COMMENTARY

In our 2021 year-end letter, we discussed four themes to watch in 2022.

1. Chinks in the Armor – the emerging reality of more frequent energy crises and elevated energy price volatility. Geopolitical events aside, these largely are outcomes of well-intentioned but misinformed policies in support of global decarbonization efforts.
2. Structural Deficits and Scarcity Value – a growing awareness that resource constraints will moderate the pace of decarbonization/electrification. Addressing this issue will require strong price signals from the market and should manifest itself in significant value ascribed to the owners of low-cost, long-duration production and cash flow streams. Rising raw material prices will flow through to the cost of intermediary and finished goods. Thankfully, technological innovation will help mitigate, but not eliminate, these dynamics.
3. A More Nuanced Approach to ESG – a shift away from overly simplistic divestment decisions towards a more engaged dialogue between capital allocators and industry participants to accelerate the production of key raw materials. In part, these discussions are being driven by institutional allocators coming to terms with a more inflationary outlook than they have faced over the last ten years. For manufacturers, it reflects a realization that the inputs necessary for future growth simply won’t be available if they don’t actively support responsible resource development.
4. The Beginning of a New Regime – both in terms of market leadership and more broadly in terms of rising populism and the destabilizing nature of structural inflationary pressures.

As we look forward to 2023, these themes are still playing out, and in many cases are only just beginning to be acknowledged by market participants and policy makers. These are long wave dynamics and as a result, our focal points for the coming year in some ways are extensions or corollaries of what we were watching in 2022.

1.   Commodity Markets Are Tight.

For the most part, commodity markets remain tight, with low above-ground inventories and limited spare capacity.

While absolute inventories are low, they are even more striking in the context of days of demand, with copper sitting at three days to cover.

This is the lowest level since 2004 when global demand growth was running at 10% per year, fueled by the rapid industrialization of emerging market economies and China’s entry into the WTO. In contrast, 2022 demand increased by around 0.5%, well below long-term trends. While markets are celebrating “disinflation”, what we are witnessing is simply base effect – comping generationally high levels of inflation with slightly lower readings. With inventories low despite lackluster demand, limited spare capacity, and rising marginal costs, we expect the outlook for commodity inflation to remain relatively elevated over the next five to ten years.

2.   Thank Goodness for Natural Gas.

While admittedly not a quote from Gavin Newsom it is nevertheless an economic reality. In contrast to many commodities, natural gas inventories are healthy, and both global and domestic prices are well off recent highs.

In part, this is due to demand destruction in Europe and part due to warmer than normal weather on both sides of the Atlantic. The root cause, however, is the fact that North American natural gas is very low-cost relative to the rest of the world, meaning that we have an abundant, and cheap source of lower carbon fuel right in our backyard that can respond quickly to domestic and international price signals. The rapid proliferation of renewables combined with and enabled by the availability of low-cost natural gas has allowed the US to meaningfully reduce the carbon intensity of its power stack and maintain strong economic growth over the last 15 years, with GDP up almost 50% over that time frame. Together, the two energy sources have cut US reliance on coal for electricity by 60+% and largely eliminated oil-fired generation, critical steps in the fight to halt climate change.

How fortunate are North American consumers and businesses to have access to such a resource? If the US was burdened with EU natural gas prices in 2022, it would have represented approximately an incremental $1 trillion expense, 3.5% of GDP vs a realized growth rate of approximately 2.9%.

For illustrative purposes, look at power prices in the US, UK, and Europe in 2021 and 2022. Since natural gas-fired capacity is often on the margin, differences in natural gas prices show up in wholesale spot power prices.

In short, the US avoided a recession and continued to reduce its carbon footprint due to our low-cost reserves of natural gas. Thank goodness for natural gas.

Many regulators and pundits want to ban natural gas because it is a hydrocarbon. While we appreciate the point, it simply isn’t feasible today and likely won’t be in the foreseeable future for three very important reasons:

1.  Natural gas is both available (current proved reserves more than 50x current consumption on a global basis) and inexpensive relative to other fuel options on an energy-equivalent basis as well as at the household level.

2.  Natural gas-fired power plants are key to maintaining the integrity and stability of the grid, particularly as intermittent, non-dispatchable wind and solar development rates accelerate.

