Thursday Night Links

• Thoreau’s hissy fit in Civil Disobedience was motivated in part by his desire to avoid service in such a just, quick, winnable, and decisive war that won the United States the most valuable real estate in the world, the Pacific coastline, including much of the Mountain West. That millions of New Englanders later eagerly volunteered to invade their own country in a much bloodier war of attrition showed that it was not pacifism that motivated them, but their own “leapfrogging loyalties.” [The Tom File]
• Out of a million lives our knowledge came, A million subtle craftsmen forged the means; Steam was our handmaid and our servant flame, Water our strength, all bowed to our machines. Out of the rock, the tree, the springing herb We built this wandering beauty so superb. [John Masefield]
• Instead of “reasoned debate” from within the leftist worldview, an entirely different approach to historiography is required – one that interprets the world through a Classical lens. If the United States is to maintain a self-image based on pride and truth, we need a way of thinking that recognizes the propaganda war being waged over the meaning of American history, but steps over it. A historical view which actively upholds Columbus, for example, as opposed to merely resist his destruction. Within this framework the subconscious and aesthetic associations of great men like Columbus must not be merely neutral, but positive and inspirational. If revisionist historical discourse aims to humiliate, we should use history to celebrate and uplift. [Alaric]
• Cumulatively, these effects are at first linear over time, then quadratic, and eventually exponential. The forces are proportional to the square of velocity, so faster HSR trains damage rails faster. The Tokaido line averages around 140 mph (somewhat less than its peak of ~185 mph), but increase that speed by just 40% and rail lifetime will (at least) halve, while track maintenance costs (at least) double. Maintenance costs that were already on the order of $200,000/km/year, in 2003 dollars. That’s $400m/year just for rail maintenance for the LA-SF route, once we correct for inflation and a higher design speed. [Casey Handmer]
• Nolan’s early films were strange, seedy and suggestive. In an alternate reality, or a previous epoch, he continued developing his insights, and became an excellent psychological filmmaker — as good as De Palma, maybe. But with his success after Batman, his technique became aggressive and clumsy, to the point of abuse. The attractive delusion that Oppenheimer is “brilliant” extends from its blinding quality. The film as a whole is defined by a graceless and overblown use of music and a barrage of short cuts and short scenes which pummel the audience into hypnotic submission. Even in the endless interrogation scenes which dominate the last act of the film — a textbook case of diegetic failure — Nolan continues to pound away at his audience, drowning-out the dialogue with telegraphed emotional manipulation. This is the antithesis of confident, masterful filmmaking, which respects intelligence, and enhances sensitivity, instead of attacking it. Nolan’s cinematic technique only partly deflects from a script which exhibits the same problems as his visual style. It is surprisingly hard to say what Oppenheimer is about. [Daniel Miller]
• Duck, especially the pressed duck, is the speciality (Canard à la presse, Caneton à la presse, Caneton Tour d'Argent, and recently renamed “Caneton de Frédéric Delair”). The restaurant raises its ducks on its own farm. Diners who order the duck receive a postcard with the bird's serial number, now well over 1 million. (Serial number #112,151 went to U.S. President Franklin Delano Roosevelt, #203,728 went to Marlene Dietrich, and #253,652 went to Charlie Chaplin). [La Tour d'Argent]
• People just seem to spend 25-30% of their income on housing (with about half of that going to “shelter”). And this seems to be true as far back as we have data: in 1901, Americans spent on average 24% of their income on housing. That’s slightly below what we spend now, but this has been pretty consistent over time, with notable exception of the Depression. Truncating the y-axis really distorts the picture here: this is consistently within a band of 22-28%. The 1950s through the 1970s do seem a bit more “affordable” than today, but since the 1980s there has been no big increase (once again, a mild decline). [Jeremy Horpedahl]
• Shortly after my fourth child was born over the summer, I understandably got quite behind in my reading. I think that I had as many as twelve unread posts. I would try to catchup on the days that I stayed home with the children. After all, they don’t require constant monitoring and often go do their own thing. Then, without fail, every time that I pull out my phone to catch up on some choice econ content, the kids would get needy. They’d start whining, fighting, or otherwise suddenly start accosting me for one thing or another – even if they were fine just moments before. It’s as if my phone was the signal that I clearly had nothing to do and that I should be interacting with them. Don’t get me wrong, I like interacting with my kids. But, don’t they know that I’m a professional living in the 21st century? Don’t they know that there is a lot of good educational and intellectually stimulating content on my phone and that I am not merely zoning out and wasting my time? No. They do not. [Zachary Bartsch]
• Further stacking the deck in favor of batteries is the fact that power arbitrage depends on differences in demand, and there is a lot more spatial correlation than temporal correlation in energy demand. For example, over a 500 mile grid people will be using power for cooking and heating at the same times of day, while local weather systems will impact wind and solar generation in a correlated way. Conversely, power demand varies by a factor of two or three over a 24 hour cycle, every day, like clockwork. Why do batteries pay for themselves in 18 months while transmission lines, if built, lose money? Wonder no longer. [Casey Handmer]
• This is interesting – it goes against our intuition about the virtue of high efficiency and high capital utilization. But it’s not particularly mysterious. Hydrogen is an energy product, and if we’re doing it right then 70-80% of the product cost will be electricity opex. This is particularly important in the context of solar cost continuing to decline. A high capex option will still cost a lot even if electricity cost goes to zero, whereas a lower efficiency, higher power consumption option will pass cost savings on cheap power through to the consumer. Practically speaking, the best way to “short” future solar cost declines is to develop infrastructure now that achieves highly scalable low capex by trading away some electrical efficiency and being flexible enough to consume intermittent renewable electricity sources. [Casey Handmer]
• At present rates of growth, non-solar sources of energy will likely be excluded from the market by 2030. As costs continue to fall, fixed asset payback times for solar and batteries will reduce to the neighborhood of 24 months. Ultimately, the price of electricity for the consumer will fall enough to transform the way our society uses energy, opening up further opportunities for industrial growth. [Casey Handmer]
• Yeah, I really struggle with that. I have a whole bunch of books that I haven’t finished which I really should just toss. Patrick Collison talks about this too. The problem of having to finish every book is you’re not only spending time on books you shouldn’t be but it also causes you to stall out on reading in general. If I can't start the next book until I finish this one, but I don't want to read this one, I might as well go watch TV. Before you know it, you’ve stopped reading for a month and you're asking “what have I done?!” I think that's part of it. This moral hectoring of ‘don't do that’ which can only be so successful. The other technique is to read a dozen books at a time. [Marc Andreessen]
• There are a lot of books out there, and I don’t have the time to get through them all. So when I’m investing time in reading, I want to keep curiosity in the driver's seat and not let it slip out the back door (and no, my home is not on wheels). Forcing myself to trudge through a boring book can put my reading habit at risk, as I imagine it does for a lot of people. What’s nice about the above process is that it can take 15 minutes or an hour—however much time I want to invest in it—but I no longer have the mental baggage of lugging around a huge list of books that I’m “going to read one day.” I can just buy books as people recommend, and follow the above process to see how interested I am. [Brian Tobal]
  
• One very interesting point by Sirower is that the U.S. legal system encourages acquirers to overpay. As a shareholder of a company that makes a stupid acquisition, you have no recourse. The managers are protected by the business judgement rule. But the shareholders of the target have much more protection against their corporation being sold "too cheaply". The equilibrium result is that acquisition prices are too high and transfer value from acquiring firm shareholders to target shareholders. [CBS]

Canadian Oil Earnings ($CVE $SU $CNQ $PREKF)

[Previously regarding Suncor Energy, Cenovus Energy, Canadian Natural Resources Limited, and PrairieSky.]

