Commentary

Market Update

Inventories across most markets remain below to well below average, as we have yet to witness a material supply response to higher commodity prices.

Consistent with low above-ground inventories, the outlook for supply remains generally constructive (i.e., subdued) across most major commodities. Political uncertainty in keySouth American producing regions has slowed project development in copper and lithium, while North American unconventional E&P companies have stayed true to their “value over volume” pledge, at least in the public markets. Drilling activity is supportive of the current pricing environment, although recently volumes appear to have benefited from drilled but uncompleted wells coming online. While this is a one-time inventory drawdown, there will be a lot of attention paid to company commentary during the upcoming second quarter earnings season. Investor appetite for a surge in activity remains low while expectations for the return of capital are high, particularly in the current commodity price environment.

Drilling Returns and Company Specific Value Creation

In the second quarter of each year, we publish our estimates of company-specific value creation for the primary positions in your portfolio, as well as a couple of reference points for large, well-known companies in the same industries. The objective of this exercise is three-fold. First, our investment process is designed to identify and quantify the return stream associated with company-specific value creation. While we do not believe that anyone can accurately and consistently forecast short-term commodity price volatility, we contend that by combining technical expertise with asset-level financial models, we have created a unique framework to estimate current net present value and future economic value creation based on well-or project-level parameters in conjunction with assumptions related to capital intensity and costs/margin structures. So, we use this analysis as an interim assessment of the business case that we are underwriting as a means to reconcile expected outcomes with realized results.

Second, our job as investment managers is to act as a conduit, connecting investor capital with individual management teams that we believe are capable of generating attractive risk-adjusted returns across a full commodity price cycle. Given the deeply cyclical nature of our industries, and the increasingly myopic time frames of public equity markets, the returns derived from prudently allocating capital into structurally advantaged projects can be overwhelmed by shorter-term commodity price expectations.¹ However, over longer periods, stock prices must reflect the intrinsic value of the underlying assets at a reasonable mid-cycle commodity price. Thus, our annual exercise creates an objective view into the capital efficiency and value creating dynamics of a company, a perspective which provides the basis for extraordinarily attractive (and thus extraordinarily nerve wracking) counter-cyclical investment decisions in the midst of whatever controversy is creating the opportunity. It also is a helpful reporting tool for our clients, who can assess whether or not our investment thesis is playing out, and perhaps more importantly understand why. We have found that this level of transparency is unique in the public and private markets and is very useful in framing the timing of new or incremental investment decisions by our clients.

And, lastly, this exercise creates insights into industry-wide trends which from time to time run contrary to the popular narrative. For instance, the basis of our January 2018 report on the real drivers of “productivity gains” in unconventional oil drilling (high grading and longer laterals) caused us to review our existing shale oil exposure. Surprisingly, low program returns were caused by efforts to pull NAV forward through tighter well spacing and expensive completion designs that in fact were destroying both well-level and corporate economics. This conclusion drove a significant part of our decision to reduce exposure to these businesses.

A few observations on the results of our 2020 review.

First, owning Tier I assets in commodities with steep cost curves is a core tenant of our investment process because it helps protect against the permanent loss of capital during downturns. According to Haynes and Boone, 254North American oil and gas producers filed for bankruptcy between 2015 and 2020, including 46 in 2020. Yet, during this period of extreme volatility in both commodity prices and equity markets, your E&P portfolio consistently generated positive returns on its capital programs. For 2020, we estimate these businesses generated high-teens to low-twenties unlevered, full-cycle drilling returns based on realized 2020 commodity prices and the forward strip at year-end 2020. Returns were up slightly compared to 2019 as better well productivities and lower capital costs offset lower near-term commodity prices.

Second, even with commodity prices trading below cash cost for much of 2020 ($2 gas/mcf, $36/bbl oil), the portfolio companies continued to compound economic value, with gas companies growing NAV by 10-20%, oil companies growing by 5% and mining companies by 5-15%. Historically, and perhaps counterintuitively, the fastest pace of NAV growth does not occur at cyclical peaks but rather in the emergence from a downturn as prices improve on top of lean, capital-efficient cost structures. We expect our companies to compound NAV at or above the high-end of our 10-20% through-cycle average in 2021.

