Commentary

The dislocations created by COVID-19 and the subsequent global economic shutdown have scarred countries and communities around the globe. The path of humanity has been altered, perhaps permanently. Despite the obvious health and financial ramifications, the natural resource industry is one of the few where there is a silver lining to the pandemic as reinvestment has slowed sharply following the initial demand shock. This is a seismic shift from the 2008 and 2015 downturns, which resulted in debt-fueled spending binges that ultimately were disinflationary and quite negative for natural resource investors.

Now, capital is fleeing the industry while longer-term demand begins to recover. This creates a fertile ground for inflation, a risk which investors have been able to ignore for most of the last decade.

While demand shocks capture the headlines, cycles are driven by supply. Production of almost all upstream commodities depletes absent reinvestment, which means that cash flow and/or access to third-party capital determines whether supply is growing or contracting. In shorter cycle commodities such as unconventional natural gas and oil, the rig and frac spread count coupled with well productivity determines supply with a six to nine-month lag. While COVID-19 and the status of OPEC+ production quotas dominated the news cycle, the reality is that North American oil and gas supply was starting to roll over prior to the pandemic.

In large part this was a reaction to lower commodity prices over the course of 2019, although supply rationalization has accelerated in a post-pandemic world of sub-$2.00 natural gas and sub-$40 oil spot pricing. However, the current rig count also reflects the growing realization that production growth is not a measure of capital efficiency or profitability, and that in fact billions of dollars of shareholder capital were spent for naught by management teams and boards that were far more interested in enriching themselves than in creating durable value for their owners.

Certain aspects of the ‘shale revolution’ took on shades of a Ponzi scheme, with consequences that are just now coming home to roost.

The mining industry has already endured the shift from irresponsible growth to capital stewardship, as shareholders forced wholesale management and board changes following the 2015 commodity downturn. From this period of austerity emerged a growing commitment to value over volumes, a focus on returning profits to shareholders, and a distinct unwillingness to deploy capital in exchange for sub-economic returns. Given the long duration nature of the mining industry, the impact on supply has manifested itself more slowly. But, the result of capital constraint is unavoidable and is always the same.

Several years of underinvestment have moderated the rate of production growth and brought the markets back into balance.

E&P companies are beginning to follow the mining industry’s lead, either as a means to renew dialogue with generalist investors or from a recognition that Net Asset Value is a function of free cash flow in the hands of the owner, not a formula in Excel. Compensation plans are increasingly weighted towards value metrics, although there is clearly more progress to be made.

In addition, a growing cohort of companies have begun to return capital to shareholders and are committing to maintaining that discipline going forward. While more rationalization is needed, the patient clearly is on the mend.

The trends toward equilibrium are evident in an analysis of supply/demand balances. The IEA’sJuly Oil Market report reveals just how historic both the supply and demand shocks were for the oil markets. Demand fell almost 11 million barrels per day (Mbpd) in the first half of 2020 and is expected to be down just under 8Mbpd for the year, or 8%. This is by far the worst demand figure on record. Conversely, supply fell almost 14Mbpd between April and June, and is currently at a nine-year low. 2021 demand is expected to recover by 5.5Mbpd, while supply is up only 1.7Mbpd. Thus, 1.4Mbpd of over-supply in 2020 (representing about a single year of demand growth) flips to a material 2.2Mbpd deficit in 2021. While OPEC spare capacity has increased from 2Mbpd to 8Mbpd at the end of the second quarter, there are limited options for incremental supply absent significantly higher commodity prices. Long-cycle projects have been undermined by almost a decade of falling commodity prices and rising volatility.

Short-cycle supply, aka US shale, does not work sub-$50. Any claim to the contrary has now been put to rest, as it is clear that well productivity is rolling over and that core inventory is far more limited than has been suggested over the past decade. The relationship between well spacing and productivity is easily observed for all basins and is illustrated below using the Permian Basin as an example.

There is still significant oil above ground which needs to be worked through. However, declining well productivity and less inventory from the area which has met almost 100% of incremental demand growth over the past decade means that the oil market will move into a much tighter balance in the future. Near term risk may be to the downside, given the uncertain global economic backdrop, but beyond that there is a far greater probability that we enter a period of $70-$100 oil prices than we revisit sub-$30 for any extended period of time. In natural gas, global inventories are elevated.

In part this is a function of COVID-related demand weakness, as evidenced by the precipitous drop in LNG volumes from US liquefaction facilities.

Of interest, however, is the fact that injections and withdrawals have not been that far off the five-year average thus far in 2020.