Suncor Energy: the market capitalization is now $41 billion (at a $31.5 share price) and the enterprise value is $53 billion. They reported earnings for the second quarter of 2023 of $1.4 billion (figures in USD), which means that shares are trading for seven times net (annualized) earnings. This was with an average WTI crude oil price of $73.75/bbl for the quarter, a $15/bbl discount for WCS, and a $2.90/bbl premium for Syncrude.

Upstream production was up 3% year-over-year, from 720k bbls/d in Q2 2022 to 742k bbls/d this quarter. Upstream capital expenditures were up 20% year-over-year, for a "production shortfall" of 17%. (Compare with shale players like OXY, where the production shortfall in the Permian this quarter was 51% or Devon, which had a production shortfall of 80%.)

Suncor's free cash flow for the quarter was $782 million, which is a 6% yield on the current enterprise value. They returned $1.04 billion to shareholders during the quarter, equally split between share repurchases and dividends, for a shareholder yield of 10% (annualized). The refining operating income was down 75% y/y even though their proprietary Suncor 5-2-2-1 index (crack spread) was only down 33%.

Cenovus Energy: the market capitalization is now $37 billion (at a $19.70 share price) and the enterprise value is $45 billion. They reported earnings for the second quarter of 2023 of $643 million (figures in USD), which means that shares are trading for 14 times net (annualized) earnings.

Upstream production was down 4% year-over-year, from 762k bbls/d in Q2 2022 to 730k bbls/d this quarter. Upstream capital expenditures were up 61% year-over-year, for a "production shortfall" of 57%. (Note that the production levels were reduced by wildfires in Alberta this year, which explains part of the shortfall.)

Cenovus's free cash flow for the quarter was $741 million, which is a 7% yield on the current enterprise value. They delivered $427 million to shareholders in the second quarter through buybacks and common share dividends; plus they repurchased 45.5 million of their outstanding warrants for $528 million.

Canadian Natural Resources: the current market capitalization (at a $61.76 share price) is $67 billion, and the enterprise value is $76 billion. They reported earnings for the second quarter of 2023 of $1.1 billion, which means that shares are trading for 15 times annualized earnings. 

Upstream production was down 1.6% year-over-year, from 1.21 million BOE/d a year ago to 1.19 million this quarter. Capital expenditures (CNQ has no downstream) were up 15% year-over-year, for a "production shortfall" of 17%.

CNQ's free cash flow for the quarter was $807 million, which is a 4% yield on the current enterprise value. They delivered $1.1 billion of shareholder returns, comprised of approximately $742 million of dividends and approximately $370 million of share repurchases, for a shareholder yield of 6.6%.

PrairieSky: the market capitalization of Prairie Sky (at $19.50 per share for the U.S. ADR) is $4.7 billion and the enterprise value with $216 million of net debt is $4.9 billion. They reported earnings for the second quarter of 2023 of $36 million, which means that shares are trading for 33 times net (annualized) earnings.

Realized pricing was down 37% y/y and production was down 10% y/y (although oil production was actually up 3%) resulting in revenue down 40%.

Cash from operations was $71 million for the quarter, a 6% yield on the current enterprise value.

Monday Morning Links

• Cleveland-Cliffs Inc. is publicly announcing a previously private offer that it had presented to the Board of the United States Steel Corporation on July 28, 2023. That offer, which was reiterated in writing to the U.S. Steel Board on August 11, 2023, proposed acquiring 100% of the outstanding stock of U.S. Steel for a per share value of $17.50 in cash and 1.023 shares of Cliffs stock. On July 28, 2023, this implied a total consideration value of $35.00 per share of U.S. Steel stock, which represented a 42% premium to U.S. Steel’s share price as of the market close on July 28, 2023. As of the close of market on Friday, August 11, 2023, this offer represents a 43% premium to U.S. Steel’s share price. [Cleveland-Cliffs Inc.]
  
• I’ve noticed that a lot of class anxiety gets rebranded as planetary extinction on the left, and rebranded as racial extinction on the right. A lot of RW types have tremendous amount identity invested in their being middle class and good at spreadsheet writing. The good news is the imminent demographic death of “the west” or “whites” is overplayed. The bad news is the class of “well compensated spreadsheet writers” is dying. If you had a Time Machine and come back to Europe or Appalachia in 2100 there will still be plenty of whites. There is a good chance that if they took a dna test there would be some Mexican/Guatemalan heritage but the vast majority would be overwhelmingly European derived. However these people would likely seem “primitive” or maybe even like “rednecks.” Meaning white people as a biological phenomenon will continue, but upper middle class ways of living and speaking likely won’t. All these doomer demographic posts should be recognized for what they are, misplaced anxieties about the complete destruction of a class of people. [Deep South SR]
• The American First Legal Foundation has taken the position that all diversity, equity and inclusion programs are illegal since the Students for Fair Admissions Inc. decision from the U.S. Supreme Court. [Faegre]
• On the first day in office, the new president could prepare executive orders targeting the concepts and formulations that have traveled from the fringes of the 1960s Left to the center of American power. At the head of this list would be a ban on the government promotion of left-wing racialist ideology, or critical race theory, and to abolish the “diversity, equity, and inclusion” bureaucracy that serves as its administrative vehicle. The order would replace all this with a system of strict color-blind equality, prioritizing the values of equal treatment, individual excellence, and race-neutral decision-making. As part of this policy, the president could also rescind Lyndon Johnson’s Executive Order 11246, which established the legal basis for “affirmative action”—a euphemism for state-sanctioned racial discrimination in the interest of favored identity groups—and forbid the use of identity-based quotas, preferences, and “disparate impact” analysis as an acceptable basis for any federal decision-making, to the fullest extent of the law. [Christopher F. Rufo]  
• Republicans spent half a century working to overturn Roe, yet they weren’t prepared for the democratic policy debate when that finally happened in Dobbs last year. Now they’re seeing abortion regimes as loose as Roe, or potentially looser, imposed by voters even in conservative states. This political liability will persist until the GOP finds an abortion message that most voters can accept. [WSJ]
• The average gas station is now packed to the brim with drugs. This place had a Whip-it stand near the checkout, that I imagine is for recreational nitrous oxide users rather than whipped cream enjoyers, as well as a massive selection of kratom. ‘Whippets’ can cause irreversible brain damage and kratom has opiate-like effects, binding to the same receptors as morphine. There were also 3 stands near the checkout dedicated to weed-adjacent things including a mix of gummies, vapes, and flower bud containers. Unsure exactly what the weed-adjacent stuff was, some of it was Delta-8. Seems like a lot of these weed derivatives stemmed from the 2018 farm bill. The kratom proliferation has been insane. One of the main kratom brands, Botanic Tonics, sells super-popular small blue vials under the name ‘Feel Free’ that merely say ‘Plant-based herbal supplement’ on the front. Despite the FDA recently seizing $3M of kratom from Botanic Tonics as well as endless stories of addiction on the subreddit r/Quittingfeelfree, Botanic Tonics is an official sponsor of UT Austin and Florida State University and gives out free vials to students. [Marginal Revolution]
  