3.  Natural gas is one of the most effective ways to mitigate carbon emissions at scale today and into the future. Because it is low-cost, abundant, and relatively straightforward to transport and store, natural gas could be used to mitigate the rapid expansion of coal-fired power generation which is occurring in both western and emerging markets, much as the US has done over the past 15 years. In 2022, European coal consumption almost completely offset reductions in US demand, increasing by 29 million tonnes (“Mt”) vs a 31 Mt drop in the US due to Europe’s lack of available natural gas. In fact, according to the IEA, global coal demand set a record in 2022, surpassing eight billion tonnes for the first time. While US and European coal demand is expected to fall over the next three years as natural gas prices normalize and coal-to-gas switching continues, demand in China and India is expected to overwhelm those declines.

Carbon dioxide has a half-life that is 12x longer than methane, meaning that emission reductions today have a profound impact on climate targets set 20 and 30 years into the future. Critically, supplanting coal with natural gas isn’t a Faustian bargain – it is simply sound climate and economic policy. As we have seen in the US, it is possible to couple renewable growth with increased natural gas consumption to displace coal from the power stack and still support a vibrant economy. Governments in China and India aren’t building new coal-fired capacity because they are evil – they are doing it to make sure that their populations and economies maintain access to cheap, stable sources of energy.

In conclusion, we continue to believe that the answer to the energy transition is “Yes”: more renewables, more conservation, more efficiency gains, more technological innovation, and more natural gas. Rob West at Thunder Said Energy captures this perfectly in his latest roadmap to “net zero.”

Mitigating air pollution – in all of its forms – is a worthy objective, one which will take every ounce of our collective will, resourcefulness, and innovative spirit. But the problems are complex and need to be addressed with data and pragmatism. Aspirations shouldn’t be confused with reality. As Henry David Thoreau put it in Walden, “If you have built castles in the air, your work need not be lost; that is where they should be. Now put the foundations under them.” Natural gas is part of that foundation. Thank goodness for natural gas.

3.  Life on the Margin – Shale Oil.

While North American businesses and consumers have been the primary beneficiary of shale gas, shale oil has been a boon for the entire world. Indeed, for more than a decade, shale oil met almost 100% of incremental oil demand. Moreover, unfettered access to capital and a blind obsession with growth meant that those barrels came onto the market at prices well below what would otherwise have been the case, contributing to an extended period of benign inflation.

Unfortunately, neither unconventional oil nor investors’ capital is an infinite resource, a reality that is just now coming into focus for the market. To understand the implications for the global economy and investors, it is helpful to examine the underlying issues.

First, it is interesting to note the differences between the global natural gas cost curve and the global oil cost curve.

North American shale gas sits at the bottom of a reasonably steep cost curve, while shale oil sits at the high end of a cost curve that is steep in the first half but relatively flat thereafter. North American shale oil is by definition a marginal asset.

Second, it was only a few years ago that shale oil was believed to be the beneficiary of technological breakthroughs that were going to yield perpetual “productivity gains” that in turn would keep break-even prices well below $50 per barrel into the future. Unfortunately, the data didn’t reconcile with the narrative.

The graph below is from a report we wrote more than five years ago called Shale Technology: Moore’s Law or Turgot’s?, which can be found here. In it, we examined well productivity across the major shale oil basins and discovered that while the average well was improving over time, the best wells weren’t getting better. In fact, outside of the ability to drill longer laterals, the majority of the improvement was simply a function of high grading.

Since there isn’t an endless inventory of undrilled locations, drilling the best wells today leaves lower-quality wells to be drilled in the future. And, in fact, this is exactly what we see when examining well performance over time.

To be clear, we are showing EOG in the Delaware Basin because both are best-in-class. If the best is getting worse, lower-quality acreage managed by less sophisticated operators must be suffering even more. US shale, the marginal global oil producer, is suffering from asset exhaustion.

This has important implications for the global economy and investors alike. While oil prices recently have been pressured by recession fears, the risk over the intermediate term is to the upside. Limited spare capacity and a lack of reinvestment (themes that are now replete across the commodity space) mean that incremental supply will need a price signal. However, in oil, the only meaningful sources of supply are OPEC, with its own agenda. and the US, where companies need both a commodity and a stock price signal to boost production, as we will discuss in more detail below.

Higher oil prices cut economic growth rates and increase inflation, with the Fed estimating that a $10 per barrel rise in oil prices cuts GDP growth by 0.1% and increases inflation by 0.2%, a figure echoed by ECB research. Perhaps more importantly, higher oil prices raise inflation expectations.