And lastly, while there can be short-term market dislocations (sometimes more severe and more protracted than we like), we expect that equity prices will converge to the intrinsic values of the businesses. This has started to happen in some of the names, but there is considerable upside to proved value today as well as continued NAV growth. While occasionally overlooked by the market, this is the power of owning structurally advantaged, low-cost inventory –asset values compound even during cyclical downturns, bolstering the owner’s safety net and creating a unique, uncorrelated return stream which ultimately is captured in the equity price.

Because this return stream is driven by a non-mean reverting variable (geology), it tends to be very persistent over time. Relative commodity prices, however, are far more mean reverting as prices oscillate around the marginal cost of supply. Thus, over the last three years –a period of historic volatility –our returns have matched the index despite our preference for smaller, upstream-companies which have much higher beta. Negative returns from commodity mix have been offset by stock selection, which we attribute almost exclusively to the power of compounding economic value through the bottom of the commodity price cycle. Driven by the Energy Transition, commodity mix should be a net tailwind for your portfolio on both an absolute and relative basis going forward. Neither the unique value creating capabilities of Tier I assets nor the structural outlook for Energy Transition-related commodities are discounted in the public equity markets today.

Inflation and the Energy Transition

The COVID pandemic, and the response of governments and central banks around the world, have engendered an on-going debate about the outlook for inflation. Transitory or perhaps a bit stickier? Inflation skeptics rightly point to the remarkable deflationary impact of technology and innovation as well as a labor pool distorted by temporary incentives for the able bodied to remain at home.

Inflation certainly has been benign over the past decade, aided by globalization, demographics and, perversely, easy monetary conditions. Cheap capital combined with distorted and ultimately misplaced definitions of value creation in the natural resource space resulted in significant excess supply which depressed commodity prices. Indeed, from the Global Financial Crisis through the second quarter of 2021, the S&P GSCI price component has averaged 3.5% annualized returns, almost 70% lower than the annualized returns of the prior seven years (2002-2008). And, that includes the 65% return of the last 12 months.

We have written for the past few years that we believed that inflation expectations were far too sanguine, at least from a commodity price perspective. The reason was simply that the industry was being starved of capital—a rational response to a decade of value destruction which inevitably set the stage for higher prices. For the most part, this recovery has materialized in the spot market, although futures prices remain less robust. In general, current commodity prices are at or above what we consider reasonable long-term averages.

Some will argue that this set-up is the essence of transitory inflation—the second derivative for commodity prices, rents, wages, etc. could all end up being negative. It is hard to imagine how to comp a chart like this with positive year-over-year growth.

However, other components of price indices look more constructive, including on the labor side, where small business compensation costs appear as if they have resumed their upward trend.

The following chart sums up the conundrum pretty well—pricing power for most industries has improved dramatically even vs. pre-COVID periods, but many companies expect the trend to moderate going forward.

We don’t have a great framework to address the inflation debate from a demand perspective which from our experience is extraordinarily difficult to forecast. On the margin, we are in the “sticky” camp, in no small part because the recent rounds of governmental largess have ended up in the hands of the consumer as opposed to the producer. From a supply perspective, we continue to believe that costs will be higher than most are expecting. This is due to three primary factors:

1. As we have discussed in previous letters and white papers, there are significant structural headwinds facing many commodities that will require strong incentive prices just to meet current demand: grade degradation, core exhaustion, limited and shrinking external supplies of capital, a lack of game-changing technological innovation to name a few.
2. Moreover, policy makers (public and private) and most investors continue to ignore the material requirements of the Energy Transition. To reiterate, investors and government authorities who choose not to capitalize or advance well-managed, low-carbon-footprint upstream projects because of overly simplistic/detached-from-reality ESG stances are doing far more harm than good to the ultimate objective—the decarbonization and broadening of the world’s energy systems.
3. The Energy Transition may in and of itself be far more inflationary than most expect.