• The DNC were running an armed covert election fraud operation in the swing States to take advantage of mail-in voting, to steal the election. This is why the Dems pushed so hard for mail-in voting. This is why the MSM/CDC/NIH over-exaggerated Covid deaths. This is why Deep State actors created and released SARS-CoV-2. All of it was one massive coordination to steal the 2020 election. They released the virus to make the “pandemic”. Then they exaggerate the virus to make everyone afraid to be close to each other, thus the public accept mass mail-in voting. Then they use the excess ballots and fake registrations to commit voter fraud in all the swing States by ballot dumping at 3:00 AM once they know how many ballots they need to win. On top of this, they used the intelligence community and Fascistic control over Big Tech to censor anyone who talked about the Hunter Biden Laptop, covid “disinformation”, or election “disinformation”. Anything that got too close to their plan to use a bioweapon to steal the election, they banned it from the Internet. This was the most sinister crime in history. Genocide, treason, global psychological manipulation. [Clandestine]
• There are sound legal, economic, and epidemiological reasons for exempting premium cigars from FDA regulation, but this ruling is yet another example of how cigar smokers are treated better under the law than users of other nicotine and tobacco products. Smoking bans often make exemptions for cigar lounges while forbidding vapes, cigarettes, and hookahs, and comprehensive prohibitions on the sale of tobacco products (like the one implemented in Beverly Hills) carve out exceptions for cigars. There's more than a whiff of classism to American tobacco law, as consumers of high-end cigars are granted the freedom to smoke what they like while vapers and cigarette smokers are kicked to the curb or denied the right to purchase their preferred products. [Jacob Grier]

Thursday Night Links

• Perhaps the hero of the story is Matt Damon’s character, Leslie Groves, an MIT-trained engineer turned Army general who, unlike Oppenheimer, plays down his intelligence, and appeals to their vanity to manipulate the scientists into completing his project. WASP restraint, manners, and self-control convinced a bunch of prima donna Communist sympathizers to build the atom bomb for capitalist America. An amazing thing about this era is the incredible ingratitude shown by these scientists and other academic refugees from Hitler’s Germany. Beyond their sympathy for the far more murderous Soviet regime, within a decade of American blood and treasure defeating the Nazis, they were attacking the American people with pseudo-scientific works like The Authoritarian Personality, which linked strong fathers, Christian faith, and military service to mental instability leading to support for fascism. The latter led to Left support for the Sexual Revolution to undermine the American family as an insurance policy against these supposed latent fascist tendencies. As is so often the case in history and life, no good deed goes unpunished. [The Tom File]
• We are in a moment in time where parts of the body politic and various legislatures are willing to allow perpetual trusts to exist unmolested and undenounced. Except for a few law professors, tax bureaucrats, and even fewer reform-minded trusts and estates practitioners, society does not seem to care anymore about perpetuities, dynasties, dynastic property, and “baronies.” Why? It is not clear if today’s equivalents of the landed gentry of yesteryear are merely meeting less resistance, if the debate (if there even is one) is asymmetrical, or if the number of folks who want perpetuities is larger than before. Or, it actually may be that the Rule Against Perpetuities has outlived its usefulness. Are economic elites seizing a prosperous moment in time to assure their primacy forever? Rich folks always push for advantage, but at the moment no one is pushing back in the perpetuities arena. Most plain folks see no danger. Why are there so few complaints? [Joel Dobris] 
• I believe that if a unitrust is to be impartial between the income beneficiary and the remainder beneficiary, it should be a 3% unitrust. The retirees or other rentiers who want to turn over to their inheritors what they began with, in real terms, should pay themselves only 3%. The person who does not want to invade principal indirectly should not spend more than 3%. Ultimately, the basis for my belief is outside the scope of this Article and perhaps outside my powers of argumentation. Having said that, let me state the point very simply and ask the reader to accept it and to continue reading. Easily available equity investments cannot be counted on to provide enough to the investor in the form of dividends or capital gain to sustain a larger payment over time without reducing principal. As one might imagine, 3% is not a popular figure. Why do people want to spend more than 3%? [Joel Dobris]
• It sounds weird, but if you look at where the money’s spent at auction, it’s almost all fashionable contemporary crap because if you think about how prices in very high-end art are set, they’re auction prices. How many people does it take to generate an auction price? Two. Just two. So, you have boneheaded Russians who want to have a Picasso on their wall so people will think they’re legit, or hedge fund managers’ wives who’ve been told to buy impressive art to hang in their loft so when people come over, they’ll say, “Oh, look, they’ve got a Damien Hirst.” The way art prices at the very high end are set is almost entirely by deeply bogus people, [laughs] which is great, actually. When I was an artist, I used to be annoyed by this. Now that I buy a lot of art at auction, I’m delighted because it means there’s all this money. You see Andy Warhol’s screen prints selling for $90 million. Yes, I know because I buy them. [laughs] I used to be annoyed by this, and now I think it’s the most delightful thing in the world because there’s all this loose money sloshing around, and so-called contemporary art is like this sponge that just absorbs all of it. There’s none left. Some of the things I buy, I am the only bidder. I get it for the reserve price. No one else in the world wants it, or even knows that it’s being sold, so I am delighted about this. [Paul Graham] 
  
• We just saw today that offshore driller Valaris is borrowing money to buy more ships. When you invest in cyclical industrial companies a constant theme is valuations that are (ostensibly) punishingly cheap but where managements want to expand capacity. If the demand was so great you could theoretically lay the risk off on the customers with long term contracts for the output - but you never see this. (Although the WSJ points out today that small bakeries have figured out that capping croissant production is good for profits.) We keep coming back to the question of producers versus royalties. The conventional wisdom being, "date the producers, marry the royalties." In theory, there is a set of relative valuations at which you should be indifferent between the two business models. And if the royalty companies are selling for 2% free cash flow yields but the producers are 1x EBITDA, you should probably prefer the producers. Where this gets more difficult is when the royalty companies are also cheap (say, double digit yields) and the producers are expanding production instead of returning cash. If we look ahead a year or two, what if that cheap producer ends up expanding, having cost overruns on its expansion, and it and its competitors end up reducing their margins because of the increased capacity? The amount of cash that shareholders ultimately receive may be a lot less than the EBITDA multiple suggests. That would imply that the producers are never as cheap as they look. [CBS]
• The royalty model is just so superior to the producer model. When we looked at coal producer earnings this quarter, we see that they are cheaper on EV/EBITDA than NRP, but they have vastly larger capital expenditure requirements. (They are also more leveraged to the coal price, for better and for worse, since they have production cost and a royalty owner doesn't.) Something fantastic about royalty companies is that they can benefit if the producers foolishly over-expand their capacity and harm their commodity price. Here's the math: suppose that a producer making a 100% margin (cost is half of selling price) expands production by 25%. Their projection was that they would use the lower volumes to drive cost down by 20% thanks to higher volume, and so the greater amount sold at a lower cost would result in 50% higher profit, a huge return on the expansion capex. However, everybody else in the industry has the same idea and inflation causes the cost of production to stay the same (instead of the projected decrease) while at the same time the selling price falls 10% because of the increase in supply. The result is that profits are flat. The expansion capex was completely wasted. But look what happens to the royalty owner: the selling price is down 10% but a 25% production volume increases results in a 12.5% increase in royalty revenue, since the royalty owner has no cost of production. And it happens with no capital expenditure on the part of the royalty owner. (Keep in mind, of course, that the selling price could fall more than enough to offset the production increase, whether because of the increased supply alone or because of other economic factors. But if that happens, the producers will really be hurting.) If it is a tough call whether to invest in the royalty or producer based on valuation, the tie has to go to the royalty owner. The reason is that the royalty stands to benefit from the classic producer management mistake (expanding). [CBS]
• This can only happen with physical books and journals. Database oriented searches are  useful, but there is much encoded knowledge in the physical organization of the library. There is much encoded knowledge in Dewey Decimal Classification just as there is on the physical layout of the place. Nothing like this exists in database oriented systems; the KNN algorithm in libraries allows one to find new things. Random sampling is also vastly more powerful in a physical library. I’ll never forget coming across the Chronicles of the House of Lords and reading about various expeditions, naval expenses and early rail systems installed in the United Kingdom. What a treasure that was; vastly better than slumming it through a bunch of wiki articles on the 19th century. Coming across the The London Times Imperial Trade and Engineering Supplement near my favorite seats in Doe library radically changed my views of economic history and the Great Depression. [Scott Locklin]

Natural Resource Partners L.P. ($NRP) - Q2 2023 Earnings

[Previously: Natural Resource Partners L.P.]

