From our perspective, 2021 was a year of considerable progress. Given the complex nature of the Energy Transition and our perspective as business analysts whose views are not beholden to a predetermined set of outcomes, we wanted to start with a recap of what we consider to be the key developments over the course of the year.
1. Defining the Energy Transition. The term “Energy Transition” is ubiquitous, yet if you ask a hundred people what it means, likely you will end up with a hundred different answers. While ambiguity is useful for marketing and fundraising, it’s a terrible place to start when faced with such a critical, complex, and capital-intensive set of issues. In our view, the Energy Transition is defined by two first principles which must be addressed in concert:
a. Decarbonizing our global energy systems
b. Addressing global energy poverty
To-date, most of the focus has been around decarbonization, with many agencies and policymakers assuming that we can achieve net-zero by 2050, but only if total final energy consumption falls over the next thirty years. This is a preposterous assumption that ignores the plight of billions of people and flies in the face of economic reality.
The vast majority of the world’s population relies on dirty, polluting fuels, and their demand for energy is going up, not down, driven by the dual engines of economic advancement and population growth. We need to invest in energy sources that reduce carbon emissions TODAY while working diligently to advance technologies that can assist in the future. Choosing to ignore existing solutions that don’t meet ivory tower definitions of “clean energy” while focusing blindly on “feel good” but sub-scale and/or uneconomic alternatives is undermining the Energy Transition, not accelerating it. By defining the Energy Transition’s dual mandate, we hope that policy decisions and capital flows will align more closely with the desired objectives going forward.
2. Understanding the Implications of a Cost Curve. Carbon abatement is a commodity – a universal, fungible good. More importantly, the carbon abatement cost curve is quite steep.
Carbon Abatement Cost Curve
Source: Thunder Said Energy, Roadmap to Net Zero
The Golden Rule of commodity investing is to focus only on “advantaged” (i.e., low-cost) assets/projects/solutions. We recognize that the carbon abatement cost curve will be more volatile than a traditional cost curve which tends to be defined by geology since carbon abatement technologies will continue to advance. However, there are three critical conclusions for Energy Transition practitioners from an analysis of the cost curve above.
First, scale matters. Investors and policymakers have to focus on low-cost solutions with capacity if they are serious about decarbonizing our energy systems today. High-cost, impractical solutions such as green hydrogen and direct air capture should be relegated to the lab bench until their relative economics improve and their ability to scale can be proven. Conversely, natural gas- and nature-based solutions are available, are low cost and should be supported by policymakers and investors. The same goes for nuclear power, a fact which is blindingly obvious to the Chinese government but seems to be incomprehensible in Europe and the U.S.
Second, owning, capitalizing and/or participating in solutions that sit at the bottom end of the cost curve will accelerate the Energy Transition and reduce the ultimate price tag. This is our primary area of focus – supplying or acquiring assets and technologies that sit at the bottom end of the cost curve. We welcome all discussion, debate and ideas which can hasten the path to net zero while addressing the energy needs of the globe’s population.
Third, there needs to be more debate focused on relative cost and scale, and a greater willingness by policy makers and capital allocators alike to support and promote solutions that can expand energy access and reduce the globe’s carbon footprint in a material way STARTING TODAY. Virtue signaling about what we’d like reality to look like in thirty years is a waste of precious time and resources.
3. Recognizing that the Energy Transition will be Inflationary. Increased renewable penetration is a central tenet of the Energy Transition, and it is a widely held view that renewables are deflationary. In part, this conclusion reflects the incredible decline in unit level costs over the past decade, and in part it is due to the fact that renewable power has zero variable cost (the “fuel” is free). In fact, the first result of an internet search on “are renewables deflationary” yields a December 15, 2020 Financial Times article whose opening line is, “Wind and solar are intrinsically deflationary…”
While that is true on a spreadsheet and in specific cases, it is clear from a review of renewable penetration rates and retail power prices that, in fact, renewable energy tends to be quite inflationary.
Electricity Prices Correlated with Renewable Penetration
Source: SailingStone Capital Partners, https://ourworldindata.org/grapher/share-elec-by-source?time=latest, https://www.statista.com/statistics/263492/electricity-prices-in-selected-countries
The reason is quite simple – renewable power is non-dispatchable and intermittent. Thus, incremental wind and solar installations require fast-cycle conventional capacity to be ready on standby until sufficient ESS is available to smooth the dispatch curve. Since these conventional facilities have fixed costs, and since renewable generation displaces a significant portion of their volumes, the result is higher costs to pay for dispatchable power and the other ancillary services required to integrate a volatile, unpredictable power supply into a system designed to function around shifts in demand. Higher costs result in higher prices. To be clear, this isn’t a theoretical argument – residents and industries in Europe and the U.K. are suffering the consequences of this miscalculation right now. We discuss this in detail here and here.
