COMMENTARY

With the exception of precious metals and sugar, most commodity prices have been in decline for the last year or so. Based on Google searches, inflation concerns appear to have waned as well.

Figure 1: Worldwide Interest In "Inflation" From 2020 to Today

With the European energy crisis seemingly resolved (at least for this year), supply chains normalizing around the Russia/Ukraine conflict, and deteriorating global macroeconomic conditions, it’s easy to understand why many investors believe that inflation has peaked.

Views on inflation are important from a real asset perspective, since one of the primary reasons to invest in the asset class is to offset the erosion in purchasing power that comes from rising prices of inputs, finished goods, and services. Historically, a diversified natural resource portfolio has provided much better protection against both increases in CPI as well as inflation shocks than other asset classes.

Figure 2: Inflation Protection

On the heels of the post-pandemic inflation spike, engagement with asset allocators about investing in natural resource equities, public or private, is picking up relative to a few years ago. However, activity levels are still low compared to historical norms.

Despite leading the market for most of the last three years, natural resource stocks make up only a small percentage of public equity indices. For example, while Energy has more than doubled relative to the rest of the market from its recent low, it was only 5.2% of the S&P 500 at year-end 2022 and 5.7% of the MSCI World Index, about half of its contribution to 2022 earnings. A trend of long-term underperformance - Energy was the worst (five times) or second worse (once) S&P 500 sector in six of the last nine years - has made it easy for investors to ignore the industry. Divestment decisions and ESG considerations have only served to institutionalize the practice of dismissing the natural resource space.

Another way to assess how investors think about natural resources is to examine the relationship between commodity prices and the equity market, which is at its lowest level in the last 50 years.

Figure 3: GSCI Commodity Index vs S&P 500 Index

While Wall Street may be ignoring commodities, that has been a much bigger ask for Main Street. In fact, 2022 witnessed the highest combined energy prices on record, matching the 1979-80 oil shock. Furthermore, primary energy costs as a percentage of global GDP approached peak levels at just over 12% in 2022, both statistics courtesy of our friends at Thunder Said Energy.

Figure 4: Primary Energy as a Percentage of GDP: 1900-2022

To reinforce the idea that energy prices have implications for the inhabitants of the real world, The Economist just published this rather morbid chart, which was brought to our attention by Paul Sankey of Sankey Research. Higher energy prices impact the day-to-day realities of many people, including those living in the so-called “developed” world.

Figure 5: Consequences of Rising Energy Prices

While the last year or so has provided a cyclical reprieve from commodity price pressures, investors would be misguided to ignore the structural challenges facing the “peak inflation is behind us” argument. We have discussed at length the inflationary impact of the Energy Transition, driven by the massive amount of capital required to achieve grid stability to accommodate accelerating renewable penetration rates as well as the increase in incentive prices required to engender a supply response in commodities like copper, rare earths, uranium, and natural gas, to name just a few, that unequivocally are central to decarbonizing the world’s energy supply while simultaneously meeting the energy demand of developing economies.

Oil is often left out of the conversation since demand appears to be at risk both in the near term given global economic uncertainties and longer term in a future dominated by EVs.

When considering the outlook for oil prices, demand gets most of the attention. While it is good fodder for market pundits, in fact demand has proven very difficult to forecast. Outside of recessions, there appears to be a strong historical bias to underestimate oil demand growth. Right on form, the IEA recently updated 2023 demand expectations to an all-time high of 102mm barrels per day (“mmbpd”) driven by non-OECD consumption.

Figure 6: Global Oil Demand Revisions: 1990 - 2023 YTD

Unlike the Global Financial Crisis and the pandemic, oil demand in the current economic malaise continues to trend higher. The issue for oil, and for investors anchored to a deflationary narrative, isn’t demand, it’s supply.

More than any other commodity, oil shapes inflation and inflation expectations. Any diversified index of commodity prices is heavily weighted towards oil, as are the most commonly referenced natural resource equity indices. And from a supply perspective, oil is facing two fundamental challenges.

