The Malthusian Trap
If someone who lived before the Industrial Revolution could visit our world today, what would surprise them the most is that no one is hungry anymore. Food has never been cheaper in human history than it is today. The real price of wheat peaked about two centuries ago and has been falling ever since.
The 13th largest company in the world (LLY) sells treatments for type 2 diabetes, caused by overeating. The 25th largest company (NVO) found a peptide hormone in Gila monster venom that helps people reduce their food intake by lowering appetite and slowing down digestion.
The Reverend Thomas Robert Malthus (1766-1834) is famous for his 1798 book An Essay on the Principle of Population [pdf], where he argued that geometric growth in population would always outpace an arithmetic growth in food production, causing hunger and famine.
But Malthus never actually makes an argument for his proposition that growth in food production is limited to arithmetic increases! On page seven of the book, he writes that "the most enthusiastic speculator cannot suppose a greater
increase than" arithmetic increases in food production, and leaves it at that.
Malthus wrote his
book as a response to optimistic social thinkers such as William
Goodwin and Nicolas de Condorcet, who imagined a future of prosperity once unjust
laws and institutions had been reformed. Malthus did not think this would
make any difference.
His theory was consistent with human experience up until that time. As The Tom File points out, the average European family in 1800 was no better off than the average citizen of the Roman Empire two millennia earlier.
The bubonic plague killed as much as half of the English population during the 14th century. Real wages in England were at their highest in the 15th century, when the population had shrunk down to about 2.5 million people. By 1600, the population was back to where it had been in 1300 just prior to the plague (around 4.5 million) and real wages had fallen to the same level as three centuries earlier. (In a paper about pre-industrial stagnation, Icelandic-American economist Jón Steinsson calls this a "400 year
plague-induced ride up and down the labor demand curve.")
But Malthus went short humanity at the low. His essay was followed almost immediately by two centuries of agricultural and industrial revolution, which produced an ever increasing availability of food to the point
of overabundance. Synthetic
fertilizers and hybrid wheat have been the two biggest factors in breaking
the relationship between growing population and hunger. Food production has outpaced population growth, contra to Malthus' simple supposition, and so the daily supply of food production per person is at all time highs even with total world population at an all time high.
What happened? Malthus' inverse relationship between population and real wages (and caloric availability) is valid in a world with no technological growth, and that was an accurate description of most of human history. You might say that Malthus' model explains all of human history except for the
last 200 years. But we now live in a world of continued technological innovation, and Malthusian predictions of famine and collapse have not come to pass.
Limits to Growth
The debate over Malthusianism returned in the mid-20th century. In 1972, researchers at MIT published a model that predicted that resources would be exhausted and population would collapse, based on an assumption of exponential population growth and an ability of technology to increase resources only linearly. (The same two assumptions that Malthus made.)
The book that was published based on the MIT study was called The Limits to Growth, and it was commissioned by the Club of Rome. Paul Ehrlich wrote a book in 1968 called The Population Bomb that predicted famines due to overpopulation. (They were supposed to happen in the 1970s.)
These Malthusian-revival concepts influenced the Chinese, who were concerned about their growing population, with TFRs above 6.0 in the 1960s. A Chinese policymaker named Song Jian, once of the designers of China's submarine launched ballistic missile, apparently read The Limits to Growth and A Blueprint for Survival on a visit to Europe. His colleagues determined that the ideal population of China was 700 million, and that a one-child policy would be required to meet that goal.
There were other thinkers, mainly economists, who pushed back against the Malthusian doomers. Their school of thought is best described as cornucopianism. The optimistic, cornucopian viewpoint stands in opposition to the pessimistic, Malthusian belief about the world that likens human beings to multiplying bacteria in a petri dish, which will grow
exponentially until they exhaust their food supply.
The two most interesting cornucopians were Julian Simon and Herman Kahn. Simon argued in his book The Ultimate Resource that human ingenuity creates new resources as required from the raw materials of the universe.
In 1980, Simon proposed a wager with Ehrlich: that the cost of non-government-controlled raw materials (including grain and oil) would not rise in the long run. Simon told Ehrlich that he could chose any raw material or materials that he wanted, and that as long as the bet was more than one year out, he would bet on the inflation-adjusted (real) price to decrease. Ehrlich chose a basket of five commodities (copper, chromium, nickel, tin, and tungsten) and a time period of one decade (1980 to 1990).
What ended up happening was that the world's population grew by more than 800 million (the largest increase in one decade in all of history) but the price of each of Ehrlich's selected metals fell. Three of the five metals went down in nominal terms and all five of the metals fell in price in inflation-adjusted terms. For all five of them, better technology allowed for either more efficient use of existing resources, or substitution with a more abundant and less expensive resource.