While investors celebrate lower inflation reading today, oil consumption is accelerating as the world continues to recover from the pandemic and as China begins to reopen.

More oil requires higher prices.

At some point, oil demand will start to decouple from the global economy, but we believe that outcome will be a function of price-induced demand destruction, not fantastical claims of autonomous taxi services, particularly over the intermediate term. Oil will be $120 before it’s $12, with serious implications for long-term portfolios that suffer from lower economic growth and higher inflation.

For an investor, the prospect of owning commodity-producing companies that sit at the high end of the cost curve should be reason to pause. Buying oil companies with a view on the commodity is great, particularly if you happen to be the unicorn that can predict short-term price volatility on a repeatable basis. Otherwise, the only reason to own a company versus the commodity is if that company can provide a return stream above and beyond commodity beta. This can only come as the result of economic value creation, which in turn is a function of the cash-on-cash returns generated by management’s capital allocation decisions.

It is extraordinarily difficult to generate excess returns in a commodity or commoditized business, and in our experience, that return stream is predicated on the shape of the cost curve and where a specific asset sits on that curve. Even the very best North American oil companies sit at the high end of the global cost curve and as a result, have generated commodity-like returns over the last cycle. This is in stark contrast to their peers in natural gas and copper, two commodities where the bottom end of the cost curve is accessible to most investors.

This conclusion is corroborated by looking at the value destruction in the E&P space during the shale revolution.

What was historically an industry that earned approximately its cost of capital (Enterprise Value/Gross Capital Invested =~1x) became one which destroyed hundreds of billions of dollars, the result of low returns and too much capital. The value destruction was particularly acute in the 2015-2020 timeframe. Even with the recent recovery in oil and the capital discipline exhibited by management, the market still doesn’t believe that companies are generating an economic return, a conclusion with which we agree.

Unconventional oil plays require higher commodity prices to generate a return. As returns improve, share prices will rise, and oil companies will receive the dual signals required to accelerate development. However, the quality and depth of the remaining shale oil inventory are diminishing, which means that future production will require higher oil prices to generate break-even economics. Shale oil is a reflexive dilemma, which is constructive for the commodity but perhaps not so much for the broader economy nor many investors, few of whom are well positioned to manage through an extended period of higher inflation.

4.  What’s Good for the Goose…

…isn’t necessarily good for the gander. One of the most striking aspects of the resource industry over the last few years is the emergence of capital discipline. To paraphrase Ronald Reagan, this is an industry that historically “(spent) like drunken sailors, but that would be unfair to drunken sailors because sailors are spending their own money.”

More recently, however, the industry has become far more spendthrift. The deep-pocketed uncle suddenly has alligator arms, the result of a confluence of factors including changes in executive compensation plans which incentivize value creation and free cash flow generation over profitless growth, constrained access to third-party capital driven by ESG and divestment considerations, a lack of viable resources to develop, and finally a chaotic regulatory environment created by politicians and policy advocates who demonize extractive industries and simultaneously attack them for not reinvesting (go to the 1:20 mark of this video for an example of this hypocrisy).

Whatever the reasons, the result of a lack of reinvestment is higher commodity prices than would be the case if the industry was spending at historical rates. Companies have benefited in the form of higher returns on capital and much improved balance sheets, as evidenced in these snapshots of the mining industry.

Interestingly enough, these realities don’t seem to have flowed through to equity markets.

Eventually, however, valuations will reflect business fundamentals, meaning that the current environment is particularly well suited for long-term investors who are interested in capturing both the unique, less correlated return stream driven by company-specific value creation and the inflation benefits of being long capital-intensive products that face structurally rising costs and limited access to capital. Paradoxically, the future is bright for low-cost, responsible producers of the building blocks of today and a decarbonized tomorrow for precisely the reasons that it will be so difficult to achieve those objectives. Resource constraints, resource exhaustion, and a lack of investment will keep commodity prices elevated and allow advantaged producers to generate attractive returns while the broader economy suffers from inflationary pressures and material scarcity. What’s good for the goose is, unfortunately, not always good for the gander.

5.  Does Anybody Got a Dime?

There is a memorable scene in Blazing Saddles (Mel Brooks, 1974) where the posse encounters a toll booth sitting in the midst of the desert, 10¢ per person. The sheriff turns to his crew, asks for change, and then orders someone back to get…a very large quantity of dimes.

