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Inflation and the Energy Transition

The COVID pandemic, and the response of governments and central banks around the world, have engendered an on-going debate about the outlook for inflation. Transitory or perhaps a bit stickier? Inflation skeptics rightly point to the remarkable deflationary impact of technology and innovation as well as a labor pool distorted by temporary incentives for the able bodied to remain at home.

Inflation certainly has been benign over the past decade, aided by globalization, demographics and, perversely, easy monetary conditions. Cheap capital combined with distorted and ultimately misplaced definitions of value creation in the natural resource space resulted in significant excess supply which depressed commodity prices. Indeed, from the Global Financial Crisis through the second quarter of 2021, the S&P GSCI price component has averaged 3.5% annualized returns, almost 70% lower than the annualized returns of the prior seven years (2002-2008). And that includes the 65% return of the last 12 months.

We have written for the past few years that we believed that inflation expectations were far too sanguine, at least from a commodity price perspective. The reason was simply that the industry was being starved of capital –a rational response to a decade of value destruction which inevitably set the stage for higher prices. For the most part, this recovery has materialized in the spot market, although futures prices remain less robust. In general, current commodity prices are at or above what we consider reasonable long-term averages.

Some will argue that this set-up is the essence of transitory inflation –the second derivative for commodity prices, rents, wages, etc. could all end up being negative. It is hard to imagine how to comp a chart like this with positive year-over-year growth. Source: Evercore ISI, July 13, 2021

However, other components of price indices look more constructive, including on the labor side, where small business compensation costs appear as if they have resumed their upward trend.

Source: Hedgeye, July 13, 2021The following chart sums up the conundrum pretty well –pricing power for most industries has improved dramatically even vs. pre-COVID periods, but many companies expect the trend to moderate going forward. Source: Evercore ISI, Company Surveys, July 14, 2021

We don’t have a great framework to address the inflation debate from a demand perspective which from our experience is extraordinarily difficult to forecast. On the margin, we are in the “sticky” camp, in no small part because the recent rounds of governmental largess have ended up in the hands of the consumeras opposed to the producer.

From a supply perspective, we continue to believe that costs will be higher than most are expecting. This is due to three primary factors.

1.As we have discussed in previous letters and white papers, there are significant structural headwinds facing many commodities that will require strong incentive prices just to meet current demand: grade degradation, core exhaustion, limited and shrinking external supplies of capital, a lack of game-changing technological innovation to name a few.

2. Moreover, policy makers (public and private) and most investors continue to ignore the material requirements of the Energy Transition. To reiterate, investors and government authorities who choose not to capitalize or advance well-managed, low-carbon footprint upstream projects because of overly simplistic/detached-from-reality ESG stances are doing far more harm than good to the ultimate objective –the decarbonization and broadening of the world’s energy systems.

3. The Energy Transition may in and of itself be far more inflationary than most expect. This last point is worth considering in more detail. Our sense is that most investors and policy makers believe that Energy Transition will be a massive net benefit for the world’s population and the global economy. As the International Renewable Energy Agency put it in their worlds Energy Transition Outlook2021, “The analysis of global socio-economic impacts…indicates that the world will be better off –in multiple dimensions –if societies take the 1.5 C Scenario route…(which) offer(s) an 11% improvement in the overall Energy Transition Welfare Index over the (Planned Energy Scenario)”.While forecasting how the largest investment and industrial undertaking in the history of mankind will impact global welfare with that level of precision may remind some readers of their recent experiences with shale well economics, the fact remains that most believe that the Energy Transition is not a cost, but an opportunity. Many scenarios are predicated on a continuation of technology-driven cost reductions, mirroring the rapid decline in renewable levelized cost of energy (“LCOE”)over the past decade.

Global LCOE of Newly Commissioned Utility Scale Renewable Power: 2010 and 2020

Renewables have extremely low or even negative variable cost after tax credits are taken into consideration. This should translate into low-costpower, surely a net benefit to the consumer.

Source: IRENA, World Energy Transitions Outlook, June 2021The challenge, of course, comes when intermittent power sources comprise a larger and larger portion of the power stack. To be clear, “intermittent” does not necessarily equal “renewable”, as Winter Storm Uri exposed. Power markets which do not provide sufficient incentives for stable, robust generation are apt to fail during periods of stress –exactly the time when power is most important. This is the definition of “fragile”, as defined by Nassim Taleb.

Creating an “anti-fragile” grid requires investment, which will necessitate higher prices. The more variable dispatch capacity that is added to the grid, the more expensive energy will be because we (the consumer) will need to pay for expensive (rarely used) stand-by capacity, storage, transmission and distribution infrastructure, etc.

