Commentary

Just over 25 years ago, Andy Pilara started a mutual fund that is the forebearer of the SailingStone Global Natural Resource strategy. 1995 was a peculiar time to focus on natural resource investing as commodity prices had been range-bound for several years and most investors were focused on emerging internet technologies and all things dotcom. A contrarian by nature, Andy realised that low commodity prices were constraining capital investment and depressing valuations, creating a fertile ground for stock picking and laying the foundation for the next recovery. While he wouldn’t claim to have foreseen the rapid acceleration of emerging market demand that was about to unfold, he understood that capital availability and supply shape commodity cycles, not demand narratives.

Fast forward two and half decades, and we find ourselves in an analogous position. As we have been discussing for the past couple of years, the environment today is quite similar to the mid-90s. Weak commodity prices and sub-economic project returns have caused capital to be rationed in the mining industry since 2013, with the energy sector following about five years later. Mining project approvals have ground to a halt, the rig count has fallen and “value over volume” is replacing “growth for growth’s sake” as a corporate mantra.

Outside of the corporate bond market, access to capital for most upstream commodity producers is virtually non-existent today. ESG is providing cover for banks to step back from relationships which have proven to be far from riskless, private equity sponsors are shifting rapidly into renewables/alternative energy, and public equity investors have little appetite for a sector like traditional energy which currently represents approximately 2% of the S&P 500 and has been among the worst performing industry segments for most of the past decade.

Macro-economic conditions and social considerations have only added fuel to the fire. An extended period of low inflation, the emergence of ESG as an asset class and the growing global commitment to achieving net zero emission status by the middle of the century has caused many to question whether an allocation to natural resources even makes sense. Much like the mid-to-late-90s, it might seem like a peculiar time to focus on natural resource investing.

We contend that the opposite is true –this is one of the most opportunity-rich environments that we’ve experienced, albeit with more nuance than we historically have observed at the beginning of an upcycle. We believe all investors, and particularly those with a socially responsible or ESG mandate, should be finding ways to make prudent, long-term allocations to the natural resource space today for five fundamental reasons:

• Reinvestment rates are insufficient to meet cyclically depressed demand
• The era of “infinite inventory” is over
• The energy transition will drive secular demand
• Inflation is a mispriced risk
• Valuations are historically compelling

Reinvestment Rates Insufficient to Meet Cyclically Depressed Demand

Despite the on-going impact of COVID-19 on demand, inventories for most commodities fell dramatically in 2020 and currently are either approaching or below normal levels.

Inventories normalized because supply fell –a function of the drop in drilling and development activity, although oil inventories clearly benefitted from OPEC+ supply management as well. In the U.S., both oil and natural gas production dropped in 2020, and we expect continued production declines, absent a ~30% increase in the rig count.

As a result, we expect North American supply growth to struggle, absent a material increase in commodity prices. This is especially true since at least public E&P’s have embraced the Shale 2.0 business plan of spending within cash flow and returning excess cash to owners.

Mined copper supply is struggling as well and given the long lead times necessary to commercialize new projects, we don’t expect a significant increase in production over the short to intermediate term.

The key takeaway is that after years of over-investment fueled by high commodity prices and readily available third-party capital, supply is being rationed. For short-cycle projects like unconventional oil and natural gas, we need to keep a weather eye on the rig count, but even after a moderate recovery, we are still well below activity levels necessary to maintain supply, let alone drive meaningful volume growth. For longer-cycle mining projects, we will almost certainly see some volume recovery post-COVIDdisruptions, but supply will remain constrained by the lack of growth investment over the last decade. The result will be upward pressure on commodity prices, particularly given the structural maturation of the asset base.

Era Of “Infinite Inventory” Is Over

We believe part of what drove the capital rush in the last cycle was the belief that (a) projects were highly economic and (b) there was an enormous base of high-return projects to develop. At this point, we’ve certainly debunked the first assumption, as it has become clear that the quoted“half-cycle” returns of 50-100%exist only in the fantasy world known as Excel. More recently, it has become clear that attempts to maximize inventory were undermining already marginal economics, forcing operators to up-space wells in 2019 and 2020.

While increased spacing improves single well economics, it mathematically reduces inventory. Thankfully, the days of investor presentations like this are behind us.

