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Investing in Natural Resources in a Changing World (Part V of V)

Part V: How we would structure a natural resource portfolio

Issues to be addressed in this research paper

Writing a paper on investment opportunities in natural resources is a daunting prospect, as the universe is almost endless. We can probably all agree that the most important natural resources are water, food and energy (in that order) as we wouldn’t survive for long without any of those, but they are far from the only ones. Various metals are critical, and so is timber, not to mention salt, and the list goes on and on. As far as energy is concerned, it used to be mostly a story about fossil fuels, but those days are long gone. So much has happened on the technology front more recently that all sorts of basic materials come into contention now when talking about the energy mix of tomorrow.

This would probably become a life-long project unless I limit myself, so I will do that. We plan to do a separate paper on investment opportunities in water, so don’t expect much on water in this paper, although I will include water generically in the natural resource portfolio that I suggest towards the end of this report.

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This research paper will be almost exclusively about the various natural resources that are being lined up to replace fossil fuels in the years to come. Accounting for over 80% of all primary energy (source: Our World in Data), the world will remain dependent on fossil fuels for many years to come, even if various governments deliver on their promise to decarbonise. As you can see below, in most countries, fossil fuels continue to account for 70% or more of the primary energy mix (Exhibit 1).

Exhibit 1: Fossil fuels’ share of primary energy (2019)
Source: Our World in data

First and foremost, the following will be about how investors can take advantage of the changing need for natural resources in the context of the ongoing digital revolution and the desire to reduce the carbon footprint. In other words, don’t expect me to spend any time on the growing demand for concrete, iron ore and timber, even if continued urbanisation will continue to drive up demand for those resources. That is not what this paper is about.

Summary of parts I-IV

Before going any further, let me briefly summarise my key observations and conclusions from parts I-IV, as that will be used as a foundation for the recommendations I am about to make.

Part I (on primary energy – mostly fossil fuels):

  1. Despite all the bad press, fossil fuels still provide the cheapest electricity, although one could argue that electricity based on renewables is only more expensive because of taxes. On a cost-only basis, certain types of renewable energy forms (primarily wind) appear to be competitive now.
  2. Although fossil fuel industry insiders are reluctant to admit this, fossil fuels leave a much bigger carbon footprint than any other primary energy forms, and that is the case even if you include the indirect footprint, i.e. carbon emissions from the energy needed to build the power stations and the energy required to run them.
  3. The combination of the big carbon footprint and the fact that renewables can still only cover a small percentage of overall demand for primary energy is likely to renew interest in nuclear. The imminent rollout of the latest fission technology (so-called SMR), which is safer than the existing nuclear technology, will likely lead to even more demand for nuclear power stations.

You can find the full text of part I here.

Part II (on a fossil fuel-free future):

  1. Both wind and solar are unreliable fuels. The wind doesn’t always blow and the sun doesn’t always shine. Adding to that, not all vehicle types are suitable for electrification (e.g. lorries, aircraft and ships). A full conversion to renewable energy forms must therefore be combined with various other new technologies.
  2. One such new technology would be the ability to convert electricity to liquid hydrogen, which could then be used in vehicles not suited for electrification.
  3. In addition to using liquid hydrogen in the transportation sector, it could also replace oil in the manufacturing of plastic products, potentially entirely eliminating the need for oil.
  4. CO2 could become a valuable asset if this technology is commercialised, as plenty of CO2 shall be required when converting electricity to liquid hydrogen. CO2 is also required when producing protein – another new technology which could address food scarcity problems in an ever more populated world.
  5. Fusion energy is the ultimate solution, as it will reduce the marginal cost of electricity to virtually zero.

You can find the full text of part II here.

Part III (on water):

  1. As the number of people on planet Earth continues to rise, and as living standards amongst those people continue to improve, demand for food will continue to grow, and that is particularly the case as far as protein-rich food is concerned. Farmers, particularly farmers rearing meat, are big users of water with 60-65% of all freshwater in the world consumed by the agricultural industry every day. Increased demand for protein-rich food (meat) will therefore drive demand for water even higher.
  2. Our freshwater resources are seriously and negatively affected by climate change, leading to water scarcity problems all over the world.
  3. Desalination is indeed an option in most (but not all) wealthier countries, but it is not a realistic option in a relatively poor African country. The probability of open warfare over disputed freshwater resources and rising migration should therefore not be underestimated.
  4. While some countries face scarcity problems, other countries could literally drown in water. As seawater level continue to rise, we will be forced to spend ever more money on various protective measures.
  5. Just as we identified fusion energy as the ultimate replacement to fossil fuels in part II, fusion energy could also be the ultimate solution to water scarcity problems, as it will dramatically reduce the cost of desalination.