In fact, based on Thunder Said Energy’s analysis, power stacks comprised of more than 40-50% renewables will face significantly higher costs due to the investments required to maintain a stable dispatch capability. This is well below the range in most accepted “scenarios” which assume 70-90% renewables in the future.

In addition, while renewable LCOE’s have fallen dramatically over the past 20 years, there are constraints to future cost reductions. Even Moore’s Law, every optimist’s favorite example of the power of technology, is beginning to break down due to physical limits of gate size, source-to-drain leakage, etc. Again, the parallel to the shale boom is too obvious to ignore -assumptions of evergreen technological advancements and productivity gains work extremely well in spreadsheets but rarely manifest themselves in the real world where the laws of physics tend to be much harder to ignore.

It would be a mistake to assume that input costs will fall into perpetuity. Anything that adds to the cost of production -whether it be a carbon tax, maturing geology, an increasingly challenging regulatory backdrop or changes to fiscal terms –is ultimately passed on to the consumer. This is one aspect of commodities that is often underappreciated –both the producer and the consumer are price takers. This conclusion is relevant when considering the outlook for mission-critical commodities like copper and lithium, but also downstream commodities like polysilicon.

It’s clear that at least a portion of the drop in solar LCOE has been driven by a 90+% decline in polysilicon prices between 2011 and 2020.

Like many other commodities,polysilicon prices have recoveredmore recently. While it seems reasonable to expect that current prices will engender a supply response, future price expectations are almost double the recent lows despite a trebling of capacity.

Polysilicon Supply/Demand and Price Expectations

Furthermore, about 70% of polysilicon is manufactured in China using…wait for it…cheap, coal-fired power. A $100/ton carbon tax would more than double the prices shown in the table above. For anycommodity, cost inflation results in price inflation.

Lastly, it is important to note that in many cases, renewable installations are struggling to meet modeled parameters. A recent study by kWh Analytics found that incidents of persistent underperformance of solar installations were 13x greater than anticipated over four years, while degradation rates were running 50-140% above the industry standard modeling assumption.2This real-world variability will impact both realized investor returns as well as grid reliability and, therefore, energy costs.

From an investment perspective, the outlook for a more inflationary Energy Transition has important implications.

1. Higher costs will translate into higher prices –this may slow the pace of the Energy Transition, an outcome which we believe is virtually assured any way due to the inability of the raw material supply chain to meet the demand inherent in virtually all 2050 net-zero scenarios.

2. Higher costs will require investors and policy makers to better understand the carbon abatement cost curve and to focus investments on the most capital-and cost-efficient means of decarbonizing our energy systems while expanding energy access in the developing world.

3. Realized returns on downstream assets such as renewable power installations may be significantly impaired by the combination of higher product costs, higher than expected maintenance costs and lower/more variable output. Conversely, the outlook for critical enabler commodities as well as the owners of long-duration, low-cost producers of these commodities is as attractive as we have seen in the last 25 years.

Why does this matter? Hundreds of billions of dollars have been invested in the Energy Transition already, and a hundred plus trillion will need to be deployed over the next three decades to achieve the mission’s two primary objectives: carbon abatement and addressing global energy poverty. Despite the massive material requirements of this undertaking, and the incredible valuations that exist today for many mission-critical projects, the majority of investors appear to be anchored in a deflationary world view, bound by overly simplistic ESG considerations. Capital allocators who are serious about achieving net zero status while assisting the billions of people facing energy poverty on a daily basis must actively find opportunities to expand the supply of raw materials necessary to increase the supply of clean, abundant energy.

Capital allocators who have a mandate to identify and exploit uncorrelated return streams must look beyond the convenient, well-trodden path of renewables and EV’s where much of the blue-sky scenario is already reflected in asset values and find ways to gain exposure to the same structural trends but with a free option on the unknowable future. And, lastly, capital allocators charged with preserving the long-term purchasing power of their portfolio must find assets classes which both benefit from inflation and where the premium on that insurance policy isn’t so onerous that it defeats the purpose of insurance to begin with. We believe that we are in the very early stages of a cyclical recovery which is coinciding with one of the most important and material-intensive undertakings in the history of mankind. We look forward to helping our clients achieve the emerging dual objectives of the institutional investor – to do well and to do good.

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Monthly Commentary from Dan Pickering

August was a flattish month overall for energy, but there was plenty of activity beneath the surface. Much like July, the S&P500 gained (+2.9%) while energy indices fell. Diversified Energy dropped -2.7% (S&P1500 Energy, S15ENRS), Upstream/E&P was flattish (-0.2%), oilfield services declined -2.7% and Midstream fell -3.4% (AMZ). Oil retrenched -7.4% (~$68.50/bbl), while gas roared another +12.2% to finish the month at ~$4.40/mcf.

