“The remarkable feature about physical laws is that they apply everywhere whether or not you choose to believe in them. After the laws of physics, everything else is an opinion.” —Neil deGrasse Tyson
For the past few years, our conversations with asset allocators have revolved around four core topics:
Recent events, ranging from the U.K. energy crisis last fall to supply fears created by Russia’s actions in Europe, have brought many of these issues into sharper focus. In fact, we were pleased to read a recent report from JPMorgan Chief Global Market Strategist Marko Kolanovic, whom we hold in high regard. In the introduction to Global Energy Outlook, Marko writes,
“The world is in the midst of an energy crisis. It is an economic crisis, but also one related to geopolitical conflicts, tensions between the developed and developing world, political divisions within the developed world, and economic inequality across the globe…Our main finding is that by 2030, energy demand growth will exceed supply growth by ~20% based on current trends, primarily driven by emerging economies and their efforts to develop and lift their citizens out of poverty…There isn’t a single type of energy that can meet the specific demand profile, and investment will need to be inclusive of all fuels including oil and gas, renewables, nuclear, and other forms of energy. Not all fuels are made equal and for the most part (and within this time horizon), different sources of energy are not fully fungible.”
Increased awareness of the constraints and physical realities of our collective efforts to both expand and decarbonize the world’s energy systems is a prerequisite to creating the policy and investment climate necessary for success. The next step is to move beyond spreadsheets and soapboxes and start figuring out how to capitalize responsibly sourced raw materials, infrastructure projects, and energy solutions so that economic crises do not become humanitarian ones.
For most of the past decade, we have been spoiled by cheap, readily available inputs combined with the deflationary benefits of globalization. Notwithstanding the pandemic, the world economy was booming, greased by walls of liquidity and a relatively benign geopolitical environment. It was an ideal time to be, well, an idealist. The pendulum now appears to be swinging in the other direction.
Given that oil is an input for so many intermediate and end products, including the production of other commodities, its influence is far greater than one would expect from something that only represents about 3% of global GDP. Over the last decade or so, the world has benefited from the emergence of shale oil – relatively inexpensive and sourced from functioning, stable democracies. In fact, North American unconventional oil has been the most significant wedge of new supply over the last ten years, meeting the majority of global demand growth from about 2010 to 2019. Of course, supply is a function of capital investment, and shale oil dwarfed all other regions over that period.
Source: Goldman Sachs, Top Projects 2022, 19 April 2022
However, in retrospect, it is clear that the era of shale oil was a disinflationary pause as opposed to the beginning of a period of structural deflation. Perhaps more importantly, lower commodity prices were the outcome of abundant, cheap capital, not radical improvements in capital efficiency.
Source: Goldman Sachs, Top Projects 2022, 19 April 2022
Of far more importance, given the intractable nature of such decisions, ESG-driven capital constraints have meaningfully increased the cost of production, more than offsetting any benefit from unconventional supply.
Source: Goldman Sachs, Top Projects 2022, 19 April 2022
While of course this is the explicit objective of divestment-related investment policies, the unfortunate reality is that:
For context, the $30/barrel spread on the above graph presents about $220bn in incremental cost that is being born by the consumer every year. Divestment decisions may make sense in a vacuum, but unfortunately supply and demand are real world conditions. The combination of a decade of value destruction and the impact of ESG-driven investment policies by institutions and governments alike have resulted in a prolonged period of underinvestment, the implication of which is only now becoming obvious.
Russia’s invasion of the Ukraine is exactly the type of unforecastable event which upends commodity markets, the sort of shock which galvanizes seemingly unrelated threads into a full-blown calamity. While it was easy to overlook during a period of abundant supply followed by a pandemic-driven demand shock, longer-term spare capacity is low and falling.
Source: Cornerstone Analytics, 22 April 2022
Source: Goldman Sachs, Top Projects 2022, 19 April 2022
Since inventories represent the intersection of supply and demand, it’s clear that the run-rate pace of investment is struggling to meet current energy needs.
Source: Bernstein, 14 April 2022
Source: U.S. Capital Advisors, 25 April 2022
Given the fact that energy demand is growing, not falling, a gap will emerge if capital does not flow back into the sector.
Source: JPMorgan, Global Energy Outlook, 20 April 2022
While it is not surprising that energy security is now the topic du jour, the reality is that a supply response is possible with incremental investment. The oil and gas markets are not resource constrained – just capital constrained. In fact, JPMorgan estimates that $1.3 trillion across primary energy sources will balance the market by 2030, which in the context of a $150+ trillion energy transition seems like an achievable goal, particularly in light of current commodity prices.