You can find the full text of part III here.

Part IV (on why you need to think differently about investing in natural resources):

  1. Lithium is the most important material in modern battery technology and will most likely be the natural resource most in demand in an increasingly digital world.
  2. In cars, the cost of electrification (measured as the cost in $ per kWh) is fast approaching the equivalent cost of internal combustion engines, leading to electric vehicles taking more and more market share.
  3. As fossil fuels are phased out, OPEC’s influence will diminish, whereas South America’s will increase with Chile (being the low-cost producer of lithium) potentially becoming the new Saudi Arabia.
  4. The next generation of lithium batteries will use less cobalt but more graphite – in the form of a new material called graphene. Demand for copper, nickel, manganese and aluminium will also increase as a result. Graphene is particular interesting, as the range of applications goes way beyond lithium-ion batteries, both in manufacturing and in healthcare. For example, in the context of desalination, I note that graphene provides a very cost-effective way of filtering salt from sea water.

You can find the full text of part IV here.

The challenges investors are up against

By now, it should be obvious that investing in natural resources is likely to be a very different proposition going forward. Obviously, roads and airports will still be built – maybe less so in the old world, where governments will be forced to spend an ever bigger share of their budget on an ageing population, but that should be more than offset by rising infrastructure spending in many EM countries.

All that is no different from having invested in natural resources over the past 30+ years, as I have. What is different is that we have a new universe of natural resources that will steal the headlines over the next 10-15 years – resources like lithium and graphite that until quite recently were (and maybe still are) poorly understood in the investment community.

I have deliberately limited myself to 10-15 years. That doesn’t mean that demand for lithium and graphite will be non-existent 20 years from now. We just don’t know. Technological progress is moving so fast these days that it is impossible to predict what will be in vogue 20-30 years from now. Having said that, industry insiders have assured me that, at least for another 10-15 years, lithium-powered batteries will dominate, and the era of graphene is only about to begin.

Other than timing risk, the big challenge many investors are up against when investing in tomorrow’s natural resources is lack of access to the most promising, new technologies. The best example of that is probably what I consider the biggest opportunity of them all – fusion energy. Once fusion energy is rolled out commercially, the world will change – there can be no doubt about that, given the overwhelmingly positive impact it will have on the global economy and on Mother Nature. The problem is – how do you invest in fusion energy? It isn’t easy but more on that later in this paper.

How much should you allocate to natural resources?

Rising Demand for Natural Resources is one of five investment themes associated with the megatrend we call Rise of the East, but demand for natural resources is affected by other megatrends too, both positively and negatively. Climate Change, probably the most penetrating of all six megatrends, dramatically affects demand for natural resources. It impacts demand for fossil fuels negatively and, on the positive side, it impacts demand for all those basic materials that will replace fossil fuels in the years to come.

From an institutional investment management point-of-view, the problem is that, these days, natural resources account for only a modest share of the equity market in most countries. Take for example the US equity market where, in 1980, energy accounted for nearly 30% of the S&P 500 (source: IEEFA). As you can see in Exhibit 2 below, the corresponding number today is less than 3%. If you throw in a few materials companies that justifiably can be classified as natural resource companies plus one or two water utility companies, you may get up to 5%, but that’s about it.

Exhibit 2: S&P 500 sector weightings
Source: Siblis Research

In the context of institutional investment management, this is relevant because of the industry’s preoccupation with tracking error when constructing portfolios. In other words, if natural resources only account for about 5% of the underlying index or indices, most institutional investors will end up allocating much less to natural resources than they might otherwise have done if tracking error concerns were not such a decisive factor. However, therein lies the opportunity for those prepared to stick their neck out.

Having said that, with energy stocks being no more than 3% of the S&P500 these days, one cannot argue that going short fossil fuel companies constitutes an early move. The easy money has clearly been made already so, from a strategic point of view, I would simply avoid fossil fuel companies for now.