For the first time in 5+ years, our lead macro energy commentary is about natural gas. Our friend Mr. Front Month Natty closed August at ~$4.40/mcf and has since rallied further to ~$4.60/mcf on the back of some small Hurricane Ida dislocations and enthusiasm amongst paper traders. This 70% y/yincrease is impressive. Even more impressive is the bump in 2022/2023 full year futures prices to ~$3.70/mcf and ~$3.10/mcf, respectively. This move leaves longer-dated 2023 natural gas above $3/mcf for the first time since 2017. A combination of supportive weather, high global gas demand with resulting high LNG prices and lower gas-to-coal switching are all contributing to the rally. We expect an increase in hedging (grab that high price before it runs away!), an increase in private gas-oriented rigcount (drill/sell more gas while prices are strong!) and very little reaction from public gas-oriented producers (we promised spending discipline and increased return of capital and we can’t back off that promise in the short term!) With the high-productivity Marcellus shale essentially pipeline constrained; rigcount in the Haynesville, gassy EagleFord and SCOOP/STACK is the supply datapoint to watch going forward.

Front month WTI crude oil took a wild ride during August, falling as low as ~$62.30/bbl (-16%) before rallying to close at $68.50/bbl. The surging COVID delta variant was the primary driver, although big macroeconomic trades swept through the overall market, whipping around interest rates, currencies, commodities and stock indices. The increasing impact of trading programs and algorithms (if “X” occurs, buy “Y” and sell “Z”) makes it harder and harder to link commodity trading behavior to fundamental supply/demand influences. Said a different way –there is diminishing supply/demand information content carried in oil price behavior. Our fundamental view remains unchanged. Demand is recovering (despite the delta variant), OPEC is managing its excess supply quite well, public US shale producers are locked in a capital discipline box that doesn’t allow for much increased drilling and inventories are constructive. Oil should trade $60-$80 for the foreseeable future. As Larry David would frequently say in episodes of Curb Your Enthusiasm…pretty, pretty, pretty, pretty, good.

The US energy transition took a meaningful step forward during August with Senate passage of the Infrastructure Bill. Incentives for renewable energy, transportation electrification, hydrogen and carbon capture were scattered throughout. In a sign of the times, as President Biden was urging a greener future and providing cheap/free money to green initiatives, he also called on OPEC to increase oil production. The irony is thick. Although the US wants lower carbon, it remains the world’s biggest consumer of gasoline, and the Administration wants that gasoline to be cheap to keep voters happy (even if cheap gasoline encourages higher consumption). So the story line is: produce those hydrocarbons somewhere else, keep them cheap while we want them, invest aggressively to make them eventually obsolete and demonize the hydrocarbon industry in the meantime. It really isn’t a fair shake for fossil fuels, but it’s the reality of the world in which we live. The double irony is that by indirectly starving the oil and gas industry of capital, these government approaches are actually helping to make hydrocarbon prices higher and hydrocarbon investments more lucrative (for those willing to participate).

In early August, the UN published a report from the Intergovernmental Panel on Climate Change (IPCC). It was characterized as a “code red for humanity” by the UN Secretary General and called for quick action to avert a climate catastrophe. We see “quick” as a relative term when tackling decarbonization. No coordinated global effort will be quick as measured in stock market time. Achieving net zero carbon emissions by 2050 is aspirational, not practical. But the bell is ringing for action and capital continues to pour into the Climate/Decarbonization/Sustainability space at a staggering pace via SPACs, PrivateEquity funds, institutional investor allocations, ESG instruments, sustainability-linked bonds and other financial vehicles. We generally see high valuations and overcapitalization. That doesn’t make decarbonization wrong, it will just make it expensive and painful, a lesson investors learned the hard way in the US shale boom.

Finding/capturing alpha should be the highest priority for decarbonization-focused investors. The good investments are going to be huge (and relatively scarce). The bad investments are going to be donuts (and relatively plentiful). Energy stocks rode a roller coaster during August. Macro fears took them down 10-20%, only to see a broad recovery later in the month. Energy stocks are dealing with numerous crosscurrents. The Value vs. Growth debate. The energy transition overhang. The onus of being the best group in the market for most of the year (profits to take when people look to reduce risk). Discounting ~$50/bbl when the 2022-2025 forward curve averages ~$60/bbl. Lots of noise. Butunderneath the noise is a solid investment case. We find it hard to believe inflation is transitory given cheap money and expensive labor. Combine that with an industry that is getting better via improving returns on capital and you have a recipe for ongoing outperformance. We remain bullish.As always, we welcome your questions and appreciate your interest.