Natural Resource Partners L.P. (NRP) is a limited partnership that owns mineral rights throughout the U.S. (totaling 13 million acres) as well as a 49% minority interest in Sisecam Wyoming, a trona ore mining and soda ash production business located in the Green River Basin of Wyoming. 

NRP does not produce any minerals - they lease acreage to operators in exchange for royalties. The majority of their mineral rights revenues come from royalties on Appalachian coal production, with additional amounts from coal royalties in the Illinois Basin and the Powder River basin. They also derive revenue from minimum lease straight-line charges, wheelage charges, and oil and gas royalties.

The market capitalization of NRP (at $68) is $860 million. Total liabilities net of current assets and deferred revenue were $146 million at the end of the second quarter (10-Q). There are 121,667 units of Class A Convertible Preferred Units after the (significant) year-to-date redemptions. The terms governing the liquidation preference are:

The “liquidation value” will be an amount equal to the greater of: (1) (a) the per unit purchase price multiplied by (i) prior to March 2, 2020, 1.50, (ii) on or after March 2, 2020 and prior to March 2, 2021, 1.70 and (iii) on or after March 2, 2021, 1.85, less (b)(i) all preferred unit distributions previously made by NRP and (ii) all cash payments previously made in respect of redemption of any PIK units; and (2) the per unit purchase price plus the value of all accrued and unpaid distributions.

The partnership has been able to redeem 128,333 preferred units year to date for $128 million ($1,000 per unit). The partnership has some leverage in negotiating these repurchases because only 1/3 of the units can be converted in any 12 month period, and only when the unit price is above $51. We will use $1,000 per unit for the remaining units while realizing that the actual cost of redeeming the remaining units could vary (and be higher) than this. That puts the enterprise value now at $1.13 billion.

Royalty revenue for Q2 was $61 million compared with $76 million for Q1. Earnings from Sisecam Wyoming were $27 million, up from $19 million the prior quarter. Cash from operations was $73 million in Q1 and $81 million in Q2. So the YTD cash from operations of $154 million is a 27% yield on the enterprise value.

For the entire year-to-date, capital expenditures have only been ten thousand dollars. The partnership borrowed $14 million, paid $51 million of distributions to unitholders, paid $15 million of distributions to preferred unitholders, and paid $128 million to redeem preferred units. 

You'll notice that 81% of revenue was converted to cash from operations (YTD), and all cash from operations was used to either pay claims senior to the common unitholders or to pay distributions to the common unitholders. (The preferreds have a 12% cumulative coupon and the credit facility where the partnership borrowed to help repay preferreds has an interest rate in the 8% range.) Also, note that even though only $50 million has been distributed to unitholders year-to-date, a significant fraction of the $150 million of net income YTD is likely taxable and will be reported to unitholders via K-1.

If coal prices and production levels as well as earnings from the Sisecam interest hold up, then the partnership could pay off its remaining $268 million of net liabilities in just over three quarters from now. Paying off liabilities is management's stated intention - from this quarter's call which actually had some questions:

We intend to continue to pay down our preferred and debt as rapidly as we can to the extent we can borrow on our credit revolver at a lower cost than the 12% on the preferreds and to the extent that we can have the preferred holders waive the make-whole premium, which is called a MOIC, M-O-I-C, so that we're able to buy those bonds back at par.

If we can replace 12% obligations with something more like 7% or 8% obligations, we're going to do that as much as we can and then immediately begin paying down the revolver with cash that we generate as well. And our goal is to pay down the preferreds, the bank revolver and then of course continue paying down our private placement notes, which are on an amortization schedule and also by the time they settle in first quarter of 2025, settle our warrants that are outstanding. We're going to want to get rid of all of those obligations as soon as we possibly can. [...]

Our strategy is to eliminate all of these obligations we have the preferreds, the debt and settle our warrants before such time as we begin to raise the distributions or look at consider raising the distributions. And the reason for that is that we have learned firsthand that it would be imprudent for a company such as ours with our business profile to rely at all on sourcing capital from banks or from capital markets to fund our business in the future. So when you can no longer rely on rolling forward or refinancing your credit obligations, you have to assume that you operate with no permanent debt in your capital structure.

So we want to clean everything up, stay on the same path we've been on now for quite a while. And once we have the capital structure fully clean, then we will evaluate capital deployment strategies. It's not going to be too long in the grand scheme of things, we see light at the end of the tunnel. But early 2024, is too soon. Because remember even when we take out those preferreds, we're simply switching the obligation from preferred units to debt. So that's our philosophy. And when we look at it, we think in the long run on a risk-adjusted basis this is going to maximize value for common unitholders.

If we look out a year from now, assuming that cash from operations holds up, they are able to pay off these liabilities, and the unit price remains the same, then the same ~$300 million of annualized cash from operations would be available for distribution to common unitholders with a market capitalization of $860 million. Potentially a 35% yield, or $20+ per unit on the current $68 price.

The royalty model is just so superior to the producer model. When we looked at coal producer earnings this quarter, we see that they are cheaper on EV/EBITDA than NRP, but they have vastly larger capital expenditure requirements. (They are also more leveraged to the coal price, for better and for worse, since they have production cost and a royalty owner doesn't.) 

Something fantastic about royalty companies is that they can benefit if the producers foolishly over-expand their capacity and harm their commodity price. Here's the math: suppose that a producer making a 100% margin (cost is half of selling price) expands production by 25%. Their projection was that they would use the lower volumes to drive cost down by 20% thanks to higher volume, and so the greater amount sold at a lower cost would result in 50% higher profit, a huge return on the expansion capex. 

However, everybody else in the industry has the same idea and inflation causes the cost of production to stay the same (instead of the projected decrease) while at the same time the selling price falls 10% because of the increase in supply. The result is that profits are flat. The expansion capex was completely wasted.

But look what happens to the royalty owner: the selling price is down 10% but a 25% production volume increases results in a 12.5% increase in royalty revenue, since the royalty owner has no cost of production. And it happens with no capital expenditure on the part of the royalty owner. (Keep in mind, of course, that the selling price could fall more than enough to offset the production increase, whether because of the increased supply alone or because of other economic factors. But if that happens, the producers will really be hurting.)

If it is a tough call whether to invest in the royalty or producer based on valuation, the tie has to go to the royalty owner. The reason is that the royalty stands to benefit from the classic producer management mistake (expanding).

Paper: "Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements"

We have been arguing for the past two years (see also) that the path of least resistance for the central bank would be to do what is known as yield curve control. That concept dates back to WW II, when the Federal Reserve bought the debt issued by the U.S. Treasury, which had the effect of capping rates on longer-term Treasuries. This lasted almost a decade, from 1942 until the Treasury–Federal Reserve Accord in 1951.

