Commentary

Commodity markets continue to heal, as evidenced by falling inventories across most products.

The supply-side is contributing to the rebalancing effort, either as a function of self-imposed discipline in the oil and natural gas markets or the realities of a structurally maturing production base in commodities like copper.

North American oil and gas production has recovered more quickly than the rig count would indicate, driven by the completion of previously drilled but uncompleted wells, known as “DUCs”. DUCs are the equivalent of “work in progress” inventory and while they are more capital efficient than drilling and completing a new well, they are by definition limited in number. Based on current levels of activity, we estimate that 2021 production will be about flat year-over-year for both oil and natural gas. Demand is recovering as well, despite the ongoing impact of the pandemic. The global economy is on track to reach full capacity, lubricated by the most aggressive expansion of the global monetary base in history.

While mobility is still constrained, the industrial economy appears to be converging back towards more normal levels of activity.

90% of the world’s economies exhibit manufacturing PMI’s that are clearly expansionary and at or above five-year highs.

Despite numerous headwinds in the form of COVID-19 variants, the potential for rising vaccine reluctance and the unknown consequences of monetary debasement, our base case assumption is that demand will continue to normalize over the next 6-18 months.

It is interesting to note that industrial activity appears to be heading back towards its pre-trade war, pre-pandemic levels, which not coincidentally was the last time that commodity prices and inflation were topical. As we have stated repeatedly, the commodity markets had already begun to recover prior to COVID-19 and prior to any discussion about the potential impact of the Energy Transition. Ironically, COVID-19 served to accelerate the trough, first by further curtailing capital availability and then by unleashing the dual catalysts of global monetary stimulus and a reinvigorated commitment to the Energy Transition.

The Energy Transition

The price tag for the Energy Transition continues to be refined, and like most projects, big or small, downward revisions are few and far between. Current consensus seems to be around $150 trillion to be spent between now and 2050.

This is a 10x increase relative to current spending rates and equates to about $640 per person per year for the next three decades for every single person on the planet. Another way to think about this is that it will consume approximately 30% of average disposable income for a family of five in South Africa, about 15% in countries like Mexico, Chile, and Russia and 10% in Japan, Ireland, and Spain.¹ It is more than 100% of adjusted net national income per capita in many African countries and is about 30% of adjusted per capita net income for the people of India.² Spent every year. For the next 30 years.

Of course, no one actually knows what decarbonization will cost, but the fact that policy makers and investors are accepting these figures at face value should be a red flag for anyone who has lived through prior investment manias.

That the world is embarking on this journey is no longer a debate, and with plus or minus $5 trillion a year to be spent on average, there will be plenty of opportunities to make, and lose, exorbitant amounts of money. Technology and technological advancements will play a pivotal role in developing and commercializing carbon abatement solutions and driving down costs.

However, certain aspects of the consensus view on how the Energy Transition will unfold bear further examination as they seem to defy fundamental realities.

Translating the consensus definition of the Energy Transition into a short-hand equation might look something like this:
Falling Demand (efficiency) + Increasing Renewables (duh!) – Less FossilFuels (duh!) = Lower Carbon Emissions (eureka!)

This framework is captured well in a recent publication from the International Renewable Energy Agency, also known as IRENA.

The desired end state (lower carbon emissions) is the obvious objective, and in general we are strong believers that the world will have to become far more efficient in the manner in which it consumes any natural resource, including renewable energy. However, the assumption of an overall decline in energy consumption, from around 600 EJ in 2018 to less than 540 EJ by 2050, runs counter to basic economic and demographic facts.

First, energy poverty, measured in per capita energy consumption, is a real constraint facing many developing regions of the world. Second, these same regions are expected to drive most of the global population growth moving forward. Simply consigning developing economies to a future which lacks one of the foundational building blocks of progress—low-cost energy—to fit a narrative seems naïve at best. Furthermore, it is inconsistent with the last 50 years of data. And lastly, there are large parts of the developing world where renewables will be challenged due to lower population densities, lack of transmission and distribution infrastructure and lack of renewable resources.

A far more probable outcome is one in which western economies continue to moderate energy consumption as they have for the last 20 years while emerging economies rapidly increase energy demand to address pressing humanitarian and economic prerogatives.

This isn’t an attempt to be didactic but rather an effort to highlight what we believe to be a critical flaw in the “plan” to address climate change via decarbonization. Because, after all, that is the objective—the world is signing up to invest$150 trillion to remove carbon from our energy systems as a way to combat global warming. Mathematically, a far more expedient way to achieve this goal would be to drive western energy consumption, and thus greenhouse gas (“GHG”) emissions, towards emerging market levels. This could be achieved via a dramatic slowdown of the world’s economy. In fact, Nature estimates that global CO2emissions fell 6.4% in 2020, roughly double Japan’s annual emission profile.<sup>3<sup> Is anyone up for a repeat of 2020 as a means to achieve climate goals?

The path forward must be based on data, realistic outcomes and an understanding of both the economics and scale of the available carbon abatement solutions while still supplying sufficient energy to enable global growth. Technology is sure to evolve, but the current carbon abatement cost curve looks something like this.