GLOBAL SPARE CAPACITY

First, global spare capacity is limited. On a percentage basis, excess capacity is about 3% of total demand, and that includes almost 2mmbpd, or about two of the three percentage points, from Saudi Arabia. Saudi Aramco claims to have 12.5mmbpd of total capacity, but based on historical production, we assume that actual spare capacity is meaningfully lower.

Figure 7: Saudi Arabia Crude Oil Production (000’s bpd): 2002 – February 2023

While clearly some barrels are being held back to manage global inventories and therefore price, current OPEC oil production is back to 2004 levels excluding NGL’s.

Figure 8: OPEC Crude Oil Production (000’s bpd): 2002 – February 2023

Growing demand and limited spare capacity typically is not a recipe for lower commodity prices.

U.S. SHALE OIL

The second issue facing the oil market is the current state of affairs in US shale. Recall that, unlike natural gas, US unconventional oil sits at the high end of the global cost curve.  

Figure 9: Global Oil ($/bbl LHS) and Natural Gas ($/mmbtu RHS) Cost Curves

This is important because in the decade before the pandemic, shale oil met the vast majority of global oil demand growth and until recently was responsible for almost all global reserve additions.

Figure 10: Total Liquid Reserve Additions/Revisions By Year

As one of the primary sources of incremental supply, and as the marginal producer, the future of US unconventional oil has significant implications for future oil prices, and thus inflation.

As shown in the chart above, about 12 billion boe (“barrels of oil equivalent”) of shale liquids reserves were written off in 2017. The negative reserve revisions were not price related, since oil prices were up year-over-year, but rather due to wells underperforming expectations. In early 2018, we published a white paper (found here) to examine whether or not the much touted “shale revolution” was a structural one driven by technology or a cyclical one. Specifically, "In this paper, we attempt to disaggregate structural improvements in well economics from cyclical ones in order to better understand whether we are in a period of accelerating productivity gains, a la Moore’s Law, or if we have reached the point of diminishing returns."

One of the key conclusions of the analysis was that, once standardized for changes in lateral lengths, improvements in average well productivities were not a function of technology but simply a function of high grading. 

Figure 11: Well Productivity by Quintile – Midland, Delaware, Bakken and Eagle Ford

This trend of high grading is also very clear when examining drilling activity. Operators increasingly focused their activity in the areas of highest reservoir quality, resulting in fewer low-quality wells, and thus raising the average well productivity.

Figure 12: Drilling Activity by Geologic Quality – Midland, Delaware, Bakken and Eagle Ford

In other words, the improvement in the average was caused by the exclusion of lower quality wells as opposed to the best wells getting better, which is what one would expect with technological advancements. Geology has limits, and in this case, nature was winning the battle with science.

The finite nature of inventory combined with the steep drop-off in well economics outside of the core areas of shale oil basins means that high grading eventually should have a material impact on future well economics. This is exactly what we see in the data as we roll forward from 2017 through 2022.

In contrast to average well productivities increasing by 12-13% per year from 2014 to 2017, more recent data shows average well performance plateauing and even degrading in some basins. The most striking observation, however, is the significant decline in top decile well performance in all four major shale oil plays. Looking at 12-month cumulative oil production per lateral foot, the top wells deteriorated by 10-18% from 2017 to 2022. While high grading continues to boost average well performance, the significant declines in top decile wells indicate that the pace of resource exhaustion is accelerating.

Figure 13: Change in 12-Month Oil Cumulative Production per Lateral Foot:  2017-2022

Between the steady stream of reserve revisions and the decline in well performance, it is clear that US shale is struggling. Consistent with our 2018 thesis, operators are drilling fewer bad wells, but the best wells are getting worse. This conclusion is even more alarming when assessed in conjunction with the trends in well spacing and proppant intensity.

Figure 14: U.S. Shale Well Spacing and Proppant Intensity

Outside of the Delaware basin, which not coincidently has witnessed the largest decline in average well performance over the past five years, well spacing is back to 2013-2015 levels. In all basins, proppant intensity is at or near record levels. Flat-to-declining average well performance and a steady drop in top tier well performance, despite significant increases in proppant intensity and the up-spacing of locations, is a clear indication that US shale, the global marginal producer, is facing resource exhaustion. Not good if you are betting on “lower for longer.”

