COMMENTARY

COMPANY-SPECIFIC VALUE CREATION

A common misconception among some investors is that the only way to make money when investing in natural resource companies is to correctly forecast changes in commodity prices. While it is true that changes in commodity prices typically have a significant impact on natural resource equities over shorter periods of time, with an average annual standard deviation of returns at 20% or more and a peak annual standard deviation of returns of 40-50% or more during periods of extreme volatility, this notion ignores the tremendous amount of economic value that can either be created (or destroyed) by natural resource companies.

Unlike the returns associated with changes in commodity prices, which are mean-reverting around the marginal cost of supply, returns associated with company-specific value creation tend to compound over time, driven by the capital that is deployed in new projects and the excess returns generated by those investments (economic value creation = capital invested X [return on capital – the cost of capital]). Given the capital-intensive nature of most natural resource businesses, companies in the sector tend to either create or destroy a lot of value.

Over short periods of time, the returns associated with changes in commodity prices, i.e beta, can dwarf the returns related to company-specific value creation, i.e. alpha. Since the average holding period of a stock is now measured in weeks, it is easy to understand why this misconception exists. However, over longer periods of time, the returns related to company-specific value creation (for those companies that actually create value), which tend to compound over time, are generally a much more meaningful contributor to through-cycle returns than the returns related to changes in commodity prices, which are mean-reverting.

Lost among most investors is the fact that some of the best performing stocks in the market over long periods of time have been the most advantaged natural resource companies. XTO Energy, for instance, compounded at roughly 30% per year for a decade while the underlying commodity that they produced, natural gas, compounded at around 5% per year with a lot of volatility from year to year.

Most investors struggle to capture the potentially significant (and uncorrelated) returns associated with company-specific value creation in the natural resource sector because they: 1) lack the investment horizon necessary to realize the returns related to value creation (3-5 years or longer), 2) do not have a framework to invest countercyclically to take advantage of the volatility in the public markets, and 3) do not have an investment process or manager that allows them to identify the companies that will create value by deploying capital into low-cost, high-return projects.

Over our 25+ years of investing in the natural resource sector, we have learned that consistently forecasting changes in commodity prices is impossible. The events that cause the biggest changes in commodity prices, such as weather, geopolitical events, and supply shocks, tend to be unpredictable in nature. We believe that it is foolish, at best, and unethical, at worst, to speculate on short-term changes in commodity prices with client capital.

On the other hand, we believe that it is much easier to forecast the returns associated with company-specific value creation, which again, tend to be more meaningful anyway over longer periods of time. This is where we focus our analytical efforts.

In order to forecast company-specific value creation, our research is focused on identifying the projects across industries in the natural resource and energy transition sectors that we believe will generate attractive returns on capital due to some durable competitive advantage. We use this research to target the few companies that we believe can create economic value if management teams allocate capital and execute appropriately. For many industries, these projects can take years to develop and therefore it takes some time for us to evaluate whether the returns that we underwrote when we made an investment were realized. However, for shorter-cycle commodities, such as shale gas in North America, we can evaluate project returns each year using annual reserve disclosures.

As the late, great investor David Swensen observed in Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, “price exposure plus an intrinsic rate of return trumps price exposure alone.”

DECARBONIZATION IS STALLING

Despite the increased focus on reducing carbon emissions in the developed world, it is important to note that decarbonization has, at least temporarily, slowed. Indeed, the realities of the Energy Transition are starting to become more apparent as we move from spreadsheets (aspirational commitments with limited accountability) to shovels (actual work and the oft-ignored implications of translating said spreadsheets into a complex, evolving, three-dimensional world).

While renewable penetration rates continue to soar, global emissions have recently increased at an accelerating pace, reversing almost 20 years of progress.

Figure 1: Change in Global CO₂ Emissions

A few things jump off this chart. The first is that the predominant drivers of CO₂ emission growth are increases in GDP per capita and population growth, which underpins our contention that addressing global energy poverty has to be a central plank of any energy transition framework.

Second, outside of improvements in energy intensity and the acceleration in renewable buildout, coal-to-gas switching has been one of the most important decarbonization pathways of the past 50 years. Unfortunately, many policy makers and investors lump all hydrocarbons together, a simple but highly misguided practice.

In fact, displacing coal with natural gas cuts greenhouse gas emissions by a minimum of 50% per kWh, which has allowed countries like the U.S. to sustain strong economic growth while concurrently reducing power related CO₂ emissions by almost 35% over the last 20 years.