This is a simplified version of the data that we showed in our last letter, courtesy of Rob West at Thunder Said Energy. As commodity investors, we are always interested in finding steep cost curves, and then identifying assets that currently sit or that could sit at the bottom of those curves. For example, renewables, farmland, natural gas and EVs all looking intriguing today from this perspective, and a technology like nuclear could move (and we believe will move) rapidly down the cost curve as capital intensity falls.

Conversely, we view solutions that sit at the top end of the cost curve with a mixture of curiosity and skepticism. One area that has received a lot of attention lately is green hydrogen. It seems to be a foregone conclusion that green hydrogen will be a critical component of the energy mix by 2050. Once again, IRENA has provided a simple framework to think about this evolution.

IRENA predicts that green hydrogen consumption will increase by about 150x over the next 30 years, driven by a 75% reduction in production costs and an exponential increase in available installed renewable capacity. On the surface, this doesn’t seem outrageous –technology should drive productivity gains and scale should result in cost efficiencies, much as we have witnessed with wind and solar. Dig a little deeper, however, and the thesis gets a bit more tenuous.

First, existing commercial electrolysis technologies require fresh water—purified fresh water—for the production of hydrogen. Some parts of the world may be blessed with a surfeit of clean, fresh water, and technology will certainly improve, but the consumption of any precious resource should come with clear economic and/or social benefits. Green hydrogen appears to fail on both counts, even under a set of best-case assumptions.

The copper requirements for the renewable electricity alone would consume about 120% of 2020 mine supply. Of course, the capital required to more than double current production, let alone the feasibility of that assumption, is ignored in these calculations. Furthermore, approximately 5% of future total energy supply—7,500 TWh or 27 EJ—will be consumed to produce about 3.5% of future energy consumption (19 EJ out of 540 EJ). On a spreadsheet this can be done—assuming a 75% reduction in capital intensity, a halving of energy prices and electrolyzers that run consistently at the theoretical maximum limits of efficiency–for about $2/kg, equivalent to $14/mcf natural gas. All of this to create a product with, at best, a 70% energy yield. Prior to transportation.

Since hydrogen has high energy content by weight (~33kWh/kg) but very low energy density (0.5kWh/l), the most efficient way to move large volumes of hydrogen (i.e. as a replacement for natural gas) is via liquefaction which increases energy density by about 5x. This requires temperatures of -253oC, 20oC above absolute zero and consumes another 30% of energy content, as “the current best performance for an industrial scale hydrogen liquefier…is near 10kWh/kg.”⁴ The net result is a product with 60% energy loss at a delivered cost 7-10x higher than an existing, much cheaper alternative blessed with gathering, processing, transportation, liquefaction, regasification and energy conversion infrastructure that has been built up over the past 150 years.

It is completely within the realm of future possibilities that green hydrogen emerges as a viable energy storage solution, and recent developments suggest that progress is being made in converting ammonia to pure hydrogen for commercial use.⁵ So, we intend to keep a close eye on how the related technologies evolve. However, we’ve lived through enough cycles to know how important scale and relative economics are in a commoditized industry. And make no mistake, carbon abatement is as much of a commodity as any other. Caveat emptor to those investors who venture too far up the cost curve.

Where and how energy is consumed matters. The relative costs of carbon abatement solutions matter. Our job as capital allocators is to identify durable businesses that provide asymmetric risk/return profiles. Our job as investment partners is to help our clients understand the landscape, risks and opportunities associated with one of the most important undertakings of our time. And our job as citizens of this planet is to help enable the development and implementation of carbon abatement solutions in as safe, efficient and expedient a manner as possible. We are confident that it is absolutely possible to meet the dual mandates that have emerged for institutional investors over the last decade: do well and do good. We are equally confident that a rigid, rules-based approach which places more emphasis on a narrative than data, more emphasis on how something feels versus an analysis of a project’s economic underpinnings will make it much harder for an investor to accomplish either.

Inflation

Inflation concerns appear to be rising, reversing more than a decade of declines.

Inflation skeptics point out that the last round of fiscal stimulus was quite deflationary, contrary to the expectations of many investors, including us. From a commodity perspective, the era of easy money coincided with peak euphoria in both mining and energy, resulting in a frenzy of capital misallocation. We are only now shaking off the hangover. More broadly, globalization, rock bottom interest rates, and steady supply growth kept price pressures largely in check over the last ten years. Going forward, the concern is that the unprecedented fiscal stimulus (more than 5x what was provided in the US post-Global Financial Crisis) and regionalization of global supply chains combined with already low inventory levels will drive prices higher on both a structural and cyclical basis.

We aren’t macro economists, so we will leave that debate to those who are equipped to engage. But it’s safe to say that inflation concerns are rising.

After a decade of declining prices and relatively poor returns from inflation-sensitive sectors, most investors are only beginning to contemplate how to protect the purchasing power of their portfolios in the future. Ironically, the catalysts for structurally higher raw material prices are starting to come together at exactly the same time that both a cyclical and structural increase in demandfor many commodities is in the offing.