In addition to well productivities declining over time, initial type curve assumptions have proven to be overly aggressive. Key type curve variables are offset production data, decline rates, and b-factors. B-factors define how the decline rate of an unconventional well changes over time as the well moves from fracture- to matrix-dominated flow (i.e. the hockey stick). Early on, the data can be used to support a wide range of forecasts, with the true b-factor emerging only after years of production. Some possible explanations for lower long-term b-factors and therefore steeper decline rates include: (1) lower recoveries of oil-in-place, (2) interference from increasing well density, and (3) pressure dropping below bubble point within the well’s drainage area.

Figure 15: U.S. Midland Basin B-Factors

The example above shows initial assumptions compared to results for 2017 Midland Basin wells. It is important to note that this illustration is the standard and is in no way unique to this play or this vintage. Relatively small changes in b-factors have a profound impact on how much oil is produced (the area under the curve). In this case, estimated ultimate recoveries (“EURs”) for this type curve are 30% below expectations due to the lower b-factor, which only became evident after years of actual data.

While the NPV impacts are not overly severe on a per-well basis (most of the value is captured in the first few years), structurally lower b-factors result in materially higher future capital intensity and constrain the ability of US producers to grow oil supply absent a significant increase in drilling activity. To that end, the chart below shows a sensitivity to our US oil growth forecast assuming 1.2 b-factors across the major oil shales versus our basin-calibrated models. The difference is well over 1mmbpd, which perhaps explains why OPEC doesn’t seem too worried about US shale’s ability to regain market share going forward.

Figure 16: U.S. Oil Growth Forecast Assuming 1.2 B-Factors

Examining base decline rates by year provides another perspective on this issue. The base decline is simply the aggregate production trend of all current wells using the type curve variables discussed above. Unconventional wells have steep first-year decline rates, which should, in theory, flatten over time. In a slow-/no-growth environment, which we have been in for the past few years, base decline rates should flatten as the production base matures and is less impacted by significant volumes of high decline, flush production coming on stream.

This dynamic has played out in the unconventional gas market and was clearly evident in the early days of the shale oil boom.

Figure 17: Base Decline – US Horizontal Oil Production (000 bbls per day)

Between 2014-2016, US horizontal oil production fell about 10% to 4.5mmbpd and the base decline rate fell from 50% to 40%.

More recently, however, base decline rates have held steady in the high 40% range despite an overall drop in volumes from peak levels. For context, a 47-48% base decline rate means that the US needs to add 3-4mmbpd each year just to keep production flat, the equivalent of adding a new Canada or Iraq on an annual basis.

While the stickier base decline rates are partially explained by overstated b-factors, we are concerned that they also may be related to increasing gas/oil ratios (“GORs”).

As pressure in a reservoir drops below what is known as the bubble point, gas becomes liberated from the oil and preferentially flows, causing GORs to rise. Over time, higher than expected GORs could be caused by tighter well spacing as a play moves from initial delineation to full field development. It is clear that GORs are accelerating versus expectations across the primary unconventional US oil plays, and in the Bakken and Delaware basins, markedly so.

Figure 18: GOR Trend Increasing Across Unconventional Plays

If observed trends around increasing GOR’s and oil decline rates continue, simpy maintaining production will become more difficult, particularly given the resource exhaustion discussed above. Furthermore, absent higher prices, any attempt to meaningfully grow US shale production will be extraordinarily challenged as industry claims of the quality and quantity of remaining inventory appear to be massively overstated. While we can’t say conclusively what is causing decline rates to remain at elevated levels, at this point we are comfortable stating that the best days of the US shale industry are behind it.

What are the implications of this assessment? Discretionary free cash flow will shrink at the corporate level absent much higher prices, and the capital discipline of the industry will be put to the test. We expect to see more and more M&A as producers are forced to refresh inventory and obscure the challenges associated with overstated inventory, stubbornly high base decline rates, and declining capital efficiency. More broadly, we believe that over the intermediate term, the risk to oil prices is higher not lower. In fact, we reiterate our contention that the “end of oil” will be a function of price-related demand destruction, not technology-driven obsolescence.

