Commentary

The commodity markets continue to heal, despite an extremely volatile economic and geopolitical backdrop. While public equity valuations suggest that skepticism is abundant, the improvements which we have been discussing over the last couple of years are becoming more evident in the data. Since “prose is architecture, not interior decoration,” according to Ernest Hemingway, in this letter we’ll let graphs and charts tell the story.

First, capital available for reinvestment continues to be restrained by both lenders and investors. This is evident in debt and equity issuance for unconventional oil and gas producers in North America, as well as in the significant reductions in exploration capital for most mining sectors over the last several years.

Of note, Barrick CEO Mark Bristow recently acknowledged that the “prospect of a serious reserve crisis is looming” for the gold industry, a pointed reminder of what happens when production isn’t replaced in an inherently depleting business.

In addition to the reduction in external capital availability, it is becoming apparent that many unconventional hydrocarbon basins are suffering from core exhaustion.

This is relevant since North American unconventional production met the bulk of incremental global oil demand between 2014 and 2019 and allowed U.S. natural gas consumption to increase by about 50% from 2006 to 2019. In natural gas, core exhaustion is occurring across the basins and is most pronounced in the highly prolific northeast Marcellus Shale. Over the past three years, the average well drilled in northeastern Pennsylvania has declined in productivity by 19% as companies are forced to step outside of the most economic parts of their acreage.

The northeast Marcellus core is heavily developed. We estimate there are roughly 100 undrilled locations remaining with gas price breakevens below $2.50/mcf, with “breakeven” defined as 15% full cycle unlevered cash-on-cash returns assuming current service costs. We analyzed the Marcellus, Utica, and Haynesville Shales to determine remaining inventory in sub-regions defined by breakeven gas price based on type curves representing the average well for each sub-region. While remaining locations are plentiful, the runway of sub-$2.50locations is increasingly limited. In addition, we expect a large portion of the $2.50-$3 inventory to be negatively impacted as service costs normalize, particularly in the service-intensive Haynseville Shale.

In the oil basins, we see a similar phenomenon. While not as mature as the Bakken or Eagle Ford plays, the Delaware Basin provides a good dataset where we can observe the hallmarks of core depletion. Over the past six years, wells have gotten longer and completions have become more proppant-intensive, although it appears that the industry has reached the tipping point where further improvements in productivity are outweighed by costs, or operators are physically unable to extend lateral length due to landownership constraints. At the same time, wells have begun to be upspaced after years of downspacing in an attempt to maximize inventory over returns.

Unfortunately, the industry has maximized neither, as the dreams of dozens of wells per zone across multiple zones per section have been discarded in the face of interference and poor performance. In terms of returns, well results continue to degrade despite upspacing and the very best technology. This is especially apparent when comparing performance after the initial 6-month period, as more recent wells benefit initially from larger completions and harder drawdown but suffer later from poor reservoir management. Bombastic claims about the time value of money are far less resonant when oil is sub-$40.

With Tier I acreage largely drilled up and companies increasingly reliant on upspacing to meet economic thresholds, the deflationary benefits of high grading, longer laterals and cyclically depressed service costs have likely run their course, with incremental wells requiring higher commodity prices to generate breakeven returns. As assets mature, cash costs and capital intensity rise. We’ve seen this movie before, most recently in the copper industry.

With external capital providers actually consuming available cash flows via debt reduction and dividends while commodity prices curtail free cash generation, supply growth is challenged. In shorter cycle commodities such as unconventional oil and natural gas, recent activity levels have resulted in a sharp contraction in production. At the current rig count, we expect supply to continue to fall for both oil and natural gas. A much higher rig count will be required to keep production flat, but only if commodity prices provide both the signal and the cash flows necessary to fund an acceleration in activity.

The horizontal gas rig count troughed in July at 61, a 73% drop from the January 2019 peak. There are currently72gas rigs and 161 oil rigs active. Based on our analysis of basin decline rates and well productivities, and keeping oil rig count at the current level, we believe that we need to add 85-100 gas rigs to offset continued declines in associated gas and shale gas production. This would represent a 115-150% increase from current activity levels.

The oil rig count troughed in August at 146, down 80%from the peak. The precipitous drop in oil rigs during the second quarter was a logical reaction to elevated inventories coupled with demand uncertainty caused by the pandemic. However, as prices have recovered, the rig count has as well, although the preponderance has come from private operators trying to maintain cash flows, not public companies who are increasingly adopting the recommendations we laid out in white papers published more than three years ago, Life in the Echo Chamber and Shale 2.0. U.S. oil production will continue to decline at current activity levels. We estimate an additional 135 oil rigs is required to keep production flat.

