A lot has been written about inflation lately. And, while we are reluctant to add to the growing discourse on this topic, since much of it, unfortunately, has not been terribly additive to the existing understanding of the many factors that impact price levels, we feel compelled to do so given our expertise in the natural resource sector and our extensive research into the energy transition.
Many investors naively think about inflation as a simple, one-factor phenomenon. As we have discussed in previous white papers though, there are many different causes of inflation and, therefore, many different types of inflation. Nuance is the rule.
Keynesian economists believe that price levels are determined largely by changes in aggregate demand (demand-pull), typically resulting from fluctuations in employment levels. As employment rises, demand for goods and services increases, driving prices higher. The lower the unemployment rate, the less likely supply will be able to keep up with demand, leading to higher prices for goods and services. This view is reinforced by the inverse relationship between inflation and unemployment rates that has been observed at different points of the economic cycle and is best illustrated by the Phillips Curve. While most economists agree that the Phillips Curve represents an oversimplistic explanation of price levels, the theory remains the most frequently cited approach to understanding and forecasting inflation.
The problem, with this theory, like much of economics, is that there are periods when this relationship breaks down in the real world. During the 1970s, for instance, inflation and unemployment rates were both elevated for nearly a decade. More recently, inflation has been relatively benign for much of the last decade even during periods when unemployment rates were quite low. The failure of the Keynesian demand-pull theory and the Phillips Curve to explain 1970s stagflation led to a number of alternative theories regarding the causes of inflation.
Monetarist economists, including Milton Friedman, offered a different explanation of inflation. They believe that the inverse relationship between price levels and unemployment rates is a shorter-term phenomenon. While changes in unemployment may help to explain cyclical changes in inflation, they do not accurately explain longer-term changes in inflation rates. Instead, monetarists believe that price levels are driven by changes in the money supply. Gold bugs are particularly fond of this theory. If the Phillips curve is helpful in understanding short-term inflation, at times, the Monetary Theory of Inflation is meant to help explain changes in price levels over longer periods of time.
Nonetheless, the relationship between inflation and money supply is not particularly strong, in part because the velocity of money can vary widely and unpredictably. In fact, the rapid expansion of the money supply in the U.S. since 2008 and the relatively modest inflation experienced since then shows that the relationship is anything but linear.
To help explain periods of stagflation, New Keynesian economists created the cost-push theory of inflation. Quite simply, cost-push inflation is caused by increases in the cost of raw materials and/or labor. Increases in input costs can be caused by a variety of factors, including supply shocks, geopolitical events, government regulations, natural disasters, and changes in geology. Prolonged cost-push inflation can lead to price increases for other goods and services and can impact future inflation expectations. As natural resource investors, we believe that cost-push inflation is particularly important when trying to understand commodity price inflation.
Lately, a new theory about inflation has emerged. Pushed primarily by technophiles, the idea is that innovation will push prices for most goods and services lower over time. While the role of innovation is, no doubt, important, particularly as it relates to understanding productivity, it also is not very accurate in forecasting overall price levels. Indeed, prices for most goods and services have increased significantly over very long periods despite the technological developments and innovations that have occurred in nearly all industries. If innovation were the most important variable influencing prices, deflation would be the rule. At best, innovation has partially offset the inflationary forces impacting many goods and services while reducing the cost for some technology-oriented goods and services. Unfortunately, though, you “can’t eat an iPad” to avoid inflation in the cost of real-world goods like food and energy.
Figure 1: History of Technological Innovation
Source: Barclays, Yahoo
One thing that is clear is that inflation is a very complicated phenomenon. It is the net result of changes in supply and demand for many goods and services across multiple industries and is influenced by many variables. Attempts to explain complex processes in simple ways are likely to be fraught with errors.
Rather than speculate on how changes in macro conditions will impact CPI or PPI, we prefer to take a more bottoms-up approach toward understanding a few of the more important variables that influence inflation. Given our expertise, we focus our attention on the outlook for commodity prices, though we acknowledge that many other factors will impact overall inflation.