This scene comes to mind every time we get into a conversation about the energy transition. A few years ago, we started talking about a $150 trillion price tag over 30 years to reach net zero, and we felt confident that the risks to both quantum and timeframe were to the upside. At the time, our estimates were met with skepticism, but there is a growing awareness that the capital intensity of the energy transition will be far higher than previously anticipated.

Even if the money was available, we contend that there are serious constraints to achieving net zero in the allotted timeframe. Fortunately, western governments are beginning to embrace this reality, most notably in the US with the recently passed Bipartisan Infrastructure Law and the Inflation Reduction Act. The impact on reshoring manufacturing capacity has been profound, as evidenced by the map below.

From our perspective, however, the real challenge lies with the resource base. While we absolutely need to break China’s hegemony over processing, manufacturing, and assembly capacity in areas like rare earth oxides, nickel laterite, copper smelting, and batteries, that can be and is being accomplished. The barriers to entry are relatively low in the grand scheme of the problem. Finding and developing new, economically and technically viable sources of rare earths, nickel, copper, scandium, vanadium….the list goes on…is a far more daunting task. There are no shortcuts to the billions of dollars and decades required to discover, build, and commercialize a large-scale mine.

More importantly, there is no getting around the fact that in many cases we are talking about elements, which the Oxford dictionary defines as “each of more than one hundred substances that cannot be chemically interconverted or broken down into simpler substances and are primary constituents of matter.”

In other words, resource availability is a challenge that will be difficult, if not impossible, to engineer around. Alchemy is not a solution, nor is ignorance, willful or otherwise. The solution requires innovation, conservation, efficiency gains, and ultimately hundreds of billions if not trillions of dollars of risk capital, capital that requires an adequate risk-adjusted return.

This gets us to an important consideration – the source of said capital. Over the past 15 years, we have been trained to rely on governments to bail society out of its problems. To a certain extent, this approach made sense, particularly given the magnitude of challenges related to the Global Financial Crisis and COVID. But, like everything in life, moderation is the key. The problem with relying too much on government largess is that the existing obligations are large and growing.

Inflation, of course, makes the issue much more pernicious, with some estimates showing that the combination of entitlements, mandatory spending, and interest payments will surpass federal government revenue in the next decade.

Achieving climate goals will require more money. Meeting entitlement commitments will require more money. Paying interest on and refinancing high and rising federal debt will require more money.

There are only two ways for a government to get more money – collect it and print it. Incremental taxes will eventually undermine economic growth while printing money tends to be inflationary, especially when the money is funding consumption, not production.

We believe that monetary and fiscal inflationary pressures will be exacerbated by rising marginal costs for many commodities, especially given the need for incremental supply to both sustain the global economy and enable the energy transition.

History suggests that rising inflation coincides with periods of rising populism, which in turn often leads to periods of economic and geopolitical instability.

History may not repeat itself, but it is helpful to understand the historical context as we look forward. Fortunately, many of these issues are not impossible to solve, but they do require a level-headed approach. There is no singular path forward, and, as we discussed above, almost certainly the answer is “yes.” One thing we know for sure – we definitely are going to need some more dimes.

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. In addition, appreciation for supply issues in commodities like copper seems almost the consensus today. Combined with the obvious need for copper, nickel, etc to “electrify the world”, you’ve got quite a narrative. We are waiting to get into a conversation about Escondido grade profiles or Codelco’s volume projections at the next PTA meeting.

The challenge, of course, is what to do with this information. It’s analogous to receiving the opening kickoff in the Super Bowl. You’ve caught the ball. Now what? Unless you’ve spent time developing, operating, and/or underwriting projects all over the world across an array of different industries over the last few decades, it’s difficult to fathom the landscape facing the natural resource sector, a landscape that will present both opportunities and risks for investors. Caveat emptor.

More broadly, we believe that a period of heightened volatility and inflation expectations will eventually result in the market assigning a premium to sustainable cash flow streams, particularly when those cash flows are associated with the responsible production of a key raw material, service, or technology that is helping to enable decarbonization paths while sustaining 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 turn out to be another strong cycle for commodities. Skepticism, ignorance, and policy are starving capital-intensive industries of the fuel 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 shareholders, 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 our future estimates of NAV. 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

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