This sub-maintenance level of drilling activity is occurring relative to a demand profile which, depending on the commodity, is somewhere between “not as bad as we thought” and “we’re out of what??”

Natural gas demand has proven to be far more COVID-resistant than many feared, despite weak LNG draws over the summer.

Oil demand has been more tepid and is currently about 7-8% below 2019 levels.

Copper demand is robust, largely driven by China where consumption is running well above recent historical levels. This is evident in both apparent demand estimates as well as treatment charges, which are inversely correlated to end market demand.

Outside of commodities, we can see evidence of a demand recovery in rail and bulk freight indices, which have rallied 4-8x off the spring bottom.

While demand has snapped back from historically depressed levels, we remain cautious as it relates to near-term consumption ex-China, where the government is once again using periods of cyclical price weakness to drive investment and purchase strategic stockpiles.

Despite current demand levels generally below prior year figures, inventories are either shrinking or it’s clear that they are about to. For copper, inventories have fallen about 35% this year and are at their lowest level in more than a decade. Relative to demand, inventories represent less than 10 days of consumption.

In natural gas, current inventories are at multi-year highs but 2021 will look meaningfully different absent a sharp increase in drilling activity.

And in oil, OECD inventories are falling counter-seasonally. North American and Pacific region inventories, which together represent about two thirds of OECD storage capacity, fell by about 40mm barrels in the third quarter, relative to normal builds of about 25mm barrels.

Compared to the second quarter of 2020, which saw builds in the OECD about 200mm barrels above normal, it’s evident that while inventories remain bloated, the trend is moving towards equilibrium…with all the standard caveats.

Finally, with the outlook for commodities improving, it is important to note that your portfolio companies continue to execute at a very high level. In our last letter we reviewed drilling returns and NAV growth for 2019, which were impressive given the weak commodity environment that all companies endured last year. It is clear from these results that you own truly Tier I assets. This position has allowed management teams to take proactive steps to address misplaced concerns around corporate liquidity which, in conjunction with the improved commodity backdrop, has led to a significant reduction in bond yields relative to the early days of the coronavirus pandemic.

Valuations

Since the credit markets are far more focused on and sensitive to financial stress than the equity market, the sharp improvement in yields should be an encouraging sign to current and potential owners of these businesses. Remarkably, the bond market moved from questions of solvency to lending billions of dollars of multi-year unsecured capital to your portfolio companies in the matter of a few months.

While bond yields appear to be moving towards a more rational assessment of risk, the equity markets appear unable to overcome fears of persistent oversupply despite the fact that surpluses existed for a relatively short period of time. Using natural gas as an example, the chart below shows the last three years of U.S.supply/demand balances.

It is evident that 2019 was oversupplied and prices responded accordingly, falling from $3.16 on average in 2018 to $2.56 in 2019. Supply continued to suppress price and activity levels in 2020, averaging well below $2.00 through July of this year before increasing, with the 2021 futures strip at $2.92as of quarter-end. The recent run-up in cash and near-spot prices reflects the growing acknowledgment that absent third party capital, the industry needs something close to $3.00 to generate sufficient cash flow to meet demand. However, equity prices for companies that own the bulk of the remaining inventory in the lowest-cost supply basin in North America reflect a different assessment of the future, one which remains almost completely disconnected from reality.

Consistent with our observations in the natural gas market, your portfolio continues to trade at a discount to the value of the proved producing reserves valued at strip prices, despite the improvement in stock prices since the first quarter. If stocks are efficient discounting mechanisms, the market is betting on some combination of two scenarios. First, current valuations require a significant reduction in future commodity prices which impairs cash flowing assets and renders future inventory worthless, which, as we have shown, we do not believe is sustainable absent a multi-year contraction in demand. Second, current valuations require companies to go into liquidation almost immediately, a conclusion which is at odds with current free cash flow yields and with what the credit markets are suggesting.