In addition, the Energy Transition will be incredibly material intensive, a fact which is either not well understood or conveniently ignored.
Mineral Demand for Clean Energy Technologies
Source: IEA, The Role of Critical Minerals in Clean Energy Transitions, May 5, 2021; https://iea.blob.core.windows.net/assets/9d6f9b13-c478-41c6-9ffe-6a05f3ab73ef/Criticalmineralslaunchslides.pdf
Production of commodities like copper, nickel, lithium, natural gas, and aluminum will all need to increase significantly in the coming years, which in turn will require massive amounts of risk capital to be deployed. Since capital availability for these types of projects is low, due in no small part to “climate aware” policy decisions made by commercial banks, asset allocators and governmental agencies, these expansions will have to be funded by cash flows which in turn are a function of commodity prices. While commodity prices have recovered from pandemic lows, investors should prepare for a period of much higher prices relative to the last five years. The supply base for many commodities is mature and in decline. Given the sharp rise in demand from the acceleration of renewables deployment, grid refurbishment, EV sales, etc, commodity prices will have to rebase at higher levels to incentivize and support a supply response.
And, lastly, the proliferation of carbon pricing will, by definition, increase the cost of anything which relies on hydrocarbons for any portion of its supply base. Since hydrocarbons represent about 83% of primary energy production, that means that the cost of just about everything will have to increase if we are going to incorporate carbon explicitly into the cost of goods sold. Perversely, until the entire global energy system is decarbonized, increased renewable production will result in steepening cost curves and thus more upward pressure on pricing. This will be positive for low-cost producers but is a clear negative for the consumer since, of course, for any commodity both producers and consumers are price takers.
To be clear, we aren’t arguing against the adoption of universal carbon pricing, nor are we bearish on renewables. Just the opposite, in fact. But, we should all understand the risks inherent in our decisions, and prepare ourselves accordingly.
4. The Emergence of “Real Co” Commodity Producers. From an industry perspective, perhaps the most constructive development of the last few years is the emergence of what we refer to as “real companies” that happen to produce commodities. The shift from volume to value started in the mining industry almost a decade ago, driven by irate shareholders and the abrupt closure of capital markets. The energy industry followed suit several years later for the same reasons, and today the commitment to balance sheet management, prudent capital allocation and the return of excess cash flows to shareholders has created a virtuous cycle of improved commodity fundamentals and strong company-specific financial metrics.
Source: Morgan Stanley, The Case for Energy in 2022, January 11, 2022
E&P Return on Capital Employed
Source: USCA Research, January 14, 2022
Source: Raymond James Research, RJ Energy Market Outlook, January 10, 2022
As the realities of the Energy Transition become more apparent – the implications of the carbon abatement cost curve, inflation risks and the material intensity of both decarbonizing and expanding the world’s energy systems – investors increasingly will seek ways to gain exposure to structurally advantaged producers of key enablers commodities. This will benefit both the owners of these assets as well as the Energy Transition writ large. Given the material intensity of this endeavor, as discussed above, it is absolutely critical that producers have both the assets and the access to capital required to meet future demand. Being viewed as a going concern is a necessary precursor to attracting new investors.
We expect 2022 to be another year of progress, marked by the continued evolution of a more nuanced and realistic assessment of the risks and opportunities associated with the Energy Transition. While we aren’t big proponents of crystal balls, the following are four areas of particular interest that we’ll be watching in the coming year.
1. Chinks In The Armor. The Energy Transition is generally viewed as a universal good – we can protect the planet and its inhabitants, create more high-paying jobs and drive down energy costs in one fell ($150+ trillion) swoop. Anyone attempting to engage in debate about unintended consequences or potential risks usually is brushed aside, discredited as being a “climate change denier” or “uninformed.” Of course, the macro backdrop of the past several years has helped reinforce this view, with “clean” tech massively outperforming anything related to “dirty” commodities on the back of record low interest rates and the value destructive spending frenzy which plagued so many upstream industries.