Nonetheless, it is worth noting that increases in energy and food tend to push prices for other goods and services higher as well, especially when the increase in commodity prices is sustained for a longer period of time. However, many investors and central bankers ignore food and energy inflation, focusing their attention on “core” inflation instead, on the basis that changes in energy and food prices are cyclical and mean-reverting. And, while there is some validity to that perspective in the short run, given the cyclical and mean-reverting nature of commodity prices, it also ignores the important role that secular changes in commodity prices can have on inflation longer-term. As the chart below shows, most periods of above-average inflation (>2-3%) have been driven by sustained increases in commodity prices of 5-10% per annum, on average, or more.
Figure 2: Historical Inflationary Environments
Source: BLS, BEA
Since most investors and central bankers do not have a framework for forecasting longer-term changes in commodity prices and since periods of sustained increases in commodity price inflation have been episodic (the 1970s and 2000s), the important role that commodity prices play in driving changes in overall price levels is often underappreciated. Ignoring the relationship between commodity prices and inflation, however, can be a costly mistake for investors during periods of sustained commodity price increases.
Our investment process begins by researching the cost of supply for the various projects that make up the supply cost curve for commodities and forecasting how those supply costs will change over time. This framework allows us to have an informed opinion about the marginal cost of supply for commodities, which is essential when underwriting investments over a 5-10 year period. As the chart below shows, commodity prices follow changes in supply costs over longer periods, albeit with a high degree of volatility over the short term.
Figure 3: Copper – Structural Cost Inflation
Source: SailingStone Capital Partners estimates and analysis, Wood Mackenzie 3Q 2022
Understanding the variables that drive longer-term changes in commodity prices, therefore, can be useful for those investors that are concerned about the impact that inflation may have on their assets and liabilities. The extent to which changes in commodity prices impact individuals and institutions depends on the goods and services in their respective consumption baskets. Universities and healthcare organizations, for instance, have benefited from inflation in higher education costs and healthcare costs, respectively, and the comparatively low rate of inflation in their energy costs.
Figure 4: Inflation by Consumer Goods and Services
Source: United States Bureau of Labor Statistics, Ourworldindata.org
As central banks scramble to fight the current bout of inflation, which was considered transitory just a few months ago, investors now are beginning to pay attention to the risks posed by inflation. However, without an understanding of the factors that impact longer-term changes in commodity prices, investors and central bankers are likely to be surprised by the changes in inflation that are tied more to structural shifts in commodity prices than other commonly understood variables and academic theories.
Given the tremendous cyclicality that characterizes most commodities, it is critical for investors to distinguish short-term cyclical fluctuations from multi-year secular trends. We believe that this is particularly important today given the divergent short-term and longer-term trends that we see in the natural resources sector.
In the near term, we believe that higher interest rates, reduced economic activity, and rising unemployment will result in declining prices for many commodities. When combined with potentially lower labor costs and rents, we would expect to see overall inflation decline materially over the next 6-12 months. In fact, we wouldn’t be surprised if there were a brief period of deflation.
The cyclical decline in commodity prices and inflation will likely create quite a bit of confusion as it relates to the longer-term outlook for commodity prices and inflation. As always happens, we expect investors to extrapolate the temporary decline in commodity prices too far into the future.
To help investors assess the longer-term outlook for commodity price inflation, we think that it is instructive to look at the factors that drove commodity prices lower over the previous decade. The decline in commodity prices over the 2012-20 period was caused by a reduction in supply costs for many commodities. The downward shift in supply costs was driven by a number of factors, including 1) abundant capital availability, 2) the declining cost of capital, 3) a period of relative geopolitical stability, 4) increasing globalization, 5) favorable demographic trends, 6) limited efforts to reduce carbon emissions, 7) a lack of capital discipline among producers, 8) service cost deflation, 9) technological innovation (shale oil and gas), and 10) significant reinvestment opportunities. The decline in supply costs over this period helped create a benign environment for inflation, despite the increase in money supply and the relatively low level of unemployment, one that was uniquely favorable for the consumers of basic materials and uniquely challenging for the owners of natural resources.
However, when we evaluate the factors that will impact supply costs for most commodities going forward, we believe that it is likely that commodity prices will need to increase substantially over the next decade. While cyclically weak demand may temporarily mask the underlying increase in supply costs (what we will call transitory disinflation), commodity prices will follow supply costs higher over time.
We believe that the actions of central banks as well as governmental and institutional policymakers are compounding the structural supply challenges facing many commodities by discouraging investment and increasing the cost of capital. The lower levels of reinvestment will likely exacerbate the structural inflationary pressures when cyclical demand returns to more normal levels.