Our "path of least resistance" thesis supposes two things: number one, that the government (meaning the Fed and the Treasury) will likely take the easy path in response to a challenge rather than something hard that might have greater long-term benefit. In other words, that the government has a very high discount rate or low pain tolerance. And number two, that printing money - in whatever euphemism you want to use to describe it - would be that easiest path.

In our review of Nick Timiraos' hagiography of Federal Reserve chair Jerome Powell, we observed that Powell has been closely involved in the response to six financial embarrassments or crises, and he has recommended, advised, or chosen the bailout every time. Had he chosen different courses, for example to discourage moral hazard, it would have been at the cost of greater short term pain. But we are aware that Powell's commitment to bailouts has never been tested against conditions of rising inflation. He sure has been talking tough about inflation for the past year. How can we predict what he is actually going to do?

Along comes a paper by an academic economist named Charles Calomiris titled Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements, just published by the Federal Reserve Bank of St Louis. Calomiris is a "system man," a baby boomer economist who went to Yale and got a PhD in economics from Stanford, before being part of a number of think tanks. He has had four commentaries published by the Wall Street Journal in the past year. For all we know, he was in Skull and Bones. The abstract of his article:

As a matter of arithmetic, the trends of US government debt and deficits will eventually result in an outrageously high government debt-to-GDP ratio. But when exactly will the United States hit the constraint of infeasibility and how exactly will policy adjust to it? This article considers fiscal dominance, which is the possibility that accumulating government debt and deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low. Is it a serious possibility for the United States in the near future? And how might various policies change (especially those related to the banking system) if fiscal dominance became a reality?

What is utterly fascinating about this paper is that he is looking at an impending crisis - the over-indebtedness of the federal government - and reasoning through the possible responses, looking for the easiest one: the path of least resistance. Broadly speaking, he sees three possible choices:

First, reduce fiscal deficits. He confesses that it "may be a hard policy to enact," since the main contributors to the deficit are Medicare, Social Security, and the defense budget. Look at a long term chart of Unitedhealth Group or Lockheed Martin. Does the market seem worried that those budgets are going to get axed? Social Security and Medicare are the only benefits that normal, hard working people get from a lifetime of federal income taxation. It says a lot about Paul Ryan that his main political priority was to try to cut these benefits. Anyway, Calomiris does not think that this would be a path of least resistance.

Second, increased income taxation. Calomiris says that it is an unlikely path, "not only because of the lack of political consensus about taxation but also because it would reduce growth in income, which would partly offset" any benefit that it might confer. 

The third choice is what the paper is really about. Calomiris thinks that the path of least resistance would be "inflation taxation," which is implemented by large and inflationary purchases of government debt.

"To be specific, here is how I imagine this occurring: When the bond market begins to believe that government interest-bearing debt is beyond the ceiling of feasibility, the government's next bond auction 'fails' in the sense that the interest rate required by the market on the new bond offering is so high that the government withdraws the offering and turns to money printing as its alternative."

The Federal Reserve would buy the bonds that the Treasury issues, thereby funding government budget deficits. It is the same as printing money to fund the deficit, but with a fig leaf of euphemism and confusion. The "inflation tax" refers to the amount of real value that government bondholders lose to inflation. If there is $25 trillion of federal debt held by the public and there is a ten percent inflation (devaluation), then the inflation tax raises $2.5 trillion, a healthy amount in relation to the current annual expenditure level of $6.5 trillion.

The euphemism and confusion part of the inflation tax is actually very important because it allows the government to collect more than it would be able to if it were honest about what was happening. Here is how Calomiris explains it:

"When fiscal dominance hits and leads to monetization [printing money], if this is not anticipated sufficiently far in advance, it also causes some or all existing bonds (long-term bonds with existing low coupons that aren't indexed to inflation) to fall in nominal value. This is a one-time gain to the government because, going forward, the government will pay a market interest rate on all new debt issues that incorporates the future rate of inflation. If the average duration of government debt is sufficiently long, and fiscal dominance is not anticipated years in advance, the government could benefit from a substantial capital gain from the unexpected inflation tax, which increases its real capacity to issue new interest-bearing debt by a similar amount."

Calomiris thinks that the inflation tax is the path of least resistance because people "are not aware that they are actually paying it, which makes it very popular among politicians." 

If you were running things, how would you maximize the amount you could raise via the inflation tax? You need to trick bondholders, otherwise the market interest rate on new debt issues will reprice higher for inflation. This seems to imply that the best strategy is periodic, large devaluations with the rest of the time spent talking very tough about inflation.

Coal Earnings ($BTU $ARCH $AMR $HCC $X)

[Previously: Coal Producer Earnings for Q1 2023, Warrior Met Coal, Peabody Energy.]

Peabody Energy
The market capitalization of Peabody (BTU) is now $3.2 billion versus $2.8 billion when we wrote about them last quarter. (It was $4 billion when we wrote about them in August 2022.) Total liabilities less current assets are now $340 million, and current assets now exceed current liabilities plus long term debt. We would put the enterprise value at $3.5 billion now. For the second quarter of 2023 (release), adjusted EBITDA was $358 million, down from $391 million in the first quarter. That puts the EV/EBITDA at 2.4x (annualized).  

During the second quarter, Peabody's seaborne thermal coal sold for $101 per ton with a $51 cost per ton; seaborne met coal for $190 per ton with a $138 cost per ton; PRB coal for $14 per ton with a $12 cost per ton; and other U.S. thermal coal for $54 per ton with a $40 cost per ton. Once again, seaborne thermal coal was the most profitable segment in Q1, earning $198 million of adjusted EBITDA (production was up 10%), with seaborne met right behind, earning $103 million in adjusted EBITDA. The U.S. thermal coal (PRB & other) earned $78 million for the quarter.

Peabody reported "Available Free Cash Flow" (AFCF) for the quarter of $375 million. They have said that they plan to return to shareholders at least 65% of AFCF. That would imply a shareholder yield on the current market capitalization of 31% (annualized). During the quarter, they repurchased $173 million of shares and paid $11 million in dividends. They bought back 8.3% of outstanding shares during the second quarter.

The seaborne thermal coal is mined in Australia. Seaborne met coal is mined in Australia and Alabama. The PRB coal is, of course, mined in Wyoming, and the other U.S. thermal is mined in Illinois, Indiana, Colorado, and New Mexico.

At the end of 2022, Peabody had 2.1 billion tons of proven coal reserves and 379 million tons of probable reserves. The proved reserves were comprised of 94 million tons of seaborne thermal coal, 102 million tons of seaborne met coal, 1.7 billion tons of thermal coal in the Powder River Basin, and 155 million tons of other U.S. thermal coal. The enterprise value is thus $1.62 per ton of proved and probable reserves. One thing to mention is that you get a lot of thermal coal with Peabody: almost 2 billion tons. That is a lot of BTUs and you never know; they might come in handy.

Arch Resources
The market capitalization of Arch Resources (ARCH) is $2.5 billion versus $2.1 billion last quarter. Their total liabilities less current assets are now $143 million, and current assets exceed current liabilities plus long term debt. We would put the enterprise value at $2.6 billion now. For the second quarter of 2023 (release), adjusted EBITDA was $130 million, down from $277 million in the first quarter. That puts the EV/EBITDA at 5x using this quarter or 3.2x using the first half of the year (annualized).

They sold 2.5 million tons of coal in Q2, up from 2.2 million in Q1, but the price of met coal was $153/t versus $210/t the prior quarter. The cash cost per ton was up to $90 versus $83 the prior quarter even though total production was up.