This last point is worth considering in more detail. Our sense is that most investors and policy makers believe that Energy Transition will be a massive net benefit for the world’s population and the global economy. As the International Renewable Energy Agency put it in their worlds Energy Transition Outlook2021, “The analysis of global socio-economic impacts…indicates that the world will be better off—in multiple dimensions—if societies take the 1.5 C Scenario route…(which) offer(s) a 11% improvement in the overall Energy Transition Welfare Index over the (Planned Energy Scenario)”.

While forecasting how the largest investment and industrial undertaking in the history of mankind will impact global welfare with that level of precision may remind some readers of their recent experiences with shale well economics, the fact remains that most believe that the Energy Transition is not a cost, but an opportunity.

Many scenarios are predicated on a continuation of technology-driven cost reductions, mirroring the rapid decline in renewable levelized cost of energy (“LCOE”)over the past decade.

Global LCOE of Newly Commissioned Utility Scale Renewable Power: 2010 and 2020

Renewables have extremely low or even negative variable cost after tax credits are taken into consideration. This should translate into low-cost power, surely a net benefit to the consumer.

The challenge, of course, comes when intermittent power sources comprise a larger and larger portion of the power stack. To be clear, “intermittent” does not necessarily equal “renewable”, as Winter Storm Uri exposed. Power markets which do not provide sufficient incentives for stable, robust generation are apt to fail during periods of stress—exactly the time when power is most important. This is the definition of “fragile”, as defined by Nassim Taleb.²

Creating an “anti-fragile” grid requires investment, which will necessitate higher prices. The more variable dispatch capacity that is added to the grid, the more expensive energy will be because we (the consumer) will need to pay for expensive (rarely used) stand-by capacity, storage, transmission and distribution infrastructure, etc.

In fact, based on Thunder Said Energy’s analysis, power stacks comprised of more than 40-50% renewables will face significantly higher costs due to the investments required to maintain a stable dispatch capability. This is well below the range in most accepted “scenarios” which assume 70-90% renewables in the future.

In addition, while renewable LCOE’s have fallen dramatically over the past 20 years, there are constraints to future cost reductions. Even Moore’s Law, every optimist’s favorite example of the power of technology, is beginning to break down due to physical limits of gate size, source-to-drain leakage, etc. Again, the parallel to the shale boom is too obvious to ignore—assumptions of evergreen technological advancements and productivity gains work extremely well in spreadsheets but rarely manifest themselves in the real world where the laws of physics tend to be much harder to ignore.

It would be a mistake to assume that input costs will fall into perpetuity. Anything that adds to the cost of production -whether it be a carbon tax, maturing geology, an increasingly challenging regulatory backdrop or changes to fiscal terms—is ultimately passed on to the consumer. This is one aspect of commodities that is often underappreciated—both the producer and the consumer are price takers. This conclusion is relevant when considering the outlook for mission-critical commodities like copper and lithium, but also downstream commodities like polysilicon.

It’s clear that at least a portion of the drop in solar LCOE has been driven by 90+% decline in polysilicon prices between 2011 and 2020.

Like many other commodities, polysilicon prices have recovered more recently. While it seems reasonable to expect that current prices will engender a supply response, future price expectations are almost double the recent lows despite a trebling of capacity.

Polysilicon Supply/Demand and Price Expectations

Furthermore, about 70% of polysilicon is manufactured in China using…wait for it…cheap, coal-fired power. A $100/ton carbon tax would more than double the prices shown in the table above. For any commodity, cost inflation results in price inflation.

Lastly, it is important to note that in many cases, renewable installations are struggling to meet modeled parameters. A recent study by kWh Analytics found that incidents of persistent underperformance of solar installations were 13x greater than anticipated over four years, while degradation rates were running 50-140% above the industry standard modelling assumption.³ This real-world variability will impact both realized investor returns as well as grid reliability and, therefore, energy costs.

From an investment perspective, the outlook for a more inflationary Energy Transition has important implications.

1. Higher costs will translate into higher prices—this may slow the pace of the Energy Transition, an outcome which we believe is virtually assured anyway due to the inability of the raw material supply chain to meet the demand inherent in virtually all 2050 net zero scenarios.
2. Higher costs will require investors and policy makers to better understand the carbon abatement cost curve and to focus investments on the most capital-and cost-efficient means of decarbonizing our energy systems while expanding energy access in the developing world.
3. Realized returns on downstream assets such as renewable power installations may be significantly impaired by the combination of higher product costs, higher than expected maintenance costs and lower/more variable output. Conversely, the outlook for critical enabler commodities as well as the owners of long-duration, low-cost producers of these commodities is as attractive as we have seen in the last 25 years.