Below, we discuss some of the more important variables that underpin our views regarding the longer-term outlook for commodity prices and inflation.
One of the biggest myths about the energy transition is that the move toward a lower carbon economy will be deflationary. To the extent that this view reflects any fundamental consideration, it is likely based on the flawed idea that adding low variable cost wind and solar power will result in lower power costs. While it is true that incremental wind and solar power drive power prices lower during periods when it is windy and sunny, the intermittent nature of these resources means that additional investments in energy storage and baseload power need to be made to ensure the stability and reliability of the grid. The much higher level of capital invested per MWh generated pushes power costs higher, not lower. The reality is that power costs for consumers increase as renewable penetration rises, as the chart below clearly shows, even if some portion of this increase is being absorbed by the government and taxpayers.
Figure 5: Electricity Prices Correlated with Renewable Penetration
Source: ThunderSaid Energy
In addition, the transition to electric vehicles and renewable power will drive demand for many materials that are integral to the energy transition much higher over time, including aluminum, copper, lithium, nickel, rare earths, and silver. As the demand curve shifts out to the right, higher-cost projects will need to be brought online, pushing supply costs and prices higher. The chart below shows the material intensity of renewables and electric vehicles.
Figure 6: Material Intensity of Energy Transition
The energy transition, by definition, will be inflationary. The faster the transition, the higher the inflation; the slower the transition, the longer the inflation.
The transition away from coal and oil toward renewables, nuclear, and decarbonized gas (the three pillars of the energy transition) will take decades. While the energy transition requires much greater levels of investment in both the higher-carbon sources of energy that dominate the energy mix today, and the lower-carbon sources of energy needed in the future, many institutions, including some commercial banks, have significantly reduced the capital allocated to fossil fuels and, at the same time, have not invested in the materials needed to facilitate the transition to a lower carbon economy.
Figure 7: Underinvestment and Energy Inflation
Source: Dealogic, Enverus, Prequin Pro
The predictable result is that reinvestment in new coal, oil, and natural gas supplies is not keeping pace with demand, pushing prices meaningfully higher. If investment in the materials that underpin the energy transition remains below the level needed to support the growth in renewables and electric vehicles, inflationary pressures from the underinvestment in fossil fuels will become even more acute.
So, while divestment is intended to be a catalyst for positive change, the unfortunate reality is that it is extremely counterproductive in practice. Rather than accelerate the multi-decade move toward a lower-carbon economy, it is causing significant energy inflation, increasing geopolitical instability, and compounding global energy poverty – all while driving coal usage and carbon emissions higher in 2021 and 2022.
Many investors point to the interest rate hikes under former Fed Chairman Paul Volcker as the driving force behind the decline in commodity prices and inflation during the 1980s. However, the reality is that the decline in oil prices was driven by supply and demand trends that were in place well before the increase in interest rates.
On the supply side, significant investment in new oil projects in the U.K. North Sea, Alaska North Slope, and U.S. Gulf of Mexico pushed non-OPEC production meaningfully higher. Oil and NGL production from North America and Europe grew from just over 13-mmbd in 1975 to nearly 20.0-mmbd in 1985.
At the same time, oil demand in North America and Europe remained relatively flat from 1975-85 due to improving fuel efficiency standards. In fact, oil demand in the U.S. declined from about 19-mmbd in 1978 to nearly 15-mmbd by 1982-83, driven in large part by the increase in fuel efficiency standards as mandated by the 1975 Energy Policy Conservation Act.
While rising interest rates may have impacted inflation tied to rising labor costs, the increase in money supply, and perhaps most importantly, inflation expectations, the decline in commodity prices was driven primarily by both significant investment in new supply and increased energy efficiency standards before the hike in interest rates.
In an effort to curb inflation, central bankers are raising interest rates to temporarily reduce demand. However, higher interest rates will not address the structural supply shortage for most commodities. Instead, rising interest rates are more likely to reduce the amount of capital that is available for the new projects that are needed to meet current demand and support the energy transition. This represents a significant change from the days of the shale revolution when capital was cheap and abundant.
In addition, higher interest costs and a higher discount rate are likely to push supply costs higher for commodities. After all, producers will require higher commodity prices to cover rising financing costs and meet a higher hurdle rate. As shown below, higher interest rates are likely to push commodity prices higher in the long run, not lower, at least until investment in new projects is sufficient to address future demand growth.