Over the last ten years, consumers have benefited from the application of new technologies that unlocked unconventional oil and gas reserves, as well as seemingly endless pools of capital made available to both the E&P and mining industries. However, declining head grades, increasing depth and the resulting increase in ore hardness have all contributed to structural cost increases for the production of most industrial metals, and we are starting to see evidence of analogous resource maturation within unconventional energy as well.

Core exhaustion in key plays such as the Eagle Ford Shale, Bakken Shale, and Northeast Marcellus Shale highlight the fact that low-cost inventory is, by definition, finite. Recent trends towards up-spacing in the Permian show that even the best basins are not immune to the physical constraints of geology. In addition, current oilfield service pricing is unsustainably low. The combination of less core inventory and mean reverting service costs suggests that over time, investors should expect North American oil, and eventually natural gas, to require higher prices to enter the market. North American oil volumes have met the bulk of incremental global demand over the last decade. In general, the marginal producer of a commodity sets the price.

One push back on this observation comes from investors who note that many North American oil companies claim to have thousands and thousands –decades –of “low-cost” or even “double premium” locations left to exploit. Putting aside the fact that we are still waiting for a company to post 100% IRR’s on their drilling programs, we contend that actions –in the form of recent corporate M&A –speak louder than words.

To simplify an example, we split the Midland basin into two megacompanies: Public and Private. From a land position perspective, it’s clear that Public owns the core while Private is relegated to more peripheral acreage.

Differences in acreage quality also show up in well results. It’s interesting to note that Public wells are largely flat to down over the past four years, while Private was flat 2020 vs 2019. Plateauing or declining productivity is typically a sign of core exhaustion.

Finally, Private has been far more aggressive in terms of its activity levels over the past three years.

In fact, Private currently is operating nearly as many rigs as Public to support about one third the oil volumes.

To recap, Public owns generally higher quality acreage and exhibits better capital efficiencies, consistent with a lower growth rate and superior well productivities. If, in fact, Public has thousands of remaining low-cost drilling locations and expects to continue to maintain its capital discipline (zero to single-digit growth), why would it acquire Private with lower quality acreage, lower capital efficiencies and most likely a much higher base decline rate? Putting aside strategic considerations (adjacent acreage, operating efficiencies), the most common answer is that recent transactions have been touted as being free cash flow accretive, which certainly is the phrase of the hour. Unfortunately, when an acquisition is financed with a preponderance of debt and cash, free cash flow accretion is an absurdly low bar, and certain doesn’t provide any insight into expected cash-on-cash returns. We contend that a more likely answer is that Public’s management knows that core inventory is relatively scarce, and that 2ndand 3rdtier acreage will have to be exploited sooner rather than later. If that is the case, paying full and fair value for inventory is an existential decision, returns be damned. Unfortunately, this rarely is a winning formula for investors.

In summary, from an input cost perspective, we believe that a maturing suite of producing assets will require higher prices on average to incent production going forward. This is particularly true if investors maintain their discipline and if service providers are able to achieve sustainable margins. This is a very different environment than the one which has existed for most of the last decade. Critically, we expect that inflationary pressures will increase independent of the Energy Transition, although we also expect that rising demand for mission-critical raw materials will only make matters worse. It’s always easier, and cheaper, to buy insurance when you don’t need it. We continue to believe that long-term investors should consider finding inexpensive inflation protection for their portfolios.

Skepticism And Euphoria

With the promise of tens of trillions of dollars to be spent, it is no surprise that investors are excited about the Energy Transition. Well-loved “growth” industries such as EVs, EV charging infrastructure, renewables, related software, etc. are awash with public and private equity. To a certain extent, this has flowed through to natural resource equities as well, most obviously in commodities like lithium and copper, although in general, Value is still historically cheap relative to Growth.

As value investors, entry price matters. Certain areas that appear structurally attractive on the cost curve have already attracted a significant amount of capital which in turn has depressed prospective returns.

Furthermore, we believe that many valuations do not appropriately reflect real world issues like technology risks, appropriate maintenance capital requirements, etc. That, of course, assumes that valuations are based on profitability or free cash flows at all. Conversely, companies owning long-duration, low-cost assets producing raw materials that are unequivocally requisite for the Energy Transition are still trading at historically depressed valuations. Based on very conservative estimates of inventory, your portfolio is trading at a 35-40% discount to Net Asset Value (NAV), calculated at either the strip or a long-term $60 oil/$3 natural gas/$3 copper price deck. Of equal importance, free cash flow yields are in the mid-to high-teens, growing to the mid-twenties over the next couple of years with similar commodity price assumptions. Outside of 2019, these are not and have never been normal valuations.

Summary

Commodity markets are healing as the world ramps up to address one of its most pressing concerns –climate change –with one of the most capital intensive, resource intensive endeavors in the history of mankind. 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. If not, the Energy Transition will fail, and tens of trillions of dollars will be spent for naught.

More broadly, 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 shows up in the public equity markets, as valuations in many resource related areas are still attractive. Over time, we expect your portfolio 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.

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

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