains this and other information. Please carefully read a prospectus before you invest or send money.

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1. Source: International Energy Agency.
2. Source: Chevron Corporation, Q4 2019 earnings call, January 31, 2020.