They said they had "discretionary cash flow" of $151 million for the quarter, which was the difference between their CFO of $197 million and $46 million of capital expenditures. They returned all of the DCF to shareholders via a dividend of $75 million and $74 million spent repurchasing stock. That gives a shareholder yield of 24% (annualized) on the current market capitalization.

Alpha Metallurgical Resources
The market capitalization of Alpha Metallurgical Resources (AMR) is $2.6 billion, up from $2 billion last quarter. Their total liabilities (excluding deferred taxes) less current assets are now negative $320 million. We would put the enterprise value at $2.3 billion now. For the second quarter of 2023 (release), adjusted EBITDA was $259 million, down from $354 million in the first quarter. That puts the EV/EBITDA at 2.2x using this quarter or 1.9x using the first half of the year (annualized).

They sold 4.3 million tons in Q2, up from 3.9 million in Q1. They got $173/t for met coal versus $209/t the previous quarter. Their cost of coal sales improved to $106 per ton from $110.56 per ton.

Cash from operations was $317 million and capital expenditures were $55 million. They paid $7 million of dividends and bought back $150 million of stock during the quarter, for a shareholder yield of 24% (annualized) on the current market capitalization. The company announced that they are going to cease paying a dividend after the fourth quarter and focus their cash on share repurchases. (See investor presentation.)

Warrior Met Coal
The market capitalization of Warrior Met Coal (HCC) is $2.1 billion, up slightly from $2 billion when we wrote about them last quarter. Their total liabilities (excluding deferred income taxes) less current assets are negative $700 million, so the enterprise value is $1.37 billion. For the second quarter of 2023 (release), adjusted EBITDA was $130 million, down from $259 million in the first quarter. That puts the EV/EBITDA at 2.6x using this quarter or 1.8x using the first half of the year (annualized).

They sold 1.8 million tons versus 1.9 million in the first quarter, although the production level was actually higher this quarter. The average price fell from $257/t to $209/t and the cash cost increased from $119/t to $129/t. 

Cash from operations was $125 million and they spent $136 million on capital expenditures. Warrior is developing a Blue Creek mine, and this capex is displacing shareholder returns. What's worse is that there have been some cost overruns:

More than a year after the relaunch of the Blue Creek mine development in May 2022, Warrior has initiated important and highly beneficial project scope changes that will require incremental capital expenditures over the life of the project while lowering operating costs, increasing flexibility to manage risks, and make better use of multi-channel transportation methods. Most of these scope changes are transportation and logistics-related, with additional amounts related to inflation for these changes only. They are expected to increase total capital expenditures for the Blue Creek mine by approximately $120 - $130 million over the remainder of the project development period. [...]

In addition, the Company has experienced inflationary cost increases ranging from 25 to 35 percent in both operating expenses and capital expenditures for its existing mining operations since late 2021. The Company is also experiencing inflationary pressures at Blue Creek, especially in relation to labor, construction materials and certain equipment, that is expected to continue during the remainder of the project development period. As a number of key material contracts are currently being negotiated, and due to uncertainty regarding future inflation rates, the Company is not providing an estimate of the impact of inflation at this time. [...]

Subject to the considerations discussed above, our revised estimate of capital expenditures in 2023 for the development of the Blue Creek mine is approximately $250 to $300 million and is subject to change. The increase in 2023 capital expenditure estimate is primarily driven by change in transportation scope discussed above. The Company currently expects development spending at Blue Creek to be the highest in 2023 and 2024, with 2024 being a similar amount to 2023 that is subject to change.

The project remains on schedule with the first development tons from continuous miner units expected in the third quarter of 2024 and the longwall scheduled to start up in the second quarter of 2026.

It is not clear whether it is a great idea to be expanding capacity when the met coal price is already showing some weakness. Why not just return cash to shareholders? Maybe it's a smart investment, if the coal price holds up for the next decade, but the market is already saying (through the producers' valuations) that it doesn't believe that the coal price will hold up for even a couple years.

United States Steel Corporation
The market capitalization of U.S. Steel (X) is $5.5 billion, up from $4.9 billion when we wrote about them last quarter. Their total liabilities (excluding deferred income taxes) less current assets are $1.1 billion, so we would put the enterprise value at $6 billion.  For the second quarter of 2023 (release), adjusted EBITDA was $804 million, up significantly from $427 million in the first quarter. That puts the EV/EBITDA at 1.9x using this quarter or 2.4x using the first half of the year (annualized). Some color on developments:

“We are executing exceptionally well against our strategic initiatives, with all in-flight projects progressing on-time and on-budget. Notably, our non-grain oriented, or NGO, electrical steel line at Big River Steel is currently being commissioned and on track to start-up later in the third quarter. Customer demand has been robust for our NGO steels and we are pleased to announce that we've already secured our first customer orders in both industrial and electric vehicle markets.”

For the current year-to-date, the company has generated cash from operations of $894 million but spent $1.4 billion (157% of cash from operations) on capital expenditures. They have borrowed $200 million, repurchased $150 million of stock, and drawn down cash by $420 million. For the period of 2021 through the first half of 2023, U.S. Steel generated $8.5 billion of cash from operations. They invested $4.6 billion of that in capital expenditures.

As we mentioned last quarter, it does not seem great to spend more than 100% of cash from operations on capital expenditures when your company is valued at ~2x EBITDA and your market capitalization is half of book value. Those are strong signals from the market not to be investing in capacity. 

There is enormous volatility in product demand and price for U.S. Steel's products. Over the past four quarters, the price of flat rolled steel has been as low as $1,012 per ton and as high as $1,339 per ton. The price of steel pipe has been as low as $2,727 per ton and has high as $3,757 per ton.

We just saw today that offshore driller Valaris is borrowing money to buy more ships. When you invest in cyclical industrial companies a constant theme is valuations that are (ostensibly) punishingly cheap but where managements want to expand capacity. If the demand was so great you could theoretically lay the risk off on the customers with long term contracts for the output - but you never see this. (Although the WSJ points out today that small bakeries have figured out that capping croissant production is good for profits.)

We keep coming back to the question of producers versus royalties. The conventional wisdom being, "date the producers, marry the royalties." In theory, there is a set of relative valuations at which you should be indifferent between the two business models. And if the royalty companies are selling for 2% free cash flow yields but the producers are 1x EBITDA, you should probably prefer the producers.

Where this gets more difficult is when the royalty companies are also cheap (say, double digit yields) and the producers are expanding production instead of returning cash. If we look ahead a year or two, what if that cheap producer ends up expanding, having cost overruns on its expansion, and it and its competitors end up reducing their margins because of the increased capacity? The amount of cash that shareholders ultimately receive may be a lot less than the EBITDA multiple suggests. That would imply that the producers are never as cheap as they look.