So, how much should you allocate to natural resources? If a high tracking error is of concern to you, you may have to divide what I am about to suggest by a factor 2 or 3 or even more, but you should still strategically overweight certain natural resources in your portfolio. We are at the doorstep of a revolution where investing in natural resources no longer means (only) investing in oil & gas, water, iron ore, copper, land and timber. For that reason, I would allocate at least one-quarter of those of my financial resources I invest in equities to natural resources.

I should add that I do not allocate much to equities at present, and that has to do with my long-held view that equities are too expensive at present relative to the modest economic growth and modest growth in corporate earnings that I expect for at least another ten years. That said, the transition from fossil fuels to other energy forms will most definitely create sector-specific growth opportunities, even if overall GDP growth disappoints.

Not surprisingly, after years of compelling performance, technology companies dominate the list of the world’s largest listed companies when measured by market capitalisation (Exhibit 3), but are you aware that lists such as the one in Exhibit 3 change dramatically from one decade to the next? Going back to the heyday of energy in 1980, seven of the ten largest listed companies were energy companies. Today, only Saudi Aramco makes the list.

Imagine we were holding the 2030 list in our hands right now. If history is going to repeat itself, many of the names on the 2020 list below will have disappeared. Given the digital revolution and the all-encompassing impact thereof, I would be surprised if technology is not still richly represented but, equally so, I would be surprised if the names are largely the same. They never are.

Exhibit 3: Top ten companies worldwide by market capitalisation ($Bn)
Note: As at 30th April 2020
Source:
Statista

Natural resource names to focus on in the digital era

Before I begin this part, I need to make one important point. UK securities laws prohibit me from mentioning private market investment opportunities without doing case-by-case suitability assessments. Therefore, when mentioning names in the following, I will restrict myself to names in public markets. Should you have an appetite for private market investments, email either me on nj@arpinvestments.com, or email my colleague, Alison, on aml@arpinvestments.com.

With that in mind, will any natural resource company make it to the very top over the next ten years? It is hard to say, but I have a firm favourite to at least make a big jump, and that is a Chilean mining company called Sociedad Química y Minera de Chile (SQM).

Sociedad Química y Minera de Chile

SQM is one of the world’s largest lithium mining companies and is listed on the exchanges of Santiago and New York with $4.4Bn of market capitalisation. Exhibit 4 below will give you a sense as to how SQM has traded on NYSE since it was listed there in 1995. As you can see, as of the 30th October, it traded at $36.29 per share which is a far cry from pre-COVID levels.

Exhibit 4: SQM on NYSE
Source: Google

It is rarely an easy ride when you invest in natural resource companies, and you need to prepare yourself for plenty of volatility. In all fairness, SQM was already down significantly from its highs when COVID-19 struck in early 2020. Global lithium markets had been over-supplied for years, and that took its toll on the price. SQM, however, is the world’s low-cost producer of lithium and will be around long after some of its competitors have folded. It is not unreasonable to compare Chile to Saudi Arabia and SQM to Aramco in terms of status and pricing power in their respective industries.

Yellow Cake PLC

Another natural resource which I believe will do very well over the next 5-10 years is uranium (U3O8) which is the most common fuel type in nuclear power plants. Uranium has been in a near constant bear market since the 2011 nuclear disaster in Japan (Exhibit 5) with investors seemingly concluding that nuclear is going to be phased out like fossil fuels, but nothing could be further from the truth.

Exhibit 5: U3O8 price ($/lbs)
Source: Trading Economics

Whilst correct that Germany is in process of closing all its nuclear power plants (the last one is expected to be removed from the grid in 2022), and that the appetite for nuclear in the West is limited at present, the reality is that:

  1. many EM countries have a significant expansion programme underway which will drive worldwide demand for uranium higher (Exhibit 6);
  2. nuclear is as clean as wind and cleaner than solar in terms of CO2 emissions (source: WNA);
  3. nuclear is the safest primary energy form there is when measured as number of deaths per thousand terawatt hours of electricity production (source: Statista); and that
  4. nuclear is by far the most reliable primary energy form there is when measured as number of days at full power (source: EIA).
Exhibit 6: Future estimated requirements for U3O8
Source: Sachem Cove Partners, World Nuclear Association

The price of U3O8 needed to keep sufficient supplies of uranium at a cost breakeven level is around $37/lb, well above the current spot price which is marginally below $30/lb. This simple fact has deterred uranium mining companies all over the world from adding to capacity in recent years, and we know that supplies will not be increased in a meaningful way for at least another 7-8 years, as that is how long it takes to bring new mining capacity on line.