Tier I inventory is scarce, by definition, and outside of the Permian Basin and Southwestern Marcellus, core exhaustion is forcing most operators down the economic ladder. Even within the Permian, wells are being spaced further apart to protect returns. As rigs move into lower quality acreage and demand normalizes,mid-cycle commodity prices will have to increase. In copper, grades have been falling for the last 30 years, emblematic of a maturing resource base. This has put upward pressure on costs as more material must be mined and processed to produce the same amount of metal. More recently, companies have been high grading their projects which, in the absence of new discoveries, means that the industry faces even more pronounced cost inflation.

The point is not that there is a Malthusian tipping point after which we lack access to resource. Rather, our conclusion is that future production will require higher prices, particularly in unconventional oil and gas which today are benefitting from unsustainably low service costs.

Energy Transition Driving Secular Demand

As we move into a post-COVID world, undoubtedly there will be a demand surge as we settle into the new normal. Beyond that one-time event, however, the growing commitment to achieving a decarbonized world will have a profound impact on many facets of the human existence over the next several decades, not the least of which is commodity demand.

While we have written extensively on this topic in the past, it is important to understand the framework that we employ to delineate the extent of the energy transition, and to identify those segments where we believe we can find defensible business models that are capable of generating an attractive rate of return for their owners.

The energy transition isn’t limited to renewables, or to green hydrogen, or to stacks of recycled Tesla batteries run in parallel and labeled “utility-scale storage” in order to qualify for a PPA from a regulated utility. In fact, we’ve come to the conclusion that most of the grand plans being discussed today are directional at best, and highly self-serving at worst. We believe that a host of technologies and solutions will be required to both reduce carbon emissions and address energy poverty on a global scale, and that a singular approach is bound to fail. For instance, in many parts of the world, there simply isn’t the resource, the land and/or the population density for renewables to be economic. In these regions, natural gas-fired power plants may be the best option, or a CCGT fueled with blue hydrogen and carbon sequestration on the front-end.

What we can say with a high degree of certainty is that we believe the transition will be incredibly complex and must be driven by economics and science if it is going to succeed. Since the primary objective is to remove carbon from our energy systems, a logical place to start is with an understanding of the carbon abatement cost curve (long time readers are not surprised –we always start with cost curves). The following is by far the most rigorous that we’ve discovered, courtesy of Rob West at ThunderSaid Energy(“TSE”).

Assuming energy consumption increases to address the massive energy inequality which exists today, approximately 80bn tons pa of CO2will need to be abated by 2050, according to TSE. This can be accomplished at about $70/ton, provided the lowest cost options are utilized. Thus, while green hydrogen is in every other press release (we are waiting for a SPAC called “Green Hydrogen Dot Com” to open up 300% and thus complete the circle back to 1998), we are far more interested in finding opportunities at the bottom of the cost curve.

Of course, many of these carbon solutions will require vast quantities of very specific materials, with very specific characteristics. Back before it got you removed from the neighborhood association invite list, we called these things “commodities”, but today, it appears to be anathema for policy makers and analysts to acknowledge this reality. For example, Goldman Sachs estimates that the price tag for the EU Green Deal is about€10 trillion, of which €2.4 trillion will be spent on renewables. Focused only on copper, and only on incremental renewable power built in Europe, the plan will require about 21mm tons of copper, or 110% of 2020 mine supply.

Capital intensity of $20-25,000/annual ton of production equates to about $500 billion of incremental spending in 2020 dollars that has to be invested to create the supply of copper necessary to build the solar and wind farms. And that’s just for Europe, and just for power. Of course, it isn’t in the cost estimate, but more importantly what is the conclusion if we extrapolate that material intensity across different technologies, different commodities and do it on a global basis? We believe a successful energy transition will tax our natural resource base more than any other systemic shift in the history of the human race, and at best it’s a codicilin most studies.

While metal demand is largely ignored, the fate of energy fuels is a far more contentious issue. In their haste to engineer an outcome, most researchers appear willing to underwrite future conditions which seem only loosely tied to reality. Discount rates are 1-2%, total energy consumption falls 20-30% while carbon abatement technology costs decline by 20-50%. This approach results in forecasts such as the following, where oil and natural gas consumption are either eliminated or severely curtailed.

Instead of starting with “all carbon emissions must be eliminated by 2050” and reverse engineering from that conclusion, a more thoughtful question might be “can all carbon emissions be eliminated by a certain date, and if so, what is the most economic and least disruptive path that will allow us to accomplish this objective?” This approach leads to the creation first of a cost curve for carbon abatement, second the identification of the sources of carbon emissions and lastly a technology-agnostic approach which answers both parts of the question –can we get to net zero and if so, what is the lowest cost solution(capturing capital intensity, operating costs and technical risk). In that case, we end up with an energy stack which looks more like this.