Figure 2: US GHG Emissions by Major Emitting Sector‍

The relationship between the decline in power-related emission reductions and coal-to-gas switching is causal, not simply correlated.

Figure 3: US Power Generation by Energy Source

The result is that emissions per dollar of GDP have fallen by more than 50% over the same time frame. Other countries are not blessed with low-cost natural gas, and instead must rely on exporters for supply. Given the position of U.S. gas on the global cost curve and the collective commitment to decarbonization, North America should be building infrastructure and export capacity as quickly as possible. That is not the case, however, since “natural gas is a hydrocarbon.” The political opposition to advancing natural gas has exacerbated an already fragile global energy ecosystem, as evidenced by the power crisis in the U.K. and Europe, the impact of the Russia/Ukraine conflict, and more recently the 30% spike in European natural gas prices in response to the threat of a strike by LNG workers in Australia.

Unstable global gas markets force importing countries to look elsewhere for energy security. Sadly, coal is the logical option, and coal demand continues to soar, with 2022 marking a record level of production.

Figure 4: Global Coal Production (2000-2025)

Incredibly, while U.S. coal production has fallen by almost 50% since 2008 (the start of the shale gas industry), China and India have grown by a similar amount and today produce about 10x more than the U.S. on a combined basis.

While LNG exports from the U.S. are increasing, the U.S., Canada and even Mexico (via West Texas volumes) could and should be sending more volumes into the international markets. Regulators and politicians who want to combat climate change should be laser focused on expediting those volumes instead of pandering to the media. Without question, displacing coal with natural gas would have a profound impact on global emissions. Instead, we are left with the cold reality of rising coal consumption effectively offsetting the impact of renewables, and an acceleration in global emissions as a result – definitely not what was on the spreadsheet.

MONEY

The other structural challenge facing the Energy Transition is money. It wasn’t lost on us that commitments to net zero jumped in the pandemic.

Figure 5: Number of Countries and Share of Global CO₂ Emissions Committed to Net Zero

Negative real rates and highly efficient printing presses tend to make multi-hundred trillion dollar promises a lot more palatable.

Fast forward to today, however, and the outlook isn’t quite as compelling. The CBO forecasts that net U.S. federal debt held by the public will jump by about 95% between 2022 to 2033, driven by rising interest expense (+200%) and mandatory outlays (+50%), offset by U.S. GDP growing at an expected (and staggering) 4.2% per annum rate. Net federal debt held by the public will represent almost 120% of GDP by 2033, and both Medicare (2031) and Social Security (2034) will be insolvent on their own. That all assumes no global geopolitical conflicts, no pandemics, and no other disruption to what may turn out to be a very optimistic set of assumptions, all while the world will need to spend somewhere between $5-$8 trillion per year in 2023 dollars on the Energy Transition, an endeavor which currently is not even slowing the current rate of global emissions.

It also assumes that the U.S. remains the most trusted country in the world, that corporations, individuals, and other sovereign entities will continue to transact in a currency that by definition will have to be debased in order to finance a deficit that is expected to grow at about 4x the rate of GDP over the next decade. Like many other institutions, it appears that trust in the U.S. dollar has been eroding over the past few years.

Figure 6: US Dollar's Share of Global Foreign Exchange Reserves

Absent a radical cut to spending or a radical increase in taxes, neither of which is likely to be accepted in the current political environment, the only real option is to print more money, assuming anyone will take it. More money in circulation tends to be inflationary, compounding the structurally inflationary nature of the Energy Transition that we have discussed at length, and further eroding trust in fiat currencies.

OUTLOOK

Obviously, we can’t forecast the future, but in our opinion, most investors aren’t well-positioned for anything resembling an environment with higher inflation, a weakening dollar, increasingly volatile energy markets, and a less-than-linear Energy Transition.

Many institutional portfolios appear to be built for the investment regime of the last 10-15 years versus the one that may be emerging. Equities are well-owned while commodities and natural resource companies in general remain undervalued and unloved.

Figure 7: Large Cap Energy Stocks Relative Normalized Free Cash Flow Yields

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Figure 8: PMI Residual (Based on YoY Return vs PMI and Cash Rate)

Figure 9: PMI Residual (Based on YoY Return vs PMI and Cash Rate)

Viewed from another perspective, commodities appear to be the only asset class discounting a realistic potential for a recession.

Figure 10: Implied Recession Probability

In our opinion, this backdrop provides long-term investors with a unique opportunity to own durable, cash-flowing assets at highly attractive valuations while also obtaining inflation protection, diversification benefits, and a free option on the global pursuit of net zero.

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,

SailingStone Capital Partners

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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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