(A modern, "neo-Malthusian" example of Ehrlich's view on commodities is expressed in the book Blip, which argues that humanity is coming to the end of a "300 year self-terminating experiment with industrialism." The author of Blip posits that shortages of non-renewable natural resources, particularly minerals, will cause industrialism to unravel and human society to collapse by the year 2050. He makes the types of arguments that Malthusian peak-resource people make, citing the declining ore grades for minerals, the relatively short reserve lives for minerals, and the exponentially increasing demand, given growing populations. Of course, those reserve lives are based on currently known reserves. As Kahn put it, "There is little reason for known reserves to exceed the expected demand by more than a few decades. It does happen occasionally but not because shortages have prompted a search for additional supplies. Thus, if we have stumbled upon coal reserves for more than 200 years and iron ore for more than 1,000, we can hardly expect private investors to be excited about a proposal to look for still more.")
Herman Kahn
He has been all but forgotten now, but Herman Kahn
was famous in the mid-century for his work on nuclear war-fighting
strategy for the RAND Corporation. (He was one of the inspirations for
the eponymous character in Stanley Kubrick's 1964 film Dr. Strangelove.) Kahn's bestselling and controversial book On Thermonuclear War was a sensation for a period of time, but he got bored with nuclear strategy by 1965 and turned his attention to
growth and development, and particularly to rebutting the neo-Malthusian, Limits to Growth thinking that was growing in popularity at the time.
(Kahn had
the idea that world wars were unlikely to happen again: "modern
technology and other developments have either obviated, lessened, or made
transitory the historic strategic value of many geographic areas," and
"national strength, power and influence today depend mostly on
technology, gross national product and a host of imponderables and hardly at
all on the possession of critical geographic areas.")
He
would probably be better known if he had lived longer, but he was obese
and died in 1983 at age 61, just as President Reagan was inaugurating
the boom that Kahn forecast in his book The Coming Boom (see our Q1 note).
We just finished reading all of his non-military books in preparation
for an essay about cornucopianism, and since he was a very interesting
character in his own right, we thought we would outline four interesting
themes that come up in his work.
While in his time Kahn was best known for his books and
lectures on nuclear war and deterrence, that feels about as relevant
today as Alfred Thayer Mahan's
thoughts on sea power. As time goes by, what seems most interesting is
that he was a leading cornucopian thinker at a time when people were
despondent about overpopulation, resource scarcity, and the environment.
(Including, ironically, fears of global cooling.)
Kahn would be
emphatically against the idea of “peak” anything when it comes to
resources. He would not have been one for peak oil, or the book
Twilight in the Desert by Matthew Simmons. The economist's viewpoint,
and the way that Kahn thought, is that humans do not "run out" of
resources. Rising prices of any good or service encourage increased
production, conservation, and innovation towards both substitutes and
towards better production methods.
For any problem involving
scarcity that Kahn considered, he always tackled it with a three prong
approach. He would make lists of all of the possible ways that more of
the resource could be found or extracted more economically. He would
think of potential substitutes for the resource, or for the ends that
the resource was being used to satisfy. And he would think of ways to
conserve the resource.
Amazingly, in his book The Next Two Hundred Years,
he wrote that, "once an effective process for the extraction of oil
from shale is developed, the total available supply of fossil energy
could be more than quadrupled." Keep in mind that he wrote that in 1976.
He just assumed that eventually people would figure out how to
extract oil from source rock instead of the reservoir rock, and forty
years later the production of "tight" oil from source rock became
meaningful. Now the production of this oil using horizontal wells and
hydraulic fracturing has surpassed conventional oil production in the U.S.
If
Kahn had ever gotten interested in commodities investing, his mantra
would have been to sell shortages and buy gluts. Note that absolutely
nothing in cornucopianism says that you cannot or will not have episodes
of rising commodity prices. Remember the book Capital Returns
about industry capital cycles: over-investment in capacity leads to low
profits and bad times for an industry, and under-investment leads to
high profits and good times. Kahn's view was that commodity prices tend
to fluctuate wildly around a trend that is downward sloping in real
terms.
He thought that there was no substantive basis for the
oil crisis of the 1970s, since "there was no physical shortage of oil,
only a cartel that succeeded in forcing at least a temporary increase in
the price of the commodity it controlled." He thought that it would be
even bearish for oil in the intermediate term: "the cartel's moves
actually decreased the possibility of future energy shortages" since
they encouraged both conservation and production.
The real price of oil did peak in 1980 and experienced a brutal crash that lasted until 1998. The Economist magazine cover
story in March 1999 was "Drowning in oil," predicting that the world
was likely to remain awash in oil. Sell shortages and buy gluts.
(Kahn: "The rate of growth in gross world product increased by about 40 percent during 1973 and at the same time there was an unusual degree of inventory accumulation accompanied by considerable speculation in commodities. As a result, prices skyrocketed and the public was told that 'everything was scarce' in 1974. But only a year later 'nothing was scarce.'")