Why does this matter? Hundreds of billions of dollars have been invested in the Energy Transition already, and a hundred plus trillion will need to be deployed over the next three decades to achieve the mission’s two primary objectives: carbon abatement and addressing global energy poverty. Despite the massive material requirements of this undertaking, and the incredible valuations that exist today for many mission-critical projects, the majority of investors appear to be anchored in a deflationary world view, bound by overly simplistic ESG considerations.

Capital allocators who are serious about achieving net zero status while assisting the billions of people facing energy poverty on a daily basis must actively find opportunities to expand the supply of raw materials necessary to increase the supply of clean, abundant energy. Capital allocators who have a mandate to identify and exploit uncorrelated return streams must look beyond the convenient, well-trodden path of renewables and EV’s where much of the blue-sky scenario is already reflected in asset values and find ways to gain exposure to the same structural trends but with a free option on the unknowable future. And, lastly, capital allocators charged with preserving the long-term purchasing power of their portfolio must find assets classes which both benefit from inflation and where the premium on that insurance policy isn’t so onerous that it defeats the purpose of insurance to begin with. We believe that we are in the very early stages of a cyclical recovery which is coinciding with one of the most important and material-intensive undertakings in the history of mankind. We look forward to helping our clients achieve the emerging dual objectives of the institutional investor—to do well and to do good.

Valuations

While stock prices have improved form the unsustainably low levels of 2019 and early 2020, 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 30-40% 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. Having said that, we would not be at all surprised if we entered a period of stock price volatility despite the very constructive fundamental outlook. In part, this reflects the sharp move in stock prices over the last 12-15 months. In addition, there is a growing list of conflicting signals in the market. The team at Empirical Research put it most succinctly in a recent report.⁴

“The oddities of the Pandemic have made it exceptionally difficult to understand where we stand. The combination of the surging Delta variant, strong inflation data, peaking in the rate-of-change of the domestic economy, less credit creation in China and a more hawkish Fed have produced a dramatic swing in sentiment.”

As a result, our portfolio diversification has increased, and cash levels have risen on the margin.

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 extraordinarily 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.

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 thattargeted 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 forecastor 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. Unless specified, all data is shown before fees, transactions costs and taxes and does not account for the effects of inflation. Management fees, transaction costs, and potential expenses are not considered and would reduce returns. Actual results experienced by advisory clients may vary significantly from the illustrations shown. The information in this presentation, including projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. 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. Performance presented is achieved by SSCP and, prior to June 1, 2014, that achieved at a prior firm unaffiliated with SSCP and at which the accounts were managed by MacKenzie Davis and Ken Settles. SSCP did not calculate the performance data prior to June 1, 2014 but believes such data to be accurate. The indices shown are broad-based securities market indices. They are not subject to management fees, transaction costs and expenses to which a managed fund or account is subject. 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
SECOND QUARTER 2021 GNR COMMENTARY| July20,2021Page 14a 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 WorldCommodity 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. Net of fee returns are presented net of the actual management fees, trading costs, foreign exchange costs, foreign withholding taxes and other direct expenses (including commissions), but before custody charges and other indirect expenses. Gross performance results are net of trading costs, foreign exchange costs, foreign withholding taxes, and other direct expenses (including commissions) but before management fees, custody charges and other indirect expenses. All returns shown assume the reinvestment of dividends and other income. Benchmark returns are gross of withholding taxes. The performance shown is for the stated time period only; due to market volatility, each account’s performance may be different. Returns are expressed in U.S. dollars.

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1. Remember, it was only last year that “experts” were telling you that natural gas was forever a sub-$2.50/mcf commodity. In our experience, these experts rarely have any personal capital exposed to their opinions.
2. Antifragile: Things That Gain From Disorder, Nassim Nicholas Taleb
3. kWh analytics, Solar Risk Assessment 2021
4. Empirical Research Partners, Portfolio Strategy July 2021

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