Franklin Equity Group: Market outlook for the natural resources sector in 2014

Although our outlook for natural resources sectors is varied across related industries, we believe the trend of cost reduction and capital discipline should ultimately be positive as most companies would be in stronger financial positions to weather prevailing market conditions while spending reductions could be sowing the seeds of tighter supply-and-demand balances in the future. Ultimately, we believe improved cost positions combined with the potential for slower supply growth, resilient demand and rising commodity prices could lead to the potential for rising equity values. In addition, we are encouraged by investors’ renewed interest in companies with stronger long-term growth opportunities as opposed to their focus on income and near-term cash flow that was prevalent over the past couple of years.

Looking to 2014, we have been tracking several trends we believe could translate into the potential for attractive equity performance for investors in the natural resources sector. We think an improving global economic outlook has set the stage for potentially stronger commodity demand, particularly from the US and Europe, which have had little, and in some cases a negative, influence on commodity markets in the recent past. Although supplies have been expanding for some commodities, production disruptions and curtailments may help limit the impact on commodity prices, while what we think could be stronger-than-expected demand could absorb some additional capacity, as was the case for some commodities in 2013. However, our strategy does not primarily rely on general trends in commodity prices and instead seeks to generate performance by identifying companies we believe possess the ability to grow earnings and cash flow in a normalized commodity price environment, or one in which prices trade near the marginal cost of production.

In energy markets, we expect healthy demand growth from developing markets while developed countries may show greater demand stability. Surprisingly, even US petroleum-product demand has been showing signs of life after a couple years of stagnation or outright declines, and although we do not expect demand from the US or Europe to grow significantly, we expect them to be less of a drag on global consumption growth than in recent years.

Importantly, the US economy has been undergoing a dramatic shift toward energy self-sufficiency through rapid crude oil and natural gas production growth driven by the application of new drilling technologies and methods to extract previously uneconomic resources. This "energy renaissance” is likely to have broad implications for the US economy and global politics, in our view.

At the company level, many US energy exploration and production companies have been moving from the assessment stage to the production of unconventional resources, which includes shale development. We believe this move has the potential to translate production growth into cash flow and improved equity valuations as producers could benefit from development-related efficiency gains. Oilfield equipment and services providers are a key component of this trend, in our view, as they strive to leverage increasingly efficient development and extraction techniques. Notably, unconventional resource development has begun in many other countries, potentially creating new markets for US companies.