Source: JPMorgan, Global Energy Outlook, 20 April 2022
Furthermore, alternatives are available and increasingly competitive on an economic basis (EVs), suggesting that current market tightness can be alleviated through incremental production, substitution and a slow or partial return of Russian volumes to the market. Other segments of the commodity markets face much different prospects, a fact which continues to be overlooked by investors and policymakers alike.
While magazines and pundits race to forecast the end of hydrocarbons, there is little question that the future is based on “the electrification of everything.” If there is one metal that is synonymous with electricity, it’s copper.
Source: BMO Capital Markets, Rethinking the Long-Term Copper Challenge, 7 October 2021
From our perspective, however, the question isn’t what copper demand looks like under various Energy Transition demand scenarios, but rather what the Energy Transition looks like under various copper supply scenarios. Quite simply, it is the metals sector where concerns around “security of supply” are most acute.
Despite decade-high prices, inventories are extraordinarily low, representing about eight days of demand. This is not normal.
Source: Scotia Bank Research, 15 April 2022
Part of the issue relates to ongoing supply disruptions from existing mines. Chile, the world’s largest producer at almost 30% of global supply, is suffering from declining grades and water shortages which are curtailing production. Imagine the oil markets if, at full capacity, OPEC production looked like this:
Source: Goldman Sachs Commodities Research, Copper: Sleepwalking Towards a Stockout, 7 April 2022
More alarmingly, the outlook for longer-term supply growth is pretty tepid in both absolute and relative terms.
Source: Goldman Sachs Commodities Research, Copper: Sleepwalking Towards a Stockout, 7 April 2022
This supply forecast is a function of both a lack of investment by the industry and lack of success with the drill bit. The mining industry was the first upstream segment to adopt the “value over volume” mantra back in the early 2010’s, and exploration spending plummeted, particularly greenfield exploration.
Source: Bernstein Research, Exploration Crisis, or the Best Time to Plant a Tree, 13 April 2022
While concerns about future supply might be ameliorated by the recent uptick in spending, overall spending levels also reflect a cold reality: we’ve stopped discovering Tier I copper deposits.
Source: Bernstein Research, April 2022
There has been limited exploration success for more than 20 years, with only the DRC’s Kamoa-Kakula qualifying as a true Tier I resource. And, to make matters worse, a combination of capital intensity, resource nationalism and increasing regulatory and environmental requirements are making the development of the few new mines likely to come into production more costly and drawn-out affairs. As exiting Anglo American CEO Mark Cutifani put it during his final days in office, “It used to take seven years to find a mine and get it into development. Now it takes 15 years or more.” None of this bodes well for the Energy Transition.
Of course, the issues of structural deficits and struggles to meet demand irrespective of price is not limited to copper – it is a challenge facing numerous commodities, many of which are central to the Energy Transition.
Source: Goldman Sachs Research, Commodity Views, 13 January 2021
It is important to note that this snapshot was taken prior to the Russia’s invasion of the Ukraine, which raises another critical issue. To the extent that there is supply, to what extent will it be available in the free markets?
In our opinion, the lunacy of trusting a despot (Putin) to ignore the most obvious weapon in his arsenal (natural gas supply) will go down in history as a Chamberlain-esque oversight by European officials. However, while high energy prices may weigh on the European economy for the next few years, at least there are alternatives in the form of increased U.S. LNG exports and the reversal of planned nuclear shutdowns. In the metals market, China dominates processing capacity in commodities like lithium and rare earth oxides and has de facto control over copper, nickel and other mission-critical commodities across the continent of Africa and into Indonesia.
We won’t know until it is far too late whether China explicitly will choose to weaponize its position, but what is the rationale behind conceding it in the first place? To quote the owner of a large, undeveloped nickel asset in an OECD country,
Since the LME nickel meltdown things have, quite literally, gone crazy. The auto industry is panicked. Honestly, I’m not sure how this will unfold, but we’ve been telling them for over five years that there will be a shortage of metal. Now they understand the problem.
It’s not just auto OEM’s that should be concerned. Investors, consumers, environmentalists, and governments would be wise to follow suit. The Energy Transition is complicated enough without artificial impediments created by well intentioned, but misinformed, beliefs which overlook the complex nature of systems like power grids and industrial operations, the raw material intensity required to “electrify everything,” and the need to reduce carbon emissions today if we are serious about achieving Net Zero in the future. Technological innovation will be a tremendous part of the equation, but it will not be the sole determinant in the success of this endeavor. If there is any good to come from the human tragedy unfolding in eastern Europe, hopefully it includes a wake-up call to the western world and its allies about the frailty of supply chains related to basic necessities like energy and food.
In 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 complex, capital-intensive, resource-intensive endeavors ever undertaken. 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 the market 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.
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