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Monthly Commentary from Dan Pickering

A September to remember. Energy had a strong month while overall markets were lackluster/weak. Against the backdrop of the S&P 500 falling -4.8%, energy indices played a little rock-and-roll with Diversified Energy adding +9.7% (S&P1500 Energy, S15ENRS), Upstream/E&P jumping +17.0% (XOP), oilfield services gaining +6.0% (OIH) and Midstream adding +3.0% (AMZ). Oil popped +9.5% (~$75/bbl), while gas roared another +35.1% to finish the month at ~$5.90/mcf.

Shazam! WTI oil closed September at ~$75/bbl and (briefly) touched $80/bbl since then. Global OECD inventories are below the 5-year average as demand has continued its recovery from covid lows and Hurricane Ida took ~30mmbbls offline in the US Gulf of Mexico. Meanwhile, sky-high European and Asian gas prices resulted in almost 500kbbls/day of demand switching from gas to oil!!! Despite oil price strength, OPEC continued its slow-and-steady approach to bringing production back to the market, leaving November’s game plan unchanged at +400kbopd. Finally, oil’s move over $77/bbl in early October represented an important technical breakout, opening up mid-high $80’s as the next “level”.

Big Wall Street banks are as bullish as we’ve seen them in the past 5+ years. Goldman Sachs has been talking $80/bbl for a while, and JP Morgan’s global strategist just signaled global economies can endure $130/bbl WTI (and 2.5% interest rates) without adverse impacts. Sheesh…what a difference nine months makes. At the beginning of 2021, the WTI forward curve was flattish, with the 2021 calendar year trading at ~$48/bbl and 2025 calendar year at ~$45/bbl. At the end of September 2021, those two contracts are trading ~$74.60 (+55% YTD) and $56.60/bbl (+26%), respectively. We’d expect OPEC supply acceleration to dampen further near-term oil price rallies, but respect the power of momentum and the near-term bias clearly has an upside feel. We’ve stated our expectation of a $60-$80/bbl fundamental trading range, so oil now feels a bit expensive in the short term and remains cheap in the long term.

International gas prices went nuts during September as Europe and Asia fought over incremental LNG cargoes. Gas prices traded over $30/mmbtu (>$150/bbl oil equivalent) with low inventories and fear of a cold winter driving the surge. China’s central government officials supposedly instructed Chinese energy industry players to “procure supply at all costs”. The term “energy crisis” is now frequently mentioned and countries across Europe are implementing everything from consumer subsidies to discussions around a windfall profits tax. US front-month gas prices rose +35% in tandem with European tightness. Elevated prices are likely the norm until there is some visibility on the severity of European winter.

More reasonable gas prices will likely return in 2022, but September was a shot across the bow for those pushing for rapid global decarbonization. As Europe rushed toward renewables and deemphasized or decommissioned nuke, coal and natural gas, their system has become inherently more volatile. Volatility translates to higher costs in periods of tightness. US policymakers should take note. But they aren’t. US Secretary of State Blinken cited high European prices as “reinforcing the need for a transition to new forms of energy, particularly sustainable energy…” We remain firmly in the all-of-the-above camp.

Looking to the energy transition, unless delayed due to covid, the 2021 UN Climate Change Conference (COP26) in Glasgow, Scotland begins at the end of October and runs for ~10 days. We expect a serious amount of decarbonization press and some eye-catching proclamations and goals. We’ve commented extensively on the achievability of many of these goals. We believe NetZero 2050 is aspirational, not practical. We are firmly convinced that decarbonization efforts are a megatrend that will be the biggest capital deployment of our lifetime. But results will take longer than hoped. Investing around this theme absolutely makes sense. Investing carefully is paramount. Sidenote which might win you a trivia contest beer – the conference is known as COP26 because it is 1) a Conference of Parties associated with the original 1994 UN climate treaty and 2) it is the 26th meeting of the group.

Turning to energy investing, it was a good month to be long. Conventional wisdom says energy has become such a small portion of the S&P500 (under 3%) that institutional money managers don’t have to pay attention. Absolutely true when the sector is languishing. Absolutely not true when commodity prices are ripping, inflation is the topic du jour and the energy sector is outpacing the S&P500 by a meaningful amount. A perfect example of the cliché of climbing the wall of worry. At the end of September, prices averaged ~$62.50/bbl WTI and ~3.55/mcf Henry Hub through 2025. The energy sector will print MOUNTAINS of cash at these levels, and it seems like much of it will be returned to shareholders for the next few years. This is Goldilocks territory. Per data from Wolfe Research, using current 2022 futures prices and current hedges (which are well below the money), larger cap E&Ps are trading at 4x EV/EBITDA (ranging from 2.7x for MRO to 5.1x for HES) with free cash yields at 16% (ranging from 23% MRO to 7% HES). At these kinds of valuations, the inevitable oilpatch volatility is worth enduring. Who cares how much these names are up off the bottom? In our opinion, there is much more to go.

As always, we welcome your questions and appreciate your interest.

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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. Source: Evercore ISI, July 13, 2021

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.

Source: Hedgeye, July 13, 2021The 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. Source: Evercore ISI, Company Surveys, July 14, 2021

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 consumeras 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) an 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-costpower, surely a net benefit to the consumer.

Source: IRENA, World Energy Transitions Outlook, June 2021The 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.

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 a 90+% decline in polysilicon prices between 2011 and 2020.

Like many other commodities,polysilicon prices have recoveredmore 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 anycommodity, 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 modeling assumption.2This 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 any way 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.