Commentary
As we have discussed for the past few quarters, rising rates, base effects, and far more persistent inflationary headwinds – the hangover from super stimulated monetary conditions post-COVID – are pressuring global economic activity and with it, asset prices. Unfortunately, we don’t think that we are out of the woods yet, as central banks remain behind the curve with both structural (higher long-term commodity prices, the impact of regionalizing supply chains) and cyclical (labor availability, inventory shortages) factors weighing down the outlook for growth and increasing the cost of capital.
Despite the associated market volatility, several dynamics are playing out which, perhaps counterintuitively, are increasing our conviction that the next five to ten years should be extremely prospective for a select group of real assets.
First, the current macro, geopolitical and policy environment is undermining the supply response which is necessary to offset a decade of underinvestment. In certain respects, this period is analogous to the early days of COVID, when near-term demand concerns curtailed a burgeoning capital investment cycle. Fast forward two years and the situation is even more acute.
For example, in Chile and Peru, incoming governments are proposing to increase taxes on new mining projects. The fiscal schemes could raise the tax burden to more than 60% of revenue under certain conditions, increasing the price required to meet minimum capital allocation hurdles from $3.50/lb to more than $4.10/lb.
Figure 1: Project IRR for 50th Percentile
Source: Macquarie Research, 12 July 2022
This is well above most practitioners’ historical assessment of marginal cost but may in fact reflect the “new” reality.
In addition, unknowns surrounding constitutional frameworks in both countries effectively have halted investment activity. This is critical as Chile and Peru represent more than 35% of 2022 total copper mine production and have the largest resource bases in the world, ranking first and second in uncommitted projects over the next decade.
Figure 2: Uncommitted Projects by 2030, ktpa
Source: Macquarie Research, 12 July 2022
Note as well that outside of Chile and the DRC, the preponderance of incremental projects are greenfield development – by definition higher cost and higher risk than brownfield expansions.
Another example of government policy undermining supply is occurring in the U.S., where infrastructure development is being held up by regulators to such an extent that New England states are forced to import natural gas from Russia despite being less than 300 miles from one of the lowest-cost natural gas basins in the world. Furthermore, attempts to alleviate the European energy crisis may be upended by an EPA decision to reverse a decades-long stay on emissions for certain gas turbines used by Cheniere, the company that is responsible for 50% of current U.S. LNG export volumes and 10% of global supply. European gas storage levels are already dangerously low, and should Russia follow through on threats to further reduce flows into the continent, EU GDP could be impacted by as much as 5% according to JP Morgan. Let’s walk through that one more time – in the midst of a crippling energy crisis, the U.S. government is threatening to reduce its natural gas supply to its most important ally, leaving the health of the world’s 3rd largest economy in the hands of a despotic regime that just invaded its neighbor.
You couldn’t make this stuff up if you tried. Suffice it to say, this level of uncertainty is not conducive to long lead-time capital investments.
The prospects for a supply response are further hindered by rapidly tightening financial conditions. While investing in natural resource assets might not have been in vogue for most of the last decade, at least capital was relatively cheap. That is no longer the case as both real rates and inflation expectations rise. In fact, a recent Jefferies analysis shows U.S. financial conditions as tight as they have been since the onset of the pandemic, and we would argue that the U.S. is about as well positioned as any country to manage through the current malaise.
Figure 3: US Financial Conditions Z-Score
Source: Jefferies Equity Research, 13 July 2022
It is important to understand that a production response requires significant capital, even in a no-growth environment. Historically, investors have overlooked the pervasive nature of depletion, but in a world with limited reinvestment activity and low above-ground inventories (more on that below), it won’t take much in the way of demand normalization to bring supply issues into sharp focus. For instance, here is the production outlook for Codelco, the world’s largest copper miner.
Figure 4: Codelco Production Forecast
Source: Codelco, http://prontus.codelco.cl/prontus_codelco/site/artic/20171010/asocfile/20171010090846/202206_corporate_presentation_vf.pdf
To simply maintain production at current levels, Codelco will have to spend more than $35 billion over the next several years, or 3.5x 2021 EBITDA in a year when copper averaged $4.23/lb. Given how difficult it is to bring new projects on-line, we’ll take the over on capital requirements and timing and the under on production rates. In our opinion, the market is far too sanguine about the future of supply, even without the prospects of a multi-decade demand pull from the Energy Transition.
More immediately, incremental production is required as evidenced by above-ground inventories of various commodities. Current inventories are sitting well below normal levels on an absolute basis, and are much more concerning in terms of days of demand coverage.