Kahn's
approach to considering problems was to think of as many potential
solutions as possible. Get our a whiteboard or easel or legal pad, and
just start writing them down. His two futurist books (The Coming Boom and The Next Two Hundred Years)
are, in large part, just lists of all the conceivable ways that the
problems that seemed pressing at that time could be solved. This is a high agency mindset.
Regarding food, Kahn pointed out that between 1790 and 1974, farm employment had declined from 90% to 4.4% of the labor force in the U.S. He saw the possibilities of: expanding tillable acreage, multiple cropping, and increasing yield per acre as ways of increasing output for a growing population.
His ultimate takeaway: "Nearly every measurable environmental blight or hazard can be corrected by a combination of technology, a reasonable amount of money, sufficient time to make the required changes, and (occasionally or temporarily) some (otherwise undesirable) self restraint." He said that he expected "the fluctuations of the commodity cycle will undoubtedly continue, around a slowly changing trend line, which is much more likely to be downward than upward sloping."
DoomerismThere
seem to be two key psychological motivations that drive doomer
thinking. First, increasing wealth resulting from GDP growth over time
can actually be bad for the upper-middle socioeconomic classes. If you
are hiring someone to mow your lawn,
watch your baby,
fix your air conditioner, or build your house, then either there is
significant income inequality between you and them or else the cost of
it is going to sting. (The way that hiring a lawyer to do something is
unthinkably expensive for middle class people.)
The type of person
who was advocating Limits to Growth thinking in the 1970s is today
looking around the crowded American Express lounge at the airport
saying, "this is unsustainable." These are frustrations of mass
affluence. (Kahn predicted that there would be plenty of frustrations,
mostly psychological, as prosperity became more universal.) Another frustration of mass affluence is the crowded ski slopes at more accessible resorts. These types of pressures require new, more exclusive to be built to keep out the mass affluent.
Why does the upper class advocate against economic growth sometimes? Simple: economic growth makes servants more expensive! Kahn points out that as societies get richer, labor (i.e. servants) gets more expensive, and believed that objections to growth came from this class interest. (He quotes Schumpeter, "one good maid is worth a household full of appliances.")
The other doomer motivation might best be described as fear. As we wrote in our review of Trillion Dollar Triage,
no one was going to auction American business off during the middle of a
pandemic to curmudgeons on the sidelines holding T-bills. But that is
what the doomers want: an opportunity that is an absolute gimme. One
problem with that is that when it comes it seems too scary, which is why
John Hussman has been bearish for 25 years, a time period that has had three major bear market lows. How could he ever buy now? He has painted himself into a corner.
We
wonder how Kahn would have invested if he had lived longer. There is
some possibility that he would have been a Boglehead indexer. That would
be the case if he decided that corporate profits would grow with GDP
and thought that indexing was an easy way to participate. But he had a
lot of insights (about computing, selling shortages and buying gluts,
and mass affluence, for example) that would have been very profitable in
public market or venture capital investing. If Kahn had been born just a
little later he might have avoided his detour into military thinktanks,
which were both a distraction in terms of subject matter (which he did
get away from) and a poor business model (which he didn't).
CopperOne of the commodities that Ehrlich put in his basket for the bet against Simon was copper, and it is perhaps the ultimate case study in cornucopian economics. Copper was $1 per pound in 1980 and it is $4.24 today. This exactly matches CPI inflation; the price of copper has not increased or decreased in real terms. So even with an extra 34 years added to the original 10, Ehrlich would have lost the copper component of the bet.
There is a great presentation by an Australian mining analyst named Richard Schodde on the copper mining industry over the past century. From 1900-2010, the cumulative world production of copper has been something like 700 million metric tons. (This would fit into a cube measuring ~1,400' on a side.) Ore grades were ~4% in 1900 and have dwindled to a fraction of a percent. Yet reserves of copper are higher than ever: over a billion tons.
(Kahn anticipated this: "In the 19th century, for instance,
only copper ores containing 4 to 6 percent of copper were regarded as
useful. At present, however, ores are worked with an ore content of as
little as 0.4 percent. It is virtually certain that in 20 to 30 years
ores with as little as 0.25 percent will be profitably exploited.")
What happened? Why aren't we "running out" of copper as the high grade mines have been depleted? And why isn't the price at least rising? Schodde says that what allowed copper to get cheaper as ore grade fell over the past century was greater economies of scale (as production went from 1 million tons of ore per year to 100 million tons) and technological improvements.
One improvement called froth flotation was the biggest thing to ever happen in copper mining. When you are mining a copper ore that is only 0.5% copper it means that for every 1 part of copper there is 199 parts of worthless waste compounds that need to be disposed of easily and cheaply.