However, reengineering and expanding the world’s energy systems is without question the most complex and capital-intensive undertaking in the history of mankind. It isn’t analogous to an organ replacement but rather, as one client adeptly observed, a complete neural transplant. And it isn’t like the patient was particularly healthy to begin with.
Introducing incremental volatility into an already stressed, fragile ecosystem can lead to catastrophic failure, which we witnessed episodically in Texas last winter and more structurally in California, the U.K. and Europe over the last few years. We believe that energy system failure and energy price volatility increasingly will become the new norm. In other words, we expect that energy crises will become more common. Beyond the obvious first order effects on consumer spending, industrial productivity, and income inequality, higher and more volatile energy prices will be structurally inflationary. Furthermore, it may serve to exacerbate already frayed social and political equilibriums as it will be hard to avoid the blame game when the one thing that everyone takes for granted in the West – cheap, reliable and always available electricity – starts to become less of a sure thing.
It is our sincere hope that recent events act as the proverbial canary in the coal mine (no pun intended) – heightening awareness of the risks associated with oversimplistic policies before the situation is irreversible. For example, the recent announcement by the European Union to allow certain natural gas and nuclear projects to qualify as “green” for financing purposes is an important first step towards a more rational approach to the Energy Transition. Of course, this is in response to record high energy prices and a 20% increase in coal-fired power production driven by cold weather, limited natural gas storage and an extraordinarily tight global LNG market. We shall see if more progress is made in 2022 for as playwright W. Somerset Maugham noted,
“The most useful thing about a principle is that it can always be sacrificed to expediency.”
2. Structural Deficits and Scarcity Value. While the Energy Transition is going to drive demand for many materials it is still in its infancy, comprising less than 10% of current global consumption for a commodity like copper. While many seem to think that moving to a 100% renewable power is simply a matter of will, the reality in the physical markets is far more sobering.1
In fact, despite the early days of the Energy Transition and the economic disruptions caused by COVID, inventories for many key raw materials are at decade-low levels.
Source: Scotia Bank Research, January 13, 2022
This is remarkable, given the sharp recovery in commodity prices over the last two years. Despite a more constructive environment, the supply side is expected to continue to struggle to meet demand, particularly in Energy Transition-centric commodities like copper, aluminum, nickel, and natural gas. Ironically, current energy price spikes in Europe and other regions are crimping the supply of processing-intensive commodities like aluminum, nickel, zinc, and fertilizers, highlighting the interconnected nature of Energy Transition-related inflation.
Estimates of Supply/Demand Balances (% of Demand)
Source: Goldman Sachs Research, Commodity Views, January 13, 2022
Of interest, the equity markets seem to be reflecting a much different perspective, with many stocks ascribing little to no value to undeveloped inventory, despite the clear need for those projects to be commercialized if efforts to expand and harden power grids, accelerate the development and deployment of ESS, increase renewable power capacity, and electrify the global transportation fleet are to be successful. We expect that 2022 will be the year that the structural deficits facing many enabler commodity markets become more apparent. Resource constraints will increase the cost of the Energy Transition, reinforcing inflationary pressures while delaying our ability to achieve net zero emission status. From an investment perspective, 2022 may be the year that the economic rent associated with owning mission-critical, long-duration, low-cost inventory starts to be reflected in stock prices.
3. A More Nuanced Approach to ESG. As we discussed in a recent white paper, ESG investing and divestment decisions are undermining the Energy Transition and in many respects are hypocritical, resulting in outcomes that are at odds with the policies’ stated intent. Choosing not to invest in or engage with responsible producers of critical raw materials results in higher cost of capital which in turn is reflected in higher prices. Again, higher prices ultimately are borne by the consumer – ESG and divestment are simply a regressive tax on the global population. Furthermore, since demand for these commodities is going up, not down, forcing production into regions of the world with more lax regulatory oversight and lower environmental standards means that the resulting carbon intensity and incidents of workplace accidents are far higher than would otherwise be the case.
We expect that 2022 will mark the beginning of a more nuanced approach to capital allocation and ESG engagement. We hope that these adjustments will be a function of lessons learned, reflecting a better understanding of the unintended consequences of prior policy stances. Perhaps less naively, we won’t be surprised if continued strong absolute and relative investment returns combined with increasing concerns about inflationary risks drive capital allocators to reassess their definitions of “impact investing.”