Add to that SMR nuclear – a new and safer technology which has just been granted approval by the nuclear regulator in the US, and add the fact that the renewable energy industry is nowhere near ready to fill the shoes of the fossil fuel industry, and I project the future of nuclear to be much brighter than Exhibit 5 leads you to believe.

The simplest way to invest in uranium is to buy Yellow Cake PLC on London Stock Exchange. Yellow Cake is (for lack of a better word) a uranium broker; it buys uranium from mining companies around the world and sells it again to licensed users of uranium, mostly nuclear power stations and various research laboratories; hence its main asset is the millions of pounds of U3O8 it stockpiles at all times.

By investing in Yellow Cake, you are directly exposed to the price of U3O8 at a meaningful discount. As at the latest count, the discount is about 22%. Furthermore, by investing in Yellow Cake, you have none of the operations-related risks you have when you invest in in uranium mining companies.

I wrote a paper on uranium in March 2020, which is available to all ARP+ subscribers here.

Graphene

Another natural resource which I think will do extraordinarily well in the years to come is graphite which is used when producing a new, revolutionary material called graphene. You may wonder what graphene is, so let me explain. Quoting digitaltrends.com (and I paraphrase), graphene is a single, thin layer of graphite which is an allotrope of carbon, meaning it possesses the same atoms, but they are arranged in a different way, giving the material different properties. In short, it is thinner than paper but stronger than steel. Just one atom thick layer of graphene is 100 times stronger than steel.

Due to its versatility, it can (and will) be used for many different purposes. Within the next few months, Samsung will begin to use graphene in lithium-ion batteries, where it is going to replace cobalt on the anode of the battery – a new technology which will dramatically reduce the charging time. Samsung have already said that they will likely roll out the first graphene battery early next year.

That is far from the only new application, though. In noparticular order of importance, graphene can be used in body armour, when filteringsalt from seawater in desalination plants, in the treatment of many cancerforms, in the manufacture of athletic shoes, when treating patients indialysis, etc. etc. The list is almost endless, and graphite is my favourite naturalresource to turn into the resource of the 21st century. If you have notread part IV of this research paper yet, I suggest you do so, as more detailsare provided.

One final point on graphene: unfortunately, we have not yetidentified the best way to invest in graphite. If any of our readers comeacross an obvious opportunity, I would greatly appreciate if you would drop mea note.

Fusion energy

Despite all the advantages a new material like graphene will bring, the ultimate game changer is fusion energy, though. In the fusion process, hydrogen (taken from water) is converted to helium, and that conversion releases about ten million times more energy than that released when burning the same amount of hydrogen. While a 1000 MW coal-fired power plant requires 2.7 million tonnes of coal every year, a fusion plant which is geared to deliver the same output will require no more than 250 kilos of fuel (lithium) every year.

Only a few grams of fuel are present in the plasma at any point in time. This makes the fusion reactor incredibly economical in its fuel consumption, and it adds important safety features to the process. Meltdowns, for example, cannot happen. In terms of cost effectiveness, if you combine the water from a half-filled bathtub with the lithium from one laptop battery and expose the hydrogen in the water to the fusion process, you end up with a huge amount of energy – about 200,000 KWh of electricity to be precise, which is about 30 years of UK per capita electricity consumption. Effectively, fusion energy will lead us to a future where the marginal cost of electricity drops to virtually zero.

On top of that, if you add the fact that the fusion process will generate no CO2 emissions whatsoever, it is hard to overstate the impact this invention will have on the global economy when it finally arrives. Unfortunately, it is still at least ten years away. Other energy forms like traditional nuclear (fission energy) will therefore be required for a long time to come if we are serious about reducing the carbon footprint.

So, how do you invest in fusion energy? So far, most research has been funded by public capital with private sector capital still being relatively new to this industry, but the fact that private capital has finally begun to enter this space tells you that fusion energy is no longer just a distant dream. In terms of specific opportunities, I suggest you read this article from Forbes Magazine and, if people tell you that fusion energy is still 30 years away (which many continue to claim), I suggest you read this article from New York Times, published only a few weeks ago.