Froth flotation takes advantage of the fact that minerals differ in the degree to which they can be wetted by various solutions. The ore is ground up and the powder is put into tanks called floatation cells, which are filled with a mixture of oils. The solution of ore powder and oils is agitated and air is pumped in, which results in a froth. Given the right combination of solution ingredients and minerals in the ore, the copper minerals will adhere to the froth, which is easily separated, and the waste material sinks to the bottom of the tanks.
The key is that the efficient rejection of waste material (which outweighs the copper content by more than two orders of magnitude) allows processing of very low grade ore. That in turn opened up deposits of low grade ores at the surface which can be mined in open-pit mines. There is a huge efficiency increase when you go from following a rich vein picks and shovels in an underground mine to using immense mining trucks to carry ore out of an open pit mine.
The ore in the open pit Bingham Canyon mine outside of Salt Lake City is low grade copper-sulfide (mainly chalcopyrite) and it has been producing copper for more than a century.
Recent Cornucopian Surprises
What got us interested in studying cornucopianism were some recent
technological surprises that seemed very un-Malthusian. As we were researching energy investments (including oil & gas and refining) we had to consider whether chemical batteries will ever get cheap enough for there to
be an actual, market-driven (not subsidized) transition from nature's
perfect transportation fuels (gasoline and diesel) to batteries for electric vehicles.
It is certainly true that the price of lithium batteries (in $/kWh) fell substantially
over the past decade, from about $1,355 per kWh to $150/kWh in 2022; an
order of magnitude decrease. An electric vehicle can go about 3 miles
per stored kWh of energy, which means that a 100 kWh battery pack will
cost $15,000 and give you 300 miles of range. In California that amount
of electricity at retail might cost $25. The gasoline to drive the same
distance would cost perhaps fifty percent more (depending on fuel efficiency and retail gasoline price), but the gasoline motor would be
much cheaper than the battery and electric motors.
So a big
question is: will the battery learning curve continue to result in
cost declines (in which case an electric vehicle transition would soon
make sense)? Or was a meaningful part of the learning curve and
order-of-magnitude cost decline caused by the commodities bear market
from 2008-2020?
We did see in 2022 that electric vehicle battery prices rose
for the first time due to higher input costs. But the electric vehicle
manufacturers responded to this by changing the cathode chemistry of
many EV batteries to lithium iron phosphate (LFP),
which has a lower energy density than the nickel and cobalt chemistries
do, but avoids using those more expensive metals. Iron is obviously not
scarce, so the big question going forward will be the price of lithium. (Also, there's a downside of LFP, which is that it seems to do very poorly
in cold weather.) We are starting to see the iron versus nickel
catalyst price difference show up at retail. The Ford F-150 Lightning
electric pickup truck's standard range (230 miles) is much cheaper than the extended range (320)
because the standard range uses an LFP battery.
There is a great tension between physics-based pessimism
about natural resources and economics-based optimism (some might say
cornucopianism) about the ability to respond to higher prices with
substitution and invention. The LFP battery seems like a major point
in favor of the cornucopian, economist viewpoint. We would not have
thought it possible a few years ago to make a battery with just lithium
and iron.
The price of lithium spiked very high (almost $40/lb) in late 2022 compared with where it was ($2/lb) before serious electric vehicle production began. One calculation
that we found is that 80g of lithium per kWh is the theoretical maximum
efficiency for a LFP battery and the current real world efficiency is
under 50%. In other words, it takes more like 200g per kWh, which would
mean that a 100 kWh battery (that can take you three hundred miles)
requires 20 kilos (44 lbs) of lithium, which currently costs around
$220 but cost more like $1,800 at the peak.
Most of the cost of a LFP battery is therefore not
from the lithium metal; perhaps only $220 for a $10,000+ pack that
holds 100 kWh. That means that the price of the battery will not benefit
much from a decline in the cost of lithium (which seems perfectly
likely as capacity expands since lithium is not all that rare). On the
other hand, when a manufactured item costs much more than its bill of
materials, it seems more likely that the final cost will continue to decline due to learning curve effects. As Winfred Hirschmann wrote in the Harvard Business Review in 1964:
Practice
makes perfect. A thing can always be done better not only the second
time but each succeeding time by trying. This everybody knows. But how
many know that the pattern of improvement can be sufficiently regular to
be predictive? How many realize that such patterns can characterize,
not only individual performance, but also the composite performance of
many individuals organized to accomplish a common task?
The
industrial learning curve quantifies such performance. It has evolved
from experience in airframe manufacture, which found that the number of
man-hours spent in building a plane declined at a regular rate over a
wide range of production. Such continuing improvement was so common in
the aircraft industry that it became the normal expectation in the war
time mass production of aircraft; thus, production and other types of
performance were customarily scheduled on some basis of progressive
betterment. [...]