The reality is that even if the market never assigns any value to future inventory such that assets can only be sold for the value of their proved developed producing (“PDP”) reserves, we expect that monetizing your portfolio over the next five years at these levels would generate mid-20% IRR’s, assuming strip pricing. 2021free cash yields are in the high teens and the discount to YE19 NAV is about 50%at the current strip. Using more reasonable long-term prices of $3 gas, $3 copper and $60 oil, PDP IRR’s are closer to 50%, free cash flow yields are in the high 30% and the discount to NAV is about 75%. Again, this ignores the fact that we are three quarters of the way through 2020, which should generate another year of double-digit NAV growth for you as owners of these businesses.

On a relative basis, it seems safe to suggest that public equity natural resource companies are less expensive than many other parts of the equity market, given that the S&P 500 has a forecast 2021 free cash flow yield of 4.4% and the NASDAQ 3.5%¹. Across a longer time series, it’s clear that stocks are very expensive relative to commodities at 1.5 standard deviations above the mean. History suggests that this occurrence is noteworthy.

We don’t have any particularly insightful macro forecasts regarding a future with zero interest rates, a global economy ravaged by COVID-19, broad-based support of Modern Monetary Theory (whether explicit or implied is irrelevant) and persistent and growing economic inequality. What we do know is that the global supply chain is likely to become increasingly balkanized, that labor will demand a greater share of economic profits and that commodity prices as well as commodity price expectations remain anchored in a past which appears increasingly incongruent with the conditions that will likely exist in the future. These are the breeding grounds for inflationary pressures, a potential outcome for which many investors appear to be uniquely unprepared.

On The Energy Transition

The global commitment to the energy transition continues to grow. China has stated that CO2emissionswill peak by 2030 and that it will be carbon neutral by 2060while California has issued an executive order requiring all new passenger vehicles to be zero-emission by 2035. It is estimated that achieving China’s objective could cost up to$5 trillion, in addition to the €7trillion for the EU Green Plan, the $5 trillion for Democratic Presidential candidate Biden’s plan, etc. Even in today’s world, these are big numbers.

How we get there is subject to an increasingly vigorous, although largely subjective, debate. More recently, we were very encouraged to discover the Stanford Natural Gas Initiative, a technology-agnostic “collaboration of more than 40 research groups…drawn from engineering, science, policy, geopolitical and business disciplines that works with a consortium of industry partners and other external stakeholders to generate the knowledge needed to use natural gas to its greatest social, economic, and environmental benefit.” It is one of the few fact-based endeavors that we have found which brings research and data to bear on the questions and challenges surrounding the path towards a lower-carbon future.

Many of the prognostications regarding the energy transition are fanciful, and surely there will be enormous mistakes along the way. However, outside of China, very few investors appear to understand that this massive deployment of capital will require billions of dollars to be invested into upstream commodities, ranging from natural gas to copper to lithium to aggregates to steel. It is impossible to forecast the future, but what we can say with a reasonable degree of certainty is that absent radical new technologies, the owners of long-duration, low-cost assets should be well positioned to capture a portion of that economic rent which comes with controlling the feedstocks necessary to enable human progress.

Summary

Perhaps counterintuitively, recent demand shocks have improved the outlook for commodities by extending the depth and duration of the capital rationalization process that was already in motion. Even after another quarter of decent results, your portfolio is trading at historic discounts to NAV. In large part this is because ESG mandates and trend-following strategies are following the same backward-looking signal: momentum and because investors still do not appreciate the implications of the energy transition on certain upstream commodities.

The recent improvement in valuations is a good start, although we expect that further appreciation will be accompanied with volatility. This is fairly normal in the phase transition between cycles. We are confident that the intrinsic value of your portfolio continues to compound, that the likelihood of permanent capital impairment is extremely low and that current equity prices ascribe no value to the long-lived, low-cost inventory that you own nor to the potential for higher future commodity prices. We expect that the demand backdrop will remain uncertain but that supply curtailments will set the stage for the next upcycle as human behavior normalizes far more quickly than production.

As commodity fundamentals improve and with more companies acting as responsible stewards of their owners’ capital, we believe that the outlook is quite promising. In fact, the prospect of positive beta in addition to historically depressed valuations creates the opportunity to generate some of the most attractive risk-adjusted returns that we have witnessed in our careers, all of which can be achieved in a manner that is consistent with ESG and GHG objectives. In other words, it is still early. Long-term, counter-cyclical investors would be wise to take notice.

During the quarter, Brian Lively was promoted to Portfolio Manager, reflecting his significant contributions to our investment process and to our partnership since joining the team in 2013. There is no change with how we work together, but we are pleased to be in a position to recognize Brian for his work ethic and impact.

We thank you, as always, for your continued partnership.