This brings us back to inflation, and the fundamental role that oil prices play in setting inflation expectations. Is the inflation boogeyman really behind us? Maybe for the moment, but Gary Larson reminds us that it is always a good idea to check the rearview mirror.

Figure 19: Sanity Check

Higher oil prices will almost certainly raise inflation expectations, a scenario that most investors appear ill-prepared to address. Simply buying public oil stocks hasn’t provided much in the way of incremental value and likely won’t going forward, as even “advantaged” US oil producers have failed to generate excess returns relative to the commodity, a structural issue reflecting shale oil’s position on the global cost curve.  

Figure 20: Advantage Producer Excess Returns vs Commodity: 2016-2022

Owning the marginal producer with deteriorating assets and limited inventory is a tough way to make money.We continue to believe that a diversified natural resource portfolio focused on low-cost, long-duration projects is one very effective way to offset inflationary pressures. In fact, a review of historical annual commodity returns reinforces the benefits of diversification as well as the mean reverting nature of commodity prices, as illustrated in the table below.

Figure 21: Historical Commodity Returns: 2013-2022

Even in a world where long-term commodity prices may be trending upward, investors should seek out industries where advantaged assets can be accessed as a means to generate excess returns and thus drive company-specific value creation. As the late David Swensen noted so presciently in Pioneering Portfolio Management, “price exposure plus an intrinsic rate of return trumps price exposure alone.”

OUTLOOK

It is an interesting time to be investing in our sectors. Over the last year, we have taken less risk in the portfolio given the global macroeconomic backdrop and the production response that has occurred in short-cycle commodities like natural gas. However, valuation spreads are becoming more interesting, and we are well-positioned to buy risk when we are appropriately compensated. These will be rifle-shots vs. sector calls as we continue to believe that the most important drivers of returns are idiosyncratic to an individual company. Investors don’t need us to buy beta.

More broadly, we believe that heightened volatility and rising inflation expectations eventually will result in the market assigning a premium to sustainable cash flow streams, particularly when those cash flows are associated with the responsible production of key raw materials, services, or technologies that are helping to enable decarbonization while sustaining global economic growth. Today, we believe that those cash flows are mispriced in the market, and we are happy to take advantage of current and future dislocations to buy extraordinary businesses at significant discounts to intrinsic value.

We are still in the early stages of what we contend will be a strong cycle for commodities. Skepticism, ignorance, and policy decisions are starving capital-intensive industries of the capital they need to meet current demand, and mother nature is making future production that much more expensive. Inflation protection is cheap, and long-term capital allocators are beginning to reassess their exposures and options to address a future that we expect will look much different than our recent past.

SUMMARY

The current environment is hindering the supply response needed to support continued economic growth and address one of the world’s most pressing concerns – climate change. Without more investment and increased engagement from stakeholders, commodity price inflation will only get worse over time, and carbon emissions will continue to increase.

The risks associated with a secular increase in commodity price inflation remain underappreciated by most investors. 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 commodity prices to reflect economic realities, and we expect stock prices to converge with intrinsic value, including a premium for the scarcity value that should be ascribed low-cost, long-lived, mission-critical resources residing in safe jurisdictions. Until then, we remain excited to deploy capital into what we believe to be one of the most fundamentally attractive setups in recent memory.

Best Regards

DISCLOSURES

This report is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities.  The opinions expressed herein represent the current views of the author(s) at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this report has been developed internally and/or obtained from sources believed to be reliable; however, SailingStone Capital Partners LLC (“SailingStone” or “SSCP”) does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained in this article are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and SSCP assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements.  In particular, target returns are based on SSCP’s historical data regarding asset class and strategy. There is no guarantee that targeted returns will be realized or achieved or that an investment strategy will be successful. Target returns and/or projected returns are hypothetical in nature and are shown for illustrative, informational purposes only. This material is not intended to forecast or predict future events, but rather to indicate the investment returns SailingStone has observed in the market generally. It does not reflect the actual or expected returns of any specific investment strategy and does not guarantee future results. SailingStone considers a number of factors, including, for example, observed and historical market returns relevant to the applicable investments, projected cash flows, projected future valuations of target assets and businesses, relevant other market dynamics (including interest rate and currency markets), anticipated contingencies, and regulatory issues. Certain of the assumptions have been made for modeling purposes and are unlikely to be realized. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in calculating the target returns and/or projected returns have been stated or fully considered. Changes in the assumptions may have a material impact on the target returns and/or projected returns presented.