Figure 5: Inventories
This should be a bright, flashing light for investors and policy makers alike. Despite a rapid slowing of western economies and ongoing tepid demand from China, inventories remain depressed while commodity prices have corrected to much higher lows than we have witnessed in prior downturns. These are not typically the signs of a balanced market. In our view, the risks of long-term supply deficits are rising.
This concern is reinforced by the unwavering commitment to decarbonization. Today, more than 90% of global GDP and governments representing 80% of the world’s population have made a pledge related to achieving net zero.
Figure 6: Global Commitment to Net Zero
Source: https://zerotracker.net/
As a reminder, net zero = raw material consumption. Staying with the copper theme, Wood Mackenzie estimates that copper demand will double over the next two decades in a 1.5o C scenario, with Energy Transition-related consumption comprising almost 70% of the increase.
Figure 7: Copper Demand Bridge: 2020 – 2040
Source: Wood Mackenzie, Copper Outlook Under an Accelerated Energy Transition, June 2022
Absent a strong price signal from the markets and far more supportive fiscal and regulatory policies from host governments, a rapid increase in production is highly unlikely if not impossible. Beyond the obvious implications for achieving climate objectives, long-duration, low-cost assets should be quite valuable in such an environment, in our opinion.
Third, company fundamentals are now extraordinarily strong, as balance sheets and free cash flow generation reflect the newfound capital discipline which is reshaping many capital-intensive industries. Company-specific NAV growth – in our opinion, the most unique, uncorrelated return stream inherent in owning structurally advantaged assets – has been consistent with the durable competitive advantage of quality companies in the space over the past five years.
Lastly, the unintended but forecastable outcomes from years of ill-informed policymaking finally are starting to materialize. From Europe’s energy crisis to the threats of rolling blackouts in Texas to the downfall of Sri Lanka’s government (read more here and here), it is now clear that a collaborative, balanced approach to addressing climate change and energy poverty today and into the future is the only feasible path to solving such a complex, capital intensive undertaking. Hopefully, recent events and the reality of looming challenges will galvanize capital allocators and policymakers alike. Specifically, committed environmentalists and humanitarians must partner with capital allocators and regulatory bodies to promote the responsible development of the mission-critical raw materials that are an integral part of the collective effort to both decarbonize and expand global energy systems. Anything less is explicitly hypocritical and lies in direct contradiction to their stated objectives. It is our sincere hope that the specter of economic, environmental, and humanitarian crises shifts the narrative from speculative aspirations to practical solutions.
In summary, a decade-long downturn, accelerated by ESG- and divestment-related capital constraints, has kneecapped the supply base of many raw materials, including those that are necessary to meet the dual mandate of the Energy Transition. Recent market volatility and increasingly obstructionist and usuary policy frameworks are only reinforcing supply-side challenges, while the commitment to net zero, and thus the implicit commitment to increasing raw material supply is stronger than ever. This structural imbalance can only be solved by massive influxes of responsibly allocated capital, which in turn will only be made available when returns are acceptable. We believe that this will require clear signals from the market in the form of higher long-term commodity prices and will result in a strategic premium being assigned to advantaged, long-lived resources with established ESG credentials located in geopolitically safe jurisdictions.
Herein lies the opportunity for long-term, countercyclical, socially responsible investors as neither of these realities is reflected in stock prices today. In our opinion, there have been very few times over the last 25 years that the disconnect between the range of potential outcomes and current stock prices has been so pronounced. We are being paid to take risks and are excited to do so using assumptions that we believe will prove to be quite conservative as the future unfolds.
Summary
The current environment is hindering the supply response necessary to address one of the world’s most pressing concerns – climate change. We remain steadfast in our belief that efforts to decarbonize our energy systems while at the same time addressing the cold reality of energy poverty must be driven by relative economics and cost/benefit analysis, not narratives and certainly not virtue signaling. If we do not take a more holistic, balanced approach the Energy Transition will fail, and tens of trillions of dollars will be spent for naught.
In addition, inflation concerns are rising, and rightly so from the perspective of the commodity markets. Capital constraints and resource exhaustion should drive prices higher, not lower, over the coming years. This runs counter to the experience of the past decade, and as a result, investors still are reluctant to embrace this potential outcome.
This skepticism is reflected in the public equity markets, as valuations in many resource-related areas are still extraordinarily attractive. Over time, we expect the market to reflect the realities of the Energy Transition, with the appropriate level of scarcity value ascribed to the building blocks of decarbonization. Until then, we remain excited to deploy capital into what we believe to be one of the most fundamentally attractive set-ups in recent memory.
Best Regards,
MacKenzie Davis, CFA
Ken Settles, CFA
Brian Lively
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