People do learn, and they learn according to a generally predictable pattern. The learning curve, I believe, is an underlying natural characteristic of organized activity,
just as the bell-shaped curve is an accurate depiction of normal,
random distribution of anything, from human I.Q.’s to the size of
tomatoes. Wherever people strive to do better, improvements result;
otherwise, how would progress take place?
By failing to
capitalize on this natural phenomenon, managers will not encourage
continued efforts once they become convinced that “further improvements
are not possible.” Further improvements are always possible over time,
so long as people are encouraged, or even ordered, to seek them. Thus,
an understanding of the learning curve becomes of crucial importance to
the business manager.
So what does this mean for internal combustion engine vehicles - have they been disrupted?
It
will take time to scale up lithium mining, lithium refining, battery
production, mining of other metals, electric vehicle part production,
and electric vehicle assembly. It will take time (a long time) for the
existing fleet of internal combustion engine vehicles to turn over. In
fact, it will be a big day when the number of ICE vehicles in use
worldwide actually begins to decline.
Another issue is that, in
addition to the production of the electric vehicles, an entire, complimentary
charging system has to be created as well to replace the distribution
system for gasoline. That is everything from the generation of
electricity to the transmission and distribution of it to the vehicle
charging locations and appliances. The transportation sector uses
about 24 quadrillion BTU of energy from petroleum (annually). The
electric power sector delivers only 13 quadrillion BTUs, out of a total
of 37 quadrillion BTUs consumed from fuels and resources. (The
electricity transmission system is very lossy.)
The electric vehicle
transition can only happen as fast as the slowest one of these steps.
All it takes in a series process (as opposed to parallel) is one
bottleneck to delay the whole process. So, it seems like an electric
vehicle transition is possible but it will be slow. And, in particular,
the bottlenecks mean that it might be unexpectedly slow, which
will continually discourage investment in industries related to ICE vehicles, which in turn could prolong the profitable part of the capital cycle.
The new lithium-iron-phosphate (LFP) battery chemistry seems like a
major point in favor of the "cornucopian," economist viewpoint whereby
innovation and substitution defeat shortages. We would not have thought
it possible a few years ago to make a battery with just lithium and
iron. The LFP chemistry took off because of scarcity of lithium and
cobalt, but it has been known as a possible cathode material at least as
far back as 1996. (Scientific papers that are "sleeping beauties" should
be part of cornucopian theory.) The prices of cobalt and nickel have
both fallen substantially since the LFP batteries were rolled out, with both metals down about 70% in price their recent peaks in the spring of 2022.
Is Fracking Sustainable?
Let's imagine four possible wheat-related business models over the time period since the price of wheat peaked:
- buying and storing physical wheat
- renting land and growing wheat
- owning land and growing wheat
- owning land and renting to a farmer (perhaps for a percentage of his harvest)
Storing
wheat would have had a strongly negative return. Not only has the real
price of wheat fallen, but the cost of storing grain is something like
25 cents per bushel per year (not counting the cost of extra drying and
handling that is required) which would be a further several hundred
basis points deducted from the annual return. Clearly this business
model would not be a winner.
The farmer renting land has a
business model that is analogous to an oil or gas producer, selling
commodity outputs and buying mostly commodity inputs, and doing the
transformation on rented land. (Although the farmer sometimes uses
premium inputs, like patented seeds and such.) The farmer on rented land
rarely has a great year. He needs the wheat price to be above his cost
to make an economic profit. That can happen occasionally on a random
basis if, for example, other farmers' crops get wiped out by pests or
weather, while his survive. This business model cannot be expected to
result in economic profit over time, although the farmer can make a
living at it. (Pardee Resources made the mistake of investing in two
agricultural investments in 2016 and they are finding out that the
farmer's economics are not good.)
On the other end of the
spectrum, the landowner renting to a farmer for a percentage of his
harvest has the a business model analogous to the mineral royalty owner.
The farmer would be responsible for the capital expenses, the operating
expenses, and the working capital investment. Something noteworthy is
that the landowner's percentage rent figure would be always positive,
never negative.
The relative outcome of these other three
business models would have depended on the price of land and other
variables. Theoretically, the market prices and rents could have been
such that the superiority of the royalty model was priced-in, but
practically we would bet that the landowner's return would have been the
best by far. Surprisingly, even as the real price of agricultural
commodities has fallen, the real value
of agricultural land has risen. Over such a long time period, the
landowner might also have benefited from the conversion of agricultural
land to higher and better uses.
Conventional U.S. oil production peaked in 1970, which was what
Marion King Hubbert (1903-1989) predicted in 1956. The price of crude
oil exploded higher and energy scarcity became a major concern. (At least
for most: Herman Kahn was sanguine about it.)
And that is what
happened. He specifically anticipated that people might eventually
figure out how to extract oil from source rock instead of reservoir
rock formations. Now the production of this "tight" oil using horizontal wells and
hydraulic fracturing has surpassed
conventional oil production in the U.S.