This is because supply has fallen as well, driven by a sharp decline in the natural gas rig count, particularly in higher cost basins such as the Haynesville and Utica shales.

Of equal importance, the flood of associated gas from plays like the SCOOP/STACK and Permian, which was supposed to support sub-$2.50 gas prices into the next decade, has failed to materialize.

Because of the constraints of storage and the highly seasonal nature of demand, North American natural gas markets must reset each year. At the current rig count, the combination of natural gas production and existing inventory will struggle to meet demand, setting the stage for higher prices.

In copper, COVID-19 has proven to be a double-edged sword, with mine supply disruptions impacting what was already a tightening market.

China demand has recovered much more quickly than we would have guessed, with June unwrought copper imports hitting a new record.

The result is near-decade low inventories despite the negative demand impact of the US/China trade war and concerns related to the pandemic.

Copper prices are rapidly approaching the pre-trade war levels of early 2018, and the market appears set to be in delicate balance or deficit over the next several years. The fundamental improvement in corporate behavior and the cyclical improvement across most commodity markets remains largely unrecognized by the market, overshadowed by share price volatility, oil and gas bankruptcies¹ and COVID-19-related demand concerns. While the current environment is anything but normal, the dislocation between fundamentals and valuation is not unprecedented and is simply a reflection of the exodus of capital that marks the end of one cycle and the beginning of another.

Company-Specific Value Creation

It is always more straightforward (and more enjoyable!) to invest with commodity beta as a tailwind, and we are in the very early stages of the transition from overcapacity to much tighter markets. However, 25 years of experience has reminded us again and again that our industry is cyclical and that over time commodity-related returns tend to mean revert. As a result, we want to focus on what drives differentiated returns across a cycle. The following is a summary of our annual analysis of company-specific value creation which we conduct after receiving year-end reserve reports in the spring. The analysis provides insight into how assets are performing versus expectations and how cost curves are evolving. In addition, it is a lens through which we can objectively grade management on their universal pledge to “create value for shareholders².” Despite another year of commodity price volatility, your portfolio companies fared quite well in 2019 when viewed through a fundamental prism.

The following table shows drilling rates of return and production growth, where applicable, as well as our estimates of NAV growth³ for the primary positions in the portfolio.

(1) Drilling returns are calculated pre-tax, including G&A using the 2019 year-end strip. Drilling returns are shown for all companies in the portfolio as of June 30, 2020, except the mining companies. Portfolio holdings are subject to change and should not be considered a recommendation to buy or sell specific securities. The specific securities identified are not representative of all securities, purchased or sold or recommended for advisory clients, and it should not be assumed that investment in the securities identified was or is profitable.
(2)Cabot Oil & Gas is not currently held in the portfolios; it is a well-known industry name which has been included as a reference point.ARCResources was not in the portfolio at quarter end but is today. Past performance is no guarantee of future results. Please see the end of this letter for important disclosure.
(3) Stock return shown for SRC Energy. PDC Energy merger with SRC Energy announced in August 2019 and closed January 2020.
Sources: FactSet, SailingStone Capital analysis, 2Q 2020

Starting with drilling returns, there are a number of points to highlight. First, natural gas drilling returns remained fairly robust in 2019, despite depressed commodity prices and, in the case of the Canadian names, abnormally wide differentials which negatively impacted realizations. This speaks to the steepness of the cost curve and the low-cost position that your portfolio companies hold. Second, full-cycle oil returns are challenging in a sub-$50 market even in the best areas. Lastly, more conventional oil plays are superior to shale oil.

One of the reasons that we spend so much time analyzing well returns is to be ahead of the impact of improving/deteriorating well performance relative to reported financial results. The correlation of drilling returns and recycle ratios is a good illustration of this dynamic.

While we do not have enough data points to draw a clean trendline for oil companies, there is no reason to believe that the relationship would be much different than the strong correlations that we see in natural gas. Two stocks –CDEV and COG –are aberrations with relatively high recycle ratios compared to drilling returns. This suggests a deterioration in capital efficiencies, with legacy production impacting the recycle ratio (calculated from reported financials) while drilling returns are more reflective of current and future expected results. We can corroborate this conclusion by vintaging well performance for each operator, which in this case is simple since both primarily are single-asset companies.

The decline in per-well cumulative production over time is indicative of a maturing core. While historical returns were attractive, and in the case of Cabot have translated into strong NAV growth, the future looks more challenging. An objective review of well performance and spacing assumptions over the last few years led us to exit shale oil and instead focus on natural gas and more conventional oil plays which exhibit attractive, sustainable returns.