Companies must step-up as well. For too long, participants in capital intensive and extractive industries have abrogated their financial, social, and moral obligations to protect the environment, improve the lives of their stakeholders and manage their consumption of precious natural resources. Companies which seize the opportunity to both actively manage and more effectively communicate their ESG strategies will be rewarded with a lower cost of capital. If we are serious about combatting climate change and addressing energy poverty, we need the collective effort of all participants pulling in the same direction. Neither virtue signaling nor dismissive corporate behavior are luxuries that we can afford.
4. The Beginning of a New Regime? We aren’t macro economists or market forecasters. However, after a decade in which historic money supply, low interest rates and deflationary pressures resulting from technology-driven productivity gains and the massive overcapitalization of most commodities created a Goldilocks backdrop for growth investors, it isn’t crazy to contemplate whether the next decade or so might look different from recent history.
By almost any metric, the equity market appears to be expensive.
Source: Goldman Sachs Research, Commodity Views, January 13, 2022
Given the current composition of the market, that shouldn’t be too much of a surprise.
Industry Weights of S&P 500
Source: Goldman Sachs Research, January 13, 2021
It’s hard to ignore the fact that the most capital-intensive industries: Energy, Materials, Utilities, and Industrials only make up about 15% of the entire market, 25% less than their prior low in 2000.
Consistent with this observation, the relative valuation of large cap growth is in the 87th percentile and has been trending up since 2007.
Relative Valuation – Large Growth vs Value
Source: Jefferies Equity Research, JEF’s Valuation Handbook, January 3, 2022
While these extremes don’t guarantee anything, “reversion to the mean is the iron rule of the financial markets.”2
While it’s impossible to predict what might cause such a shift, it’s worth noting that public equity markets are increasingly driven by momentum. The only question is momentum of what. Given an increasingly inflationary backdrop, strong and improving company-specific and industry fundamentals, depressed absolute and relative valuations and the likely emergence of the concept of scarcity value, it is entirely possible that well managed, ESG-conscious producers of critical raw materials become part of the “must-own” basket of securities and private investments. To put it mildly, that would be different.
Beyond the equity market, though, there are other reasons to believe that the future might increasingly be volatile and chaotic. Trust in governmental and societal institutions is falling, a trend that seems to have accelerated in the aftermath of the Global Financial Crisis.
And this was before the pandemic, which seems to have exacerbated tensions across an array of issues.
What does this have to do with investing and the Energy Transition? From our perspective, it highlights the fact that an enormously complex, emotionally charged undertaking is occurring against a backdrop of increasing divisiveness and distrust of exactly the types of entities that are going to be held responsible for the execution and implementation of said endeavor. Much like the grid, the global population and its societal structures appear to be as fragile as they have been in recent memory. This isn’t the type of environment that is well suited to absorb potentially economy crippling price spikes and disruptions. We certainly hope that we can navigate the next thirty years and $150+ trillion of spending without upending the apple cart, but it seems hard to argue that the risks aren’t rising. We believe that increased recognition of these potential outcomes, in addition to the favorable fundamental set-up, may cause investors to revisit their aversion to owning cash flowing, well-managed, mission-critical real assets.
Valuations have moved from “distressed” to “very cheap” over the last two years as commodity prices have normalized around the marginal costs of supply. Based on very conservative estimates of inventory and reinvestment opportunities, your portfolio is trading at a 15-20% discount to Proved Net Asset Value (NAV) with free cash flow yields that are in the mid-teens, calculated at a long-term $60 oil/$3 natural gas/$3 copper price deck which is well below the current futures strip. As a whole, balance sheets are in very good shape and most companies, having adopted value over volume strategies, are now positioned to return capital to owners through buybacks and dividends commencing this year and accelerating into the future. Relative valuation is attractive as well, with the portfolio trading at about 6x free cash flow vs the Russell 3000 at more than 20x.
The portfolio continues to provide meaningful exposure to the Energy Transition through owning the raw materials and critical industrial processes and infrastructure essential for decarbonization and to meet the growing energy demand of developing economies. Yet, the future of the Energy Transition remains a free option as our long-term price assumptions do not reflect real-world inflationary pressures that are likely to persist for many years to come. This is in stark contrast to most Energy Transition-related investments where asset values and stock prices already reflect blue sky outcomes. Capital spending on renewables, EVs and ESS continues to accelerate yet mission-critical raw materials remain undercapitalized while above-ground inventories decline. This dynamic is not sustainable, and recent supply chain issues provide some glimpse into how high prices can go when markets get nervous about availability. Running spot prices through our models increase the discount to NAV to 40-50% using proved reserves only and generates high-teens to low-30% free cash flow yields.
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 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.