Adding it all up

As mentioned earlier, I would allocate about one-quarter of the equity slice in my portfolio to tomorrow’s natural resources. Having said that, there is a caveat. Certain types of companies in my natural resource portfolio are what I call second derivatives. A good example of that would be Vestas, a global leader in the design, manufacturing, installation and servicing of wind turbines. It is strictly speaking not a natural resource company, but it benefits immensely from the ongoing energy transition from fossil fuels to renewables.

Outside of China, the wind turbine market is effectively controlled by a trio of Vestas, Siemens Gamesa and General Electric (Exhibit 7). Industry sources tell me that Siemens Gamesa and General Electric are both plagued by various problems, handing Vestas a golden opportunity to further increase its market share.

Given the already rapid growth rate in the industry, Vestas could therefore go through a period of extraordinary growth over the next few years. I would allocate 15% to second derivatives generically and a substantial part of that to Vestas. Exhibit 8 at the end sums up my Day One portfolio in natural resources.

Exhibit 7: Top 10 wind turbine suppliers globally (2019)
Source: en:former

Between lithium, uranium and graphene (graphite), I would allocate most to uranium. It may surprise you that I allocate as much as 20% to uranium but, of all the natural resources in my portfolio, uranium is the one I am most comfortable with. In a nuclear power plant, the fuel cost makes up a surprisingly small percentage of total operating costs (10-15%), meaning that even a doubling of U3O8 prices will only have a modest impact on electricity prices.

Furthermore, you rarely shut down a nuclear powerplant, once it is up and running. Even a temporary shutdown costs millions of dollars, so nobody ever does it. In other words, demand for uranium is very predictable, and so is supply, given the long lead time from an executive decision to increase mining to actual mining.

For now, I would allocate about 15% each to lithium and graphene (graphite). The market for lithium will be much bigger than it will for graphene in the short- to medium term, but the opportunity set for graphene is less well understood and, over time as the range of applications widens, I expect to allocate far more to that than to lithium.

Also, graphite supplies are not subject to the same problems as lithium supplies are, i.e. that more than 50% of all reserves are in the hands of South American countries, many of which are financially weak, which could (occasionally) lead them to oversupply the market to close a hole or two in their budget.

Other metals like manganese, nickel, copper and aluminium are also represented in my portfolio (10% combined), but those metals are all used for other industrial purposes as well; hence they bring a fair amount of economic beta into the portfolio, which is why I only allocate 10%.

As far as water is concerned, as you can see below, I allocate more to water than I do to any other natural resource (25%), and the reason is simple. If you do your homework it is hard not to reach the conclusion that water will cause us serious problems in the not so distant future. I am as convinced as I can be that water scarcity in some countries and flooding in others will create all sorts of problems in the years to come and that, given the critical nature of water, the price of it can only rise substantially.

Finally, and this may surprise you the most considering how excited I am about the prospects for this energy form, I don’t allocate a penny to fusion energy – at least not on day one – but that is only because it is still rather unclear who the winners and losers will be. Over the next ten years, as we approach the date of commercialisation, don’t be surprised to see my allocation to fusion energy to rise dramatically. I could potentially go as high as 50% when the picture is clearer. That is how excited I am about the prospects for fusion energy. In terms of visibility, we are just not there yet.

Exhibit 8: Day-One allocation to natural resources
Source: Absolute Return Partners LLP

Final comments

We have now completed our thoughts on natural resource investing in an environment impacted by digitisation and climate change. Having said that, new regulatory demands, peer pressure, shifting customer requirements, etc., make it difficult to predict precisely how it will all unfold in the years to come. Nobody knows, which is why this entire research paper (parts I-V) will probably remain work in progress for many years to come.

Finally, I have to stress that the portfolio above (Exhibit 8) is my suggested natural resource portfolio as things stand. I would be hugely surprised if my research team don’t add one or two interesting perspectives, and I would be equally surprised if my own views don’t change over time. Our research team have not yet conducted proper research on any of the names mentioned in this paper, hence none of the above should be considered a recommendation to buy. With one or two exceptions, we are not in the business of recommending single stocks anyway. Any future recommendations will likely be in the form of natural resource funds.

Niels C. Jensen

3 November 2020

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.