Earnings Season Links

• Overall, this is a big win for shareholders. Kudos to TPL Blog and Gabi Gliksberg from ATG Capital for keeping the spotlight on the board. Kudos as well to Murray and Eric leading the fight from the inside and dealing with a painful lawsuit. This agreement is not perfect, but it shows that change is coming. In that light, an outstanding question is why hasn’t management ceased prosecuting the lawsuit? They have to know that the tides are shifting and if there is any hope in remaining in their positions, or leaving with dignity, they should cease wasting shareholders’ money on this ridiculous lawsuit. [310 Value]
• Lost in all the (justifiable) weeping and gnashing of teeth over the billions wiped out when the company was hijacked by crooks is the opportunity this has created. A patient and rational investor would step in today and capitalize on the fall out, knowing they would have never been given a 50% markdown if the company was being run by ethical and competent leadership. I’ve been nibbling on the expectation that this matter gets settled in HK/SV favor. Now that the fog has lifted and we have line of sight to the end-game, it’s time to load up, IMO. [The Texas Pacific Land Trust Investor]
• In July, Enterprise crude oil exports will exceed a record 30 million barrels. Oil and gas has faced commodity price headwinds, especially compared to the premiums of last year when crude averaged over $100 a barrel during the first six months of 2022. We see no reason that crude should have been trading at the low levels of the last few months. In early June, OPEC+ announced they were extending their reductions into 2024. On top of that, the Saudis announced that they would unilaterally cut an additional 1.1 million barrels a day of production in July and August, with the option to extend these cuts as needed. Meanwhile, waterborne data confirms that Russia's exports are coming down. Inventories of crude and refined products, both in the U.S. and globally, remain very low, while OPEC+ continues to demonstrate they are committed to price stability. Even though industrial demand continues to lag, consumer demand is strong, especially in developed nations. Crude oil supply demand fundamentals continue to indicate that we're in store for much tighter balances for the remainder of the year and in 2024. [Enterprise Products Partners]
•  "As we moved into the third quarter, we observed a slowdown in business activity," Lamar chief executive Sean Reilly said. "Although we still feel positive about our efforts to control expenses, revenue for the second half of 2023 is not shaping up as we anticipated it would. As a result, we are revising our guidance for full-year diluted AFFO to a range of $7.13 to $7.28 per share."
  [Lamar Advertising Company]
• Refined products operating profit was $234 million, an increase of $67 million. Transportation and terminals revenue increased $41 million primarily due to higher average transportation rates. The higher rates were largely a result of our 6% average mid-year 2022 tariff increase as well as a higher proportion of long-haul shipments, which move at higher rates, as customers continued to take advantage of the extensive connectivity of our pipeline system to overcome various supply disruptions in the regions we serve. [Magellan Midstream Partners]
• In addition to executing on our safety and operational performance expectations, our share buyback program remains a high priority and an area where we have delivered significant progress. As of the end of July, we have cumulatively repurchased over $850 million dollars' worth of our common stock since the buyback program's inception, which represents approximately 30% of shares outstanding at the start of the program. Building on the success of our share repurchase program, the board has decided to cease our fixed dividend program after the next quarterly dividend declaration and payment, both of which we expect to occur before year end. This move consolidates our focus, bolstering the already-robust share repurchase program by allowing all available capital return dollars to flow into our buyback program, subject, as always, to market conditions, the trading price of our stock, and our evaluation of the expected return on investment of future share purchases. [Alpha Metallurgical Resources, Inc.]
• Enbridge's resilient, low risk business model is supported by our scale, diversification and high quality cash flows which positions us to withstand market volatility and deliver predictable results. Looking forward, financial discipline, execution of our secured capital program, and deployment of our discretionary investment capacity gives us confidence that we'll generate 4-6% EBITDA growth per year through 2025 and approximately 5% thereafter. We believe natural gas and oil will remain critical components of our energy supply mix across a paced energy transition. [Enbridge Inc.] 
• Canadian oil-sands producers including Canadian Natural Resources Ltd. and Cenovus Energy Inc. are rushing to expand production to fill the biggest new pipeline project in more than a decade. [Bloomberg]
• While metallurgical and thermal coal prices have decreased from the beginning of the year and decreased significantly from the record highs seen in 2022, they both remain strong relative to historical norms. Transportation and logistics challenges, limited access to capital, and labor shortages limit operators' ability to increase production and sales which should provide continued price support. NRP continues to explore opportunities for carbon neutral revenue across its large portfolio of land, mineral, and timber assets, including the sequestration of carbon dioxide underground and in standing forests, and the generation of electricity using geothermal, solar, and wind energy. [Natural Resource Partners]
  

Inflation & Empire Links

• OK, @elonmusk is definitely the most powerful American oligarch. The superstar firm dilemma is especially pronounced wrt his empire: he controls the central global social media platform; Tesla is the only viable competitor of BYD; SpaceX has a virtual monopoly on satellites; and Starshield may be the only solution to the military problem posed by Chinese ASAT capabilities. What an extraordinary concentration of power! [Policy Tensor]
  
• Rather than inflation due to a shortage of labor, what we are seeing today is inflation mostly due to an acute shortage of physical capacity. US consumption and inflation are tightly linked to the constraints stemming from plant and equipment, which are often primarily located or manufactured overseas and subject to their own logistics constraints. If either of these become impaired, there is little ability to meet demand by redirecting production to domestic capacity. However, this shortage of physical capacity is not wholly the product of mistaken actors. Instead, the decision to run down physical capacity was often an understandable and locally rational response to persistent demand shortfalls. We walk through three industries—all of which are disproportionately responsible for current inflationary pressure and representative of real production constraints—to show how price and production crashes led to a situation of long-run underinvestment in productive capacity. Such crashes inadvertently created the conditions that currently constrain production and thereby explain the bulk of realized inflation. [Employ America]
• An alternative policy path, of course, with less inflation taxation, would be for the government to decide to reduce fiscal deficits and thereby avoid the need for rising inflation and its adverse consequences for the banking system. This may be a hard policy to enact, however, given that the main contributors to future deficits are large Medicare and Social Security entitlement payments. Also, defense spending seems likely to rise as the result of increasing geopolitical risks related to China. Increased income taxation is another alternative, but this too may be unlikely, not only because of the lack of political consensus about taxation but also because it would reduce growth in income, which would partly offset any deficit reduction coming from projected increases in the ratio of taxes to income. Ultimately, it seems likely that the US will either have to decide to rein in entitlements or risk a future of significantly higher inflation and financial backwardness. [Federal Reserve Bank of St. Louis]
• A fiscal point of view isn’t encouraging about the future, however. Inflation is easing but remains high. The U.S. is running a scandalous $1.5 trillion deficit with unemployment at 3.6% and no temporary crisis justifying such huge borrowing. Unfunded entitlements loom over any plan for sustainable government finances. The Congressional Budget Office projects constantly growing deficits, and even its warnings assume nothing bad happens to drive another bout of borrowing. Do people believe that the U.S. now can raise future taxes over spending by $1.5 trillion a year to finance new debt without more inflation? When the next crisis comes and Washington wants to borrow, say, $10 trillion for more bailouts, stimulus, transfers and perhaps a real war, will markets have faith that the U.S. can repay that additional debt? If not, another cycle of inflation will surely erupt, no matter what the Fed does with interest rates. [WSJ]
• A defeated army and a broken one are two different things. An army merely defeated in battle can often make successful withdrawals, reform itself, and reconstitute its strength—as Rome did after its humiliation at Cannae, eventually destroying its great rival, Carthage. But when whole armies break, when they lose their will to fight, the whole nation can likewise break. That is what happened to the great empires in World War I. It is also the fate awaiting the Ukrainian army. [Compact]
• Consider the hapless Liz Truss, who served as Britain’s foreign secretary before her ill-fated stint as prime minister. In her role as top diplomat, Truss traveled to Russia just weeks before the invasion of Ukraine to inform the Kremlin that the West found its prior and prospective territorial conquests unacceptable. This and this piece of land was rightful Ukrainian territory, she stressed, and the world would never accept it as Russian. Truss’s Russian counterpart Sergei Lavrov, perhaps as a joke, asked whether several indisputably Russian territories “belonged to Russia.” No, Truss replied, we will never recognize Voronezh and Rostov as Russian. This is not merely a story of incompetence or ignorance. Those factors are real, but Truss’s gaffe also reflects the priorities of the West’s contemporary leaders, in which moral grandstanding takes precedence over all other factors. [Compact]
• Many South American nations welcomed China’s first steps into the vacuum left by the US in the early 2030s. Beijing did not demand what the South American nations often saw as the US’s hypocritical political and human rights standards. Nor did it attempt to force them to adhere to Washington Consensus neoliberal economic policies, to which many of the governments of the late 2020s, swept to power in the Second Pink Wave of Latin America, were fundamentally opposed. Instead, Chinese trade deals came with substantial baggage-free inward investment, which helped improve infrastructure and pay for social programmes (and, of course, enrich elites). Yet there was another aspect. After the Cold War -- during which the US had ruthlessly enforced the Monroe Doctrine at the merest hint of a potential transgression -- US foreign policy in Central and South America had been an unattractive combination of neglect, pious hectoring and political meddling backed by overweening economic and military power. Latin American elites were keen to use the opportunity of US weakness to make sure it remained at arms length permanently. [Bournbrook]
• Here's why they're having a hard time articulating the reason why vaccines cause myo/pericarditis. It's a catch 22. If they blame it on the spike protein, as Paul Offit recently did, then the question of lab leak becomes incredibly important. We need to understand why the spike is how it is and whether its origin was related to any bioweapons programs or similar. If they blame it on the LNP or other core components of the mRNA platform, they're throwing their cash cow under the bus and are risking untold billions in future revenue. So they're claiming they have no idea about the mechanism by which the vaccines are causing heart damage. Which, in any sane world, would act as rock-solid evidence that the manufacturer has no idea what its product is doing in the human body and trigger an instant recall. Sadly, in this world, it's just generating awkward clips, so it's the least bad option. If they have to choose, I guess they will blame the spike, and oh boy will that be fun after they've been claiming it's DEFINITELY not cytotoxic for years. [link]
  