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Monthly Commentary from Dan Pickering

July was a soggy month for energy. While the S&P500 gained +2.3%, energy indices fell across the board. Diversified Energy dropped -8.7% (S&P1500 Energy, S15ENRS), Midstream fell -7.1% (AMZ), oilfield services declined -12.8% and Upstream/E&P was the subsector laggard at -14.4% (XOP). Energy commodities outperformed energy stocks as oil gained +0.7% (~$74/bbl) and gas tacked on +7.2% to finish the month at ~$3.90/mcf.

Be still, sad heart! And cease repining
Behind the clouds is the sun still shining
Thy fate is the common fate of all
Into each life some rain must fall
Some days must be dark and dreary

– Excerpt from The Rainy Day, Henry Wadsworth Longfellow, 1842

Longfellow knew in 1842 that not every day or month can be perfect. July followed that playbook for the energy sector. OPEC confusion and an increase in covid fears associated with the delta variant brought some rain to energy investors. Stocks were worse than commodities. Both were volatile. We remain constructive on both.

July’s oil markets started with confusion. OPEC was somewhat in disarray with a quota disagreement between Saudi Arabia and UAE resulting in “no result” from the monthly OPEC powwow. By strict definition, this meant there would be no incremental barrels returned to the market in August or beyond. Bullish? Perhaps mathematically, but as we penned last month, fractures within OPEC create uncertainty….and uncertainty is a bad thing in financial markets. WTI oil drifted from ~$76/bbl to the low $70’s as a result.

OPEC uncertainty resolved itself mid-month with an OPEC+ agreement that gave both UAE and Saudi what they wanted. UAE received a higher baseline of production; Saudi got an extension of the OPEC+ agreement through YE2022. However, the OPEC resolution coincided with a surge in delta variant covid cases. This one-two punch (higher supply and the potential for lower demand) resulted in a gap-down day for crude as it tumbled from ~$71.50/bbl to $66.40/bbl, with an intraday low of ~$65.60/bbl. However, oil finished July a tad bit below $74/bbl. Can’t keep a good man down? Somewhat – the physical market continued to tighten (ongoing inventory draws), and overall economic activity remains strong. Thus far, delta variant is causing fear of renewed lockdowns, not an actual, meaningful deceleration of demand.

Looking ahead the delta variant is certainly a risk for energy commodities and stocks. Some corporations are delaying their return to office work. Some businesses are renewing mask mandates. There is a very real possibility of selective state/government-mandated lockdowns. All of which could lead to a dip in energy demand or a plateau of demand recovery. However, compared to the initial emergence of the virus, we now have vaccines. While cases are rising, covid deaths are a fraction of prior levels. There is also meaningful pent-up demand for a return toward normalcy, which is resulting in ongoing increases in air travel, even as covid news has turned more scary on the margin.

Factoring in the above, we have chosen to remain constructive on the oil markets. This doesn’t mean that oil can’t/won’t fall back into the $60’s (or maybe even the high $50’s). There’s a decent chance (at least 50%) that oil prices finish the year lower than current.

But probably not dramatically lower. OPEC is back on track, inventories are normalizing, demand issues should be transitory. In sum, we think it’s more appropriate to be bullish than bearish about the oil markets over the next 24 months. Of course, we fall back to a quote attributed to the economist John Maynard Keynes – “When the facts change, I change my mind. What do you do, sir?” We will be keeping a close eye on the facts.

US natural gas has been very strong, trading over $4/mcf for much of July. European gas is trading at record levels. Ironically, many US producers increased hedges during Q2 at levels well below the current strip. This has translated to gassy E&P stocks being punished as Q2 results were reported. Hedges in the high $2’s and low $3’s would have been greeted with jubilation this time last year. But when the marginal buyer of energy stocks is a hedge fund playing for upside, high $2’s and low $3’s has gotten a big fat raspberry. The free cash yields from gassy E&Ps are 8-15% even with below-market hedges and we have added to our (relatively small) gas-oriented position on weakness.

In the land of energy transition, the rush continues for partnerships, joint ventures and overall increased exposure. The current Infrastructure bill contains significant funding for various energy transition initiatives such as hydrogen and carbon capture. Electric vehicle incentives have been scaled back from the original bill, but allocations to EV charging infrastructure remains significant. We remain firmly in the camp of decarbonization as a megatrend, although finding public company plays at reasonable valuations remains challenging. We’ll keep looking! In the meantime, traditional oil and gas stocks present more consistent value and risk/reward. We’ll keep owning!

Given this month’s commentary is already sprinkled with quotes, it feels appropriate to end with another from Danny & The Juniors circa 1958 – I don’t care what people say, rock ‘n roll is here to stay.

As always, we welcome your questions and appreciate your interest.