Figure 8: Rising Rates Lead to Higher Marginal Cost
Source: Thundersaid Energy
As baby boomers retire and the labor force shrinks, labor costs are likely to rise. This is particularly relevant in extractive industries, which find it more challenging to attract younger workers. Given the number of projects that need to move forward to meet growing energy demand and reduce carbon emissions, we see labor as a meaningful constraint, one that is likely to push commodity prices higher over time.
Exacerbating demographic trends is the sudden move away from globalization. Indeed, increased globalization over the last several decades allowed companies to reduce their labor costs by moving manufacturing to countries with lower wages. The reversal of this trend will be inflationary, particularly in regions where the workforce is shrinking due to demographics.
Oilfield service costs, which declined significantly from the peak in 2014, have bottomed and are moving higher. While rising labor costs are contributing to the increase in service costs, oilfield service companies are increasingly capacity-constrained. As a result, service prices are increasing and margins are returning to more normal levels cyclically.
Figure 9: Oilfield Service Costs Increasing
Source: BLS, St. Louis Fed
Energy and labor are significant input costs for the production of non-energy commodities, too. As such, rising energy and labor costs are pushing supply costs meaningfully higher for most commodities, many of which are integral to the energy transition. This is increasing the inflationary nature of the energy transition, as the chart below showing Chinese lithium prices highlights.
Figure 10: Lithium Prices
Commodity producers maximize returns and net present value by prioritizing investments in the lowest-cost and most geologically attractive deposits. As time goes on, and as the lowest-cost projects are depleted, capital intensity and operating costs rise on a per-unit basis.
On the energy side of things, we are now seeing evidence of inventory exhaustion in some of the more mature shale oil and gas basins in North America. In the Haynesville Shale, for instance, average recoveries per well have fallen over the last several years as drilling has moved outside of the heavily drilled core part of the play. We expect this trend to only accelerate over the next decade.
Figure 11: Haynesville Well Density and Productivities
Source: Enervus and SailingStone Capital Partners
In mining, the average grade of ore mined has declined for a long time. In addition, ore hardness has increased as mining has moved deeper over time. These trends are likely to continue to push supply costs higher for most mined commodities.
Figure 12: Copper Ore Grade Decline
Source: Wood Mackenzie
Lastly, after a period of relative stability, the geopolitical backdrop has become more volatile, as best highlighted by the conflict in Ukraine and growing tensions with China. One consequence is a realignment of supply chains, particularly in the Western world. This is likely to be inflationary.
In addition, natural resources are now being used for strategic purposes in conflicts between countries and have become a focal point in the Russia/Ukraine war. If this trend continues, we would expect to see growing competition to secure natural resources around the world. In this environment, commodity prices could rise substantially to reflect the scarcity value of natural resources in a world characterized by less cooperation and free trade. Multi-year increases in commodity prices were the norm during geopolitical crises such as the Arab Oil Embargo and the Iran/Iraq War, and that trend has continued with the Russian invasion of Ukraine.
In a lot of ways, the environment from 1990 to 2020 was unusually favorable for growth. Declining interest rates, abundant capital availability, increasing globalization, limited geopolitical conflicts, favorable demographic trends, improved productivity, and relatively benign inflation created a favorable backdrop for economic growth with few concerns about sustained inflation.
However, many of these trends appear to be in the early innings of a multi-year/decade reversal. Chief among them is the availability and cost of energy and basic materials. Spare capacity continues to trend lower for most commodities, above-ground inventories are dangerously low (particularly given the ongoing war in Ukraine), and supply costs are trending higher.
Add growing geopolitical conflicts, deglobalization, shifting demographics, the rising cost of capital, inventory exhaustion, and the growing demand for clean energy and the materials needed to support the energy transition, and it seems clear that the longer-term outlook for supply costs and commodity inflation has changed dramatically.
Going forward, we expect commodity price inflation to pose a much greater risk to economic growth and investors. While we believe that commodity prices will remain highly cyclical, including a potential downturn over the next few quarters, and while there will be significant differentiation between commodities, driven in large part by the energy transition, we believe that commodity prices will generally trend higher over time due to the structural increase in supply costs for most commodities.
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.
We thank you, as always, for your continued partnership.
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