In terms of NAV growth, the portfolio companies continue to compound economic value, with natural gas names at the upper end of our expected 10-20% range and the oil companies in the lower half. Annual NAV growth can be lumpy, driven by specific investments which reduce current year NAV but set the stage for much higher growth going forward. This is the case with ARC Resources, which spent $270mm on facilities in 2019 with no corresponding impact on current year cash flows. Conversely, RRC executed a series of highly NAV accretive asset sales which boosted NAV relative to production growth (a proxy for capital spending).

Mining company NAV growth was impacted by the COVID-19 related delay at Cobre Panama (“CP”) and by a reduction in underground reserves at Oyu Tolgoi (“OT”) as the result of the revised mine plan. For the sake of conservatism, we have kept NAV’s flat with last year as we do not have complete visibility into how CP will ramp up nor into the final mine plan at OT. Overall, portfolio NAV grew at about 10-15% in 2019, generally consistent with the track record over time. This fact has not been reflected in equity prices.

Valuations

Despite the sharp recovery in valuations in the quarter, many natural resource equities remain historically inexpensive on both an absolute and relative basis. This is particularly noteworthy given the structural improvements in fundamentals which we have already discussed. Since passive and trend-following strategies now dominate equity volumes, stocks can move to levels which no objective business analyst would argue is a reasonable reflection of intrinsic value. We have lived through one extreme, as portfolio equity valuations have discounted deeply impaired bankruptcy scenarios and permanently depressed commodity prices over the past couple of years, even though there was very limited liquidity risk in the portfolio.

Of course, the opposite might be true as well. What would the space look like if “the machines” determined that inflation was a potential risk, that the US dollar might remain under pressure and that mid-cap upstream resource stocks were among the most attractive investment options, as opposed to the least? As fundamentals continue to improve (which, we believe, they will absent a sudden reacceleration of capital investment) and as natural resource stocks exhibit “momentum” off “historically oversold levels,” isn’t it plausible that high quality, well-run resource companies generating attractive returns on capital and returning excess profits to their owners could garner premium valuations, instead of steep discounts?

Dreamers dream, and cycles mean revert. What we know today is that the portfolio continues to trade at about a 70%discount to NAV using our assessment of marginal cost, or the prices necessary to meet current levels of demand. More immediately, the portfolio is generating mid-to high-teens free cash flow yields at current strip prices, which we expect to increase to mid-to high-twenties over the coming years. These are prices for which there is no precedent, particularly given the fact that many of the portfolio companies are the sole owners of the lowest cost, most economic inventory which will be required to meet future demand. Instead of trading as companies heading into receivership, we contend that these companies should garner valuations more consistent with their scarcity value over time.

From a relative perspective, it is interesting to contemplate how the resource space stacks up versus other asset classes. Resource stocks clearly are not in the top percentile of historical valuations.

Relative to gold, tech valuations look less extreme than the late 1990s but well above historical averages.

Conversely, oil relative to gold is just below Depression-era levels and the second cheapest since the 1860s.

160 years is a long time, even for the most patient investor.

The impact of capital scarcity on valuations is evident even within an asset class. ETF flows into growth have accelerated since 2018.

Furthermore, within ESG mandates, growth sectors are significantly overweight at the expense of value.

Not surprisingly, this has created a historic valuation gap between Growth and Value.

For context, the market cap of the “Big 5” (Amazon, Apple, Facebook, Google, Microsoft) appreciated by $470 billion through the first seven trading days of July⁴. Forty-five minutes worth of that incremental value would cover the purchase of Antero, EQT, Range and Southwestern and provide the owner with complete control of the North American natural gas market for the next decade, assuming that they could obtain FTC approval.

All of which is to say that natural resource equities appear cheap on both an absolute and relative basis at a time when some are beginning to question valuations in other sectors and asset classes. We expect that as fundamentals continue to improve, stock prices will follow. Better returns and more constructive corporate behavior likely will require the investment community to contemplate a more nuanced approach to certain “roadblock” issues that have emerged over the past few years.

On ESG

One of the primary pushbacks we hear about investing in the natural resource space is related to ESGconcerns. We are struck by the fact that “ESG” has evolved into an investment style and is close to becoming an asset class unto itself. Environmental, social/safety and governance factors have always had a direct impact on the economic viability and value of any company. As a result, we contend that assessing these risks is a central tenant of a fundamental research process. We have invested thousands of hours conducting onsite due diligence on projects around the globe to ensure that your portfolio companies are some of the safest, most efficient operators in their space with strong environmental performance and much improved governance standards. We are extremely proud of our ESG track record.