Note that “unconventional” oil was originally used to mean “much more costly,” but
the real price of oil (WTI crude, deflated by the producer price index)
is now lower than it was twenty years ago, when Twilight in the Desert was written. (See chart and longer view from 1946 to 2013.)
Historically,
the production of oil was limited by the requirement of finding oil
that had been trapped in a porous and permeable layer of reservoir rock.
A conventional, vertical oil well can only produce oil from rock of
sufficient porosity. For the oil to get there required a conjunctive
set of events over millions of years: burial of organic matter,
"cooking" this material into hydrocarbons at a sufficient depth and
pressure, migration from the source rock layer (e.g. shale) to a
reservoir layer, and trapping the hydrocarbons geologically in that
layer with something like an anticline, fault, or salt layer.
It
stands to reason that there is far more oil in the source rocks than
what migrated to reservoir rocks and happened to be contained by
geological traps. The horizontal drilling and fracturing of the source
rocks is more expensive than conventional production, but maybe by a
factor of 2-3 (i.e. less than an order of magnitude). It also seems as
though the producers have gotten better at this process: a typical learning curve effect.
This
makes shale producers the highest cost producers of oil. There are
still large amounts of cheaper supply out there, such as the Saudi
conventional oil fields (still producing almost 10 million barrels per
day), Canadian oil sands, and deepwater fields.
When the price
of crude oil is above the marginal cost of shale production, the shale
producers
respond by drilling more wells. This quickly drives the price of oil
back down to the shale producers' marginal cost, which is below their
full-cycle breakeven cost. This causes the business to consume capital
over time instead of generating a return on capital. Shale production
has the economics of the farmer or rancher on rented land, or of an Uber
driver. Being the highest cost producer of a commodity is a bad
business model that consumes investors' capital.
As we have noted in the past,
the mineral owners have done much better since they benefit from the
uneconomic drilling by the producers. The Dorchester Minerals
partnership (DMLP) has compounded at 10% per year (total return) since the price of oil peaked in June 2008.
The
S&P Oil & Gas Exploration & Production ETF (XOP) has made
about 1.15% per year (total return) since inception in June 2006, and it
includes a number of companies that are not shale producers or even
E&Ps, such as Texas Pacific Land. (It also gives exposure to
diversifying business segments such as the refining and conventional
production of the major integrated companies.) Investors in shale
producers have done much worse than the XOP index and have almost certainly lost money even in nominal terms.
What we have come to think is that shale is a cornucopian
bounty, and the producers do not make money because they are in a
classic bad business (resource extraction), not because there is
something unsustainable about producing oil from the source formations.
Being the highest cost producer of a commodity is just a constant tale
of woe punctuated by occasional profitable times. The good times keep
people - both managements and investors - chasing the dream.
The shipping industry is like this. As we noted
a decade ago, shipping is a bad business. The price per ton mile
continually falls in real terms. As soon as you take delivery of a new
ship, your competitors order ones that are bigger, faster, and more fuel
efficient.
Ships are lottery ticket investments
that attract gamblers. The distribution of shipping rates and ship
values has skew that attracts gamblers, because the supply of shipping
capacity (tonnage-miles) is inelastic enough (although not perfectly
inelastic) that the rates an owner can charge will have huge swings.
This is particularly attractive to agents who are buying ships with other people's money.
The
Haynesville Shale natural gas producer Comstock Resources is a perfect
illustration of high cost commodity producer economics.
During the most recent quarter,
Comstock sold 133 billion cubic feet of natural gas for an average
price of $1.90 per thousand cubic feet. As you can see in the results
above, this was not enough for Comstock to have positive free cash flow.
But if they could have sold their natural gas for about $0.50/mcf more,
that would have been enough additional revenue to be about breakeven on
free cash flow.
Jerral Wayne ("Jerry") Jones is the 82 year
old owner of the Dallas Cowboys and the majority owner of Comstock.
Earlier this year he plugged
another $100 million into the equity. As long as he is willing to
produce natural gas for a loss, the price will be slightly lower than it
might otherwise be. (Comstock is producing ~1.6% of U.S. natural gas.)
Comstock
is owned by Jones and by index funds: various funds like the iShares
Core S&P Smallcap ETF, the Vanguard Total Stock Market Index Fund,
the iShares Russell 2000 ETF, and of course the SPDR S&P Oil &
Gas Exploration & Production ETF (XOP) own most of the float.
A
funny side effect of index investing is that a slice of those
investors' capital is invested in the most inferior oil and gas business
model (the shale producers), while investments in the best business
models (the royalties and the pipelines)
are mostly off-limits to the passive investors, because they are
structured as partnerships or trusts, or they are heavily insider owned,
or private.