Target Returns and/or Projected Returns May Not Materialize. Investors should keep in mind that the securities markets are volatile and unpredictable. There are no guarantees that the historical performance of an investment, portfolio, or asset class will have a direct correlation with its future performance. Investing in small- and mid-size companies can involve risks such as less publicly available information than larger companies, volatility, and less liquidity. Investing in a more limited number of issuers and sectors can be subject to increased sensitivity to market fluctuation. Portfolios that concentrate investments in a certain sector may be subject to greater risk than portfolios that invest more broadly, as companies in that sector may share common characteristics and may react similarly to market developments or other factors affecting their values. Investments in companies in natural resources industries may involve risks including changes in commodities prices, changes in demand for various natural resources, changes in energy prices, and international political and economic developments. Foreign securities are subject to political, regulatory, economic, and exchange-rate risks, some of which may not be present in domestic investments.

You cannot invest directly in an index.  Those indices that are not benchmarks for the strategy are not representative of the strategy and are shown solely as a comparison among asset classes.  Certain indices have been selected as benchmarks because they represent the general asset class in which SSCP’s strategy invests; however, even such benchmarks will be materially different from portfolios in the strategy since SSCP is not constrained by the any particular index in managing the strategy.

The S&P North American Natural Resources Sector Index™ (S&P NANRSI) is an unmanaged modified-capitalization weighted index of companies in the Global Industry Classification Standard (GICS©) Energy and Materials sectors, excluding the Chemicals industry and Steel sub-industry.  Index weights are float-adjusted and capped at 7.5%.  Ordinary cash dividends are applied on the ex-date.  As of December 31, 2007, the strategy changed its benchmark from the Lipper Natural Resources Fund Index to the S&P North American Natural Resources Sector Index because the S&P North American Natural Resources Sector Index is composed of securities of companies in the natural resources sector while the Lipper Natural Resources Fund Index is composed of mutual funds that invest in the natural resources sector. The S&P Global Natural Resources Index (S&P GNR) includes 90 of companies in natural resources and commodities businesses that meet specific investability requirements whose market capitalization is greater than US$100 million with a float-adjusted market cap of US$100 million. Equity exposure is across 3 primary commodity-related sectors: agribusiness, energy, and metals & mining. Liquidity thresholds are the 3-month average daily value traded of US$5 million. Stocks must be trading on a developed market exchange. Emerging market stocks are considered only if they have a developed market listing. The MSCI World Commodity Producers Index (MSCI-WCP) is an equity-based index designed to reflect the performance related to commodity producers’ stocks. The MSCI World Commodity Producers Index is a free float-adjusted market capitalization-weighted index comprised of commodity producer companies based on the GICS. The Bloomberg Commodity Index (formerly the Dow Jones-UBS Commodity Index) is calculated on an excess return basis and composed of futures contracts on 22 physical commodities. It reflects the return of underlying commodity futures price movements. The S&P 500 Index is a free-float adjusted market-capitalization-weighted index designed to measure the performance of 500 leading companies in leading industries of the U.S. economy.  The stocks included have a market capitalization in excess of $4 billion and cover over 75% of U.S. equities. The S&P GSCI® Crude Oil Index provides investors with a reliable and publicly available benchmark for investment performance in the crude oil market. The S&P GSCI® Natural Gas Index provides investors with a reliable and publicly available benchmark for investment performance in the natural gas market. The S&P GSCI® Copper Index, a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark for investment performance in the copper commodity market. The S&P GSCI® Gold Index, a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark tracking the COMEX gold future. The index is designed to be tradable, readily accessible to market participants, and cost efficient to implement. The S&P GSCI® Corn Index, a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark for investment performance in the corn commodity market.

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