Specific to the commodity space, there is a growing belief among some institutions that divestment is the optimal approach to achieve reductions in greenhouse gas (“GHG) emissions while meeting the ESG demands of their constituents. Putting aside the debate of whether to divest from the producer of the desired good or the consumer creating that demand, broad-based divestment decisions specifically and immediately undermine the ability to achieve the stated objectives of reduced GHG emissions and expanded energy access. While there are some commodities such as thermal coal which are clear losers in the path towards zero emissions, other commodities such as natural gas and copper are key enablers of the energy transition, as we discussed in a recent white paper. It wasn’t lost on us that Warren Buffett has an equally constructive view of long-term natural gas demand, as evidenced by Berkshire Hathaway’s $9.7bn acquisition of Dominion’s natural gas transportation and storage assets plus a 25% stake in the Cove Point LNG project, Berkshire’s largest purchase in the last four years.

Summary

Perhaps counterintuitively, recent demand shocks have improved the outlook for commodities by extending the depth and duration of the capital rationalization process that was already in motion. Even after the second quarter rebound, resource stocks are trading at historic discounts to intrinsic value in large part because ESG mandates and trend-following strategies are following the same signal: momentum.

The recent improvement in valuations is a good start, although we expect that further appreciation will be accompanied with volatility. This is fairly normal in the transition period between cycles. We are confident that the intrinsic value of your portfolio continues to compound, that the likelihood of permanent capital impairment is extremely low and that current equity prices ascribe no value to the long-lived, low-cost core inventory that you own nor to the potential for higher future commodity prices. We expect that the demand backdrop will remain uncertain but that supply curtailments will set the stage for the next upcycle as human behavior normalizes far more quickly than production.

As commodity fundamentals improve and with more companies acting as responsible stewards of their owners’ capital, we believe that the outlook is quite promising. In fact, the prospect of positive beta in addition to historically depressed valuations creates the opportunity to generate some of the most attractive risk-adjusted returns that we have witnessed in our careers, all of which can be achieved in a manner that is consistent with ESG and GHG objectives. In other words, it is still early. Long-term, counter-cyclical investors would be wise to take notice.

Operational Update

Kathlyne Kiaie, Chief Compliance Officer, left the firm on April 30thafter 6+ years of dedicated service. Kathlyne was instrumental in building out our robust compliance program and integrating it into all aspects of our firm. Kathlyne’s focus has historically been on start-ups and she did an outstanding job in helping build an institutional-grade compliance program. As part of a planned transition, Henry Tran was promoted to Deputy CCO earlier this year to take on full responsibility for our compliance program. Kathlyne hired Henry in February 2016 as Trade Compliance Officer with a plan to move him into the CCO role at the appropriate time. Henry came to SailingStone with over 10 years of compliance, operations and risk experience in the financial services industry. Prior toSailingStone, Henry was a Compliance Consultant at Wells Capital Management where he was responsible for portfolio compliance monitoring across fixed income, separately managed accounts, insurance, private funds and registered investment companies. Previously, he worked as a Compliance Analyst at both Balyasny Asset Management and Osterweis Capital Management. Henry has already proven he is capable of filling the CCO role and has our full confidence. We thank Kathlyne and wish her well in her future endeavors.

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

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1. $30.6 billion through 6/30/20, according to Haynes Boones. This is more than any full year since 2016 and represents about 20% of the $152 billion that has been restructured between 2015-2020.
2. We have met with literally thousands of executives over the course of our careers and all of them make the pledge. Remarkably, very few can articulate the math behind the mantra or produce any data which show that they have been successful.
3. NAV growth is simply the value of reserves (calculated at a fixed commodity price deck) less net debt divided by shares outstanding. If Value Creation = Capital Deployed*Excess Returns, the only way Assets (the economic value of reserves) grows faster than Liabilities+Equity is if cash-on-cash returns exceed the cost of capital. Drilling rate of return is the IRR related to spending exploration and development capital in exchange for current and future cash flows associated with wells that were drilled and completed in the year. Production growth reflects both underlying depletion rates and the quantum of capital reinvested, and recycle ratio is unit cash margins/unit finding and development costs as crude measure of cash-on-cash returns. Simplistically, companies that generate attractive drilling returns and recycle ratios at the strip AND who invest capital in drilling should be able to grow NAV at 10-20% per year consistently across a commodity price cycle. For mining companies, reserve additions are more lumpy but long-lived reserves tend to result in NAV growth of about 10% per year as ore is turned to free cash flow with no material reduction in the time-weighted value of reserves.
4. Goldman Sachs Research, July 13, 2020

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