If there is many
times more hydrocarbons in the source rock than there were in the
reservoir formations and you can get the natural gas out for under
$3/mcf (and the oil for under $100/bbl), the future is pretty
cornucopian.
Investing in the high cost producers of commodities
(e.g. shale in oil & gas) is not going to work well if
cornucopianism is right. Those who are most bullish on the commodity
price like these because of "torque" (leverage) if the commodity price
goes up, but our hypothesis should be that the high cost producers are
lottery tickets attracting gamblers because of the skew.
If the
highest cost producers are generating significant free cash flow, then
the commodity is overpriced. We should have realized this when the
frackers were paying off debt and buying back stock
with high oil prices in 2022 and 2023. Buffett's favorite Occidental
Petroleum (OXY) is below where it was in March 2022. On the other hand,
the royalties, lower cost producers, and pipelines are all up. One idea
would be to short the highest producers against these superior business
models.
Land has always been a building block of a first
class fortune. Land is perpetual and land has many possible uses. It is
particularly interesting when we find a mineral royalty investment that
is still coupled to the surface because then we have the possibility of
alternative energy, data centers, and development for commercial,
residential, or industrial purposes.
Learning Curves
In the 1930s, an engineer at the aerospace company Curtiss-Wright realized that every time total aircraft production doubled, the labor hours required to build one aircraft dropped by 20%. (Paper: "Factors affecting the costs of airplanes".)
Bruce D. Henderson, the founder of the Boston Consulting Group, coined the phrase "experience curve" for the generalized idea that as the cumulative production of a good or service increases, the per-unit cost tends to fall by a constant percentage.
The learning or experience curve model implies that the world is full of low hanging fruit: ways of producing more with less. This is one of the things that Malthusians like Paul Ehrlich are up against when they bet against progress.
Elon Musk has a concept called the Idiot Index: the difference between the cost of a finished product and the cost of its materials. The implication is that something with a high idiot index has the potential to be made more cheaply. He asks engineers at SpaceX and Tesla to pay attention to the Idiot Indices of the parts for which they are responsible. One way that products can descend the learning curve in cost is by reducing the idiot index.
Casey Handmer of Terraform Industries (must follow) publishes a great chart of the learning rate of photovoltaic solar modules: the cost per watt as a function of the cumulative quantity that have been produced.
He calculates that the learning rate for photovoltaic solar module production increased markedly in 2009, and even with the blip upwards in 2022 has been running at 44% annual reduction in cost for the past seventeen years.
Casey also points out that the Platonic ideal of a photovoltaic solar array is essentially a thin layer of silicon. The Idiot Index of a solar module is still very high, even after a reduction in cost by three orders of magnitude over the past fifty years.
If photovoltaic solar modules and batteries get cheap enough, the future will indeed be one of radical energy abundance. We would never run out of silicon, iron, or lithium.
If batteries get good enough they would (in conjunction with photovoltaic solar) displace natural gas and thermal coal for electricity generation, and displace gasoline and diesel fuel (and therefore oil) oil for transportation.
Assuming that batteries do get cheap enough, the best line of defense for oil is maybe the time it will take to build out the electrical generation and charging capacity for an EV fleet. As we know from the Sankey charts, the quantity of energy being used in transportation is immense (https://flowcharts.llnl.gov/).
It seems as though you would have to significantly upgrade the last mile of electrical distribution to get that much more energy to people's doorsteps, which is important because a disproportionate amount (i.e. 80/20) of effort would be required for the last mile.
Investing Implications
The question of Malthusianism vs cornucopianism has huge implications for investors. Nothing could be bigger! If you knew that the world was Malthusian, the question of what assets to buy in the short term would be clear, although the long term future would be grim indeed. Let's instead think about investing implications of cornucopianism, on the hypothesis that it is a valid thesis.
A cornucopian society in the future would be a wealthier society. Herman Kahn predicted - and we have already seen - that wealthier people indulge in more leisure and more travel. Global passenger-miles flown by airlines have roughly doubled over the past twenty years. (It helps that the real price of crude oil was flat over this time period.)
One thing that we cannot create more of no matter how cheap energy or raw materials get is prime real estate. The amount of California coastline per capita goes down continually as the population grows.
If you combine two insights - increased desire and ability to travel, and scarcity of prime real estate - an implication is that the business model of Marriott International looks really good. Getting a percentage of the gross and net on over a million hotel rooms without investing the capital to build or maintain them.
The securities exchange businesses also seem interesting. The Options Clearing Corporation reports that the average daily volume of options traded is 48 million contracts for the year-to-date, a record and up 9% from last year. As people become wealthier, they seem to gamble more. Maybe what this shows is that status will still be scarce in a cornucopian world. When basic needs (food and shelter) are basically guaranteed, what people want is the opportunity to be the object of envy of others. Lotteries and bookies offer this chance, in exchange for a vig.