These two scenarios seem like reasonable bookends to contemplate what unfolds over the next thirty years. At the heart of the energy transition are energy solutions, and we contend that all three of the primary energy solutions we identify in our Energy Transition Investment Landscape will be required. While the exact composition won’t be known in the short term, we remain steadfast believers in the first law of commodity investing –the lowest cost solution always wins.

As a result, we continue to believe that low-cost natural gas will be a critical fuel not just domestically but on a global basis. Recall that unlike oil, North American natural gas sits at the bottom of the global cost curve.

In addition, blue hydrogen with associated carbon capture and sequestration (“CCS”) is multiples less expensive than green hydrogen, does not require the consumption of vast quantities of water and does not rely on excess renewable power to provide zero-cost electricity. Based on fairly conservative assumptions, we estimate that blue hydrogen with CCS at scale can produce hydrogen at approximately $1.00/kg with $3.00/mcf gas and still generate a 10% IRR for the reformer.

Compare this to green hydrogen estimates of $10-$15/kg based on nascent technologies and the appeal of the natural gas/blue hydrogen/CCS pathway is clear–these prices equate to $75-$100/mcf natural gas prices. Of interest, reforming natural gas into blue hydrogen would increase natural gas demand by about 25%, all else equal, because the gas is used to fuel the reforming process. Perhaps natural gas has a role in the energy transition after all. We are actively searching for opportunities across this value chain.

With regard to oil, we acknowledge the negative skew of longer-term demand estimates. However, even assuming a rapid acceleration of EV penetration –12% by 2025 versus the current 5% penetration after more than a decade –the impact on oil consumption is a rounding error, far outweighed by the normalization of economic activity in a post-COVID world.

In summary, the energy transition will require significant investment across the upstream and midstream commodity complex if it is going to succeed. We believe that we are in the very early stages of what will be a multi-decade increase in commodity consumption. For the first time in two decades, a cyclical upturn is coinciding with a secular demand profile that is likely to dwarf the existing supply base.

Inflation Is A Mispriced Risk

We believe very few investors are positioned to mitigate, let alone benefit from, a deterioration of purchasing power in real terms. In large part, portfolios reflect the fact that the last decade has been largely deflationary, an outcome contrary to many expectations following the surge in stimulus spending post the Global Financial Crisis.

However, unlike the initial money printing exercise, which reduced interest rates and resulted in a surfeit of supply and thus falling prices, the current rounds of stimulus are much more focused on demand. Consumers are being handed checks directly, as opposed to the government bailing out the financial sector. As a result, Morgan Stanley estimates that US households received approximately $1 trillion in aggregate transfers, three times lost wage income in addition to $1.4 trillion in excess savings and the potential for another $1 trillion in incremental federal stimulus1. Policymakers are focused particularly on income redistribution to address the inequality gap that has widened so dramatically over the past several years, increasing the probability that the money will be spent and not added to the capital stock. Corporates are also carrying the highest level of cash relative to total assets in recent memory, suggesting that there are additional deep pools of capital ready to be spent as the recovery unfolds.

In addition, the deflationary impact of globalization appears likely to be reversed in the future. Supply chains have been disintermediated and, in some cases, completely eliminated, creating incremental friction in a system optimized for just-in-time product delivery. This cost inevitably will be passed along to purchasers in the form of higher prices.

Finally, as we have shown above, commodity prices have recovered from unsustainable levels and are more likely to trend up than down going forward, which eventually will flow into living expenses as well.

Historically, real asset allocations have helped to protect a portfolio’s purchasing power. Over the last decade, it’s been easy, and profitable, to reduce or even ignore inflation-sensitive investments. Going forward, however, it appears likely that inflation will become a much bigger risk, particularly in a period of extremely low-interest rates. Now may be a good time for long-term investors to think about adding some insurance while it’s still cheap to do so.

Valuations

We started this letter referencing the similarities between the mid-to-late-1990s and today. One area where this is certainly true is valuations, where the portion of the market trading rich relative to long-term valuation metrics is at the highest level since the dot com bubble.

In large part this has been driven by the returns from large cap tech, as well as the incredible run of “green energy” stocks over the last two years.