CME Group's futures and options volumes on interest rates have grown from about 1.7 million (daily contracts) in 2004 to 14.9 million in the third quarter of 2024, an annual growth rate of 11%. That was much faster than GDP growth and still faster than the roughly 9% rate at which the federal government's outstanding debt (which is the reference for the interest rate futures and options) has grown over those two decades.
Cornucopianism would mean we never run out of fossil fuel (or any other
resource) and would need to be somewhat concerned about falling real
prices of commodities, and also with the carbon added to atmosphere from the combustion of fossil fuels.
The implications are bad for the producers of commodities, and most especially the high cost producers of commodities. Canadian oil producer Suncor's guidance of bringing down the cost per barrel is what you want to see in a cornucopian world. It is hard to own Cenovus when Suncor, Canadian Natural Resources, and Imperial Oil can produce more cheaply, let alone owning a shale producer with a far higher cost.
Refiners will do poorly in a cornucopian world with increasing usage of electric vehicles. The refining industry does best when demand for refined products is bumping up against industry capacity. But if we reach peak refined fuel demand, then the refineries - with significant barrier to exit - may have permanent excess capacity that weighs on crack spreads.
It would seem that, in oil and gas, the mineral owners, pipelines, and
lowest cost producers would do the best. They have more stable revenue,
lower operating leverage, and lower capital expenditures. They are more
like inflation protected bonds than equities. The midstream industry may be particularly interesting. Both oil and
natural gas should continue to be useful for petrochemicals longer than as a transportation fuel.
Coal for steelmaking (metallurgical) coal should be safe for longer,
although people are working on electrolysis of iron ore (which would be
like aluminum production!) as well as hydrogen-based reduction. Those
would be a function of having cheap enough photovoltaic solar power and would not be driven
by battery cost. But it would take time and significant expense to
replace existing furnaces with these new processes.
One recurring theme in discussions of energy and natural resources disruption is the capital expenditure vs operating expenditure tradeoff. If your opex input is expensive, it makes sense to spend more on capex to build something that uses the input efficiently. If your opex input is cheap, it makes sense to spend as little on capex as possible and "waste" the input inefficiently.
Casey Handmer predicts a world of extremely cheap (practically free) electricity from photovoltaic solar, and since he wants to use it for electrolysis of water to produce hydrogen, he is optimizing his electrolysers to be cheap to build instead of efficient. Another example is direct air capture of CO2 using solid versus liquid sorbents. The liquid sorbent approach requires more capital expenditure but uses less energy. So if photovoltaic solar power is cheap, that implies you would use the solid chemistry, which wastes electricity but economizes on capital outlay.
Are we in a "bubble"?
Cornucopian theory can help us think about whether or not we are in an economic or investing "bubble". We are coming up on a couple of decades of Prechter and Hussman saying that we are.
One thing we have realized is that exponential growth looks scary on an arithmetic chart, but if you plot it on a log (semilog) scale, it is just a straight line. Richard Ngo wrote a great essay last year about The Gods of Straight Lines:
I picture the gods of straight lines as innumerable hovering spirits, just in the corner of your vision, vanishing as you turn to look at them directly. It’s hard to tell if they’re still or in motion. But they’re always there, as the world glides forward on its trajectory. And when that trajectory shifts, or something disruptive happens, they slide in, and they gently push it back on track. They take joy in the work, I think. Or amusement, at least, at all the narratives that humans develop to explain why each thing happened. It’s not that those narratives are false—but they almost always miss the point.
A newspaper pushes out a vitriolic op-ed, shaking up a nation’s politics? But if it gets clicks, then another newspaper would have run it later anyway. A metropolis builds more housing to fill its desperate need? Then the opposition from homeowners just becomes stronger, and the city relaxes into the same stranglehold as almost every other. A philosopher finds a new way of viewing the world? But if it captures the spirit of the age, then someone else would have written it better in a year or ten; and if it doesn’t, then it will never gain traction anyway. A country delays industrialization for decades? Then when it starts it will simply catch up much faster, skipping all the burdensome prerequisites: straight from telegraphs to cell phones, no costly telephone wires in sight.
A global war, a global pandemic? They’re horrifically destructive and wasteful—but also invigorating and regenerative, disrupting the calcified old power structures. And the two effects cancel out. You can tell, because the lines remain straight: a few short years after the bombs stopped falling in 1945, the world economy returned to trend as if nothing had happened.
Rudyard Kipling had The Gods of the Copybook Headings. Herman Kahn had his Gods of Straight Lines. When you look a semilog plot of a macroeconomic variable such as corporate profits or GDP, it is hard to get excited about a bubble.
Things have been remarkably steady. If anything, we have been growing more slowly than we should have thanks to government failures: excess regulation and taxation, and lack of property rights. Maybe we can get back on a faster track?
Cornucopianism Bibliography
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