As is true in any melt-up, we are starting to hear valuation narratives to justify stock prices, to the extent valuation matters at all. Similar to the late1990s, upstream commodity stocks are still available at historically depressed valuations, even after the decent returns of 2020. Despite the fact that the world is woefully short the resources necessary to implement the energy transition as currently envisioned, many natural resource companies are available at significant discounts to the value of their existing production, meaning that future inventory is priced as a liability. At the end of 2020, we estimate that monetizing your portfolio over the next five years solely for the value of proved developed producing (“PDP”) reserves would generate 15-20%IRR’s, assuming strip pricing. 2021 free cash yields are in the mid-to-high teens and the discounts to YE19 NAVs are around 25-50% at the current strip. Using more reasonable long-term prices of $3 gas, $3 copper and $60 oil, PDP IRR’s are closer to 35-50%, free cash flow yields are in the high 30% and the discount to NAV is about 75%.

For comparison, investors in off-shore wind farms appear to be accepting low-to mid-single-digit returns today.

In our view, this is the opportunity for serious investors who wish to capitalize on, and accelerate, the energy transition. Geologically scarce, high barrier-to-entry enablers are available at historic discounts to intrinsic value while the more obvious downstream components of the value chain are priced as if they were riskless annuities. Just like in the late 1990s, we don’t believe that these discrepancies are sustainable over the long term.

On ESG

ESG investing has become an asset class unto itself. According to the Global Sustainable Investment Alliance’s biennial report, in 2018,25% of funds under professional management in the U.S. and 50% of funds in Europewereallocated to strategies with some ESG component. This trend remained intact through 2019 and 2020 as well.

Unfortunately, those same strategies have management fees about 2x higher than the industry average and do not appear to generate excess returns. In fact, the authors of a recent paper on the subject concluded that “return and risk differences of ESG funds can be significant but appear to be mainly driven by fund-specific criteria rather than by a homogeneous ESG factor. As a result, investors would be better served by assessing investment implications on a fund-by-fund basis.”2

We couldn’t agree more. We have integrated ESG analysis into our investment process for the last 15 years because we believe that identifying and mitigating ESG issues are fundamental components of active management. Employing screens or exclusion-based selection processes may satisfy similarly simplistic database requirements for marketing purposes, but in fact, ESG funds may be undermining their own objectives. By funneling capital into industries which pass their screens, ESG funds reduce the cost of capital for the consumers of energy, thus increasing demand, while starving those companies engaged in the real-world problems of fueling the global economy and creating the building blocks necessary to enable the energy transition, thus increasing the cost of supply. Very few investors understand this inherent contradiction.

We recognize that many institutional capital allocators have a dual mandate: to do well and to do good. While we are confident that we are in an environment in which historically attractive investment opportunities can be exploited, equally we are confident that it is possible to invest in the upstream and midstream commodity space and still maintain extremely rigorous ESG qualifications. Ignoring investment options because they don’t fit neatly into an asset allocation model isn’t just a missed opportunity to generate returns. It is an action which explicitly undermines any commitment to creating a safer, cleaner, more equitable world. Specifically, if ESG-and SRI-minded institutions want to ensure that the shift to a decarbonized future is as efficient, timely and economic as possible, they have an obligation to capitalize responsibly managed assets which provide the foundation for the energy transition.

Summary

Completing the analogy to the mid-to-late-90s, we find ourselves today at a unique point in human history. We believe that the energy transition will require a fundamental recapitalization of certain components of the commodity ecosystem. However, not only are assets mispriced, but the reality of just how scarce low-cost, long-duration assets are is almost completely ignored by the market. This is fertile ground for stock picking, particularly given the cyclical backdrop created by an extended period of capital constraint.

Over the last decade, we have evolved from a globally diversified global natural resource strategy to an energy transition strategy.

Even our “non-Energy Transition” exposure is a bit misleading, as it is comprised of an oil company which is a net sequester of anthropogenic CO2and another business which produces more natural gas and NGL’s than oil. Regardless, our transition was not a function of forecasting the next “hot dot.” Rather, it is a bottoms-up reflection of our process, based on the identification of investment opportunities which fit our risk management process: structurally advantaged assets, management teams with a track record of value creation, projects and operators that meet our ESG and above-ground risk criteria, and opportunities to acquire businesses at a discount to their current intrinsic value.

It is impossible to forecast the future, but what we can say is that we believe the owners of long-duration, low-cost assets should be well-positioned to capture a portion of that economic rent which comes from controlling the building blocks necessary to enable the energy transition. We believe that we are uniquely positioned to leverage our technical capabilities, financial acumen, and ESG credentials across a broad array of commodities as means to help investors participate in what we contend will be the next seismic shift in human progress. Much like 1995, it’s an interesting time to be thinking about resource investing. We thank you, as always, for your continued partnership.

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