Thursday Night Links

• Knowledge and productivity are like compound interest. Given two people of approximately the same ability and one person who works ten percent more than the other, the latter will more than twice outproduce the former. The more you know, the more you learn; the more you learn, the more you can do; the more you can do, the more the opportunity - it is very much like compound interest. I don't want to give you a rate, but it is a very high rate. Given two people with exactly the same ability, the one person who manages day in and day out to get in one more hour of thinking will be tremendously more productive over a lifetime. [Richard Hamming]
  
• I praise Oppenheimer strongly even though I don’t particularly like Nolan’s penchants and predilections. For instance, Nolan has practically no sense of humor. Despite his flair for self-dramatization, J. Robert Oppenheimer himself recognized that playing up his 1954 star chamber security clearance hearing as a historic cataclysm was overblown: “The whole damn thing was a farce, and these people are trying to make a tragedy out of it.” The Coen brothers could have done more with the extensive political passages in Oppenheimer, which revolve around Oppenheimer’s Stalinist 1930s and the revenge the right-wing Jews Edward Teller and Lewis Strauss took upon him in the 1950s. The Anglo-American Nolan doesn’t bring any particular insight into the conundrum of why Jews came to be associated with nuclear weapons in the 20th century, rather like Germans and rockets or WASPs and eugenics. If anything, the movie is overly critical of Oppenheimer, choosing to probe his contradictions and flaws relentlessly when it could have devoted more time to showing how a theoretician in his late 30s suddenly turned himself into the recruiter and manager of the most famous assemblage of talent in history. What made Oppenheimer the Danny Ocean of physicists, the leader whose judgment of their skills the other sages found nearly foolproof? Oppenheimer was to physicists what Johnny Carson was to comedians: their rightful St. Peter, worthy of judging them. [Steve Sailer]
• The hero of the film is midcentury American society. The system works. It makes use of Oppenheimer's talents to win WWII, and then discards him, after a fair hearing, when he becomes an annoying primadonna after the war, as he seeks policy influence that his ego and awful judgment make him clearly unqualified for. The film makes you think it's going in the direction of a standard Hollywood sob story about McCarthyism. But those deciding on Oppenheimer's security clearance actually use good investigative procedures to get to the truth, and know that he's a loyal American. They tell him that, but also that he can't be trusted because he has awful judgment. And how can anyone think they're wrong? [Richard Hanania]
• In a traditional debate round, students argue over a topic assigned by the tournament — for example, “The U.S. should adopt universal healthcare.” One side is expected to argue in favor of the motion (the affirmation side), and one against (the negation side). However, in recent years, many debaters have decided to flat-out ignore the assigned topic and instead hijack the round by proposing brand new (i.e., wholly unrelated to the original topic), debater-created resolutions that advocate complex social criticisms based on various theories — Marxism, anti-militarism, feminist international relations theory, neocolonialism, securitization, anthropocentrism, orientalism, racial positionality, Afro-Pessimism, disablism, queer ecology, and transfeminism. (To be clear, traditional feminism is out of fashion and seen as too essentialist.) [Slow Boring]
• We enter life dependent on others, we exit life dependent on others, and if we do not create others in between, it all comes to an end. This is the point that Alasdair Macintyre makes so clearly in his book Dependent Rational Animals, from which he derives communitarian or republican ethics rather than libertarian ethics. Rand, however, ignores this entire aspect of human existence. She was herself childless. Of the major characters in her three major novels, not a single one, not Dagny Taggert, not Hank Rearden, not John Galt or Francisco D’Anconia, not Howard Roark, Peter Keating, Dominique Francon, or Gail Wynand, not Kira Argounova, Leo Kevalensky, or Andrei Taganov, has or shows any interest in having children. As a teenager flush with the vigor of youth, this is easy to miss. As an adult, it is a blinding oversight. The good life for man qua man must incorporate reproduction — or there will very soon be no men to qua. But as soon as reproductive interests are entered into the moral system, the easy libertarian answers get much harder. [Contemplations on the Tree of Woe]
• Laster said he doesn’t subscribe to the idea of “minimalist judging.” The issues raised by those cases kept coming up, he said, and needed to be addressed. “Once something clusters like that,” Laster said, he begins to realize an area of law could use more clarity. “If next year, in the course of two months I see defendants in, you know, three or four different cases making the exact same argument, it’s going to flag that in my mind,” he said. [Bloomberg Law] 
• A key hallmark of a cancer cell is replication stress and genome instability, and some of the leading chemotherapies exploit this hallmark, by introducing further DNA damage that results in catastrophic consequences for the cancer cell. The high incidence of transcription replication conflicts (TRC) is a major contributor to genomic instability within cancer cells, and TRCs likely provide a potential, but not yet utilized target for chemotherapy development. Directly testing this hypothesis of targeting TRC for selective killing cancer cells has been difficult, largely due to a lack of small molecule tools that can target the resolution of TRC. Here, we report a small molecule inhibitor, AOH1996, of a cancer-associated isoform of PCNA (caPCNA), which notably, almost completely inhibits the growth of xenograft tumors without causing any discernible toxicity to experimental animals. Mechanistically, AOH1996 stabilizes the interaction between chromatin-bound PCNA and the largest subunit (RBP1) of RNA polymerase II (RNAPII) and leads to degradation of the intracellular RPB1. AOH1996 selectively dissociates PCNA from actively transcribed chromatin and causes DSB accumulation in a transcription-dependent manner, without affecting the presence of PCNA in the heterochromatin region. This indicates that inhibition of caPCNA activity by AOH1996 leads to transcription-associated collapse of DNA replication. [Cell]

Update on the Shale Treadmill

Oil & gas producers have started reporting earnings, so we can give an update on the Shale Treadmill that we wrote about in May. You may recall that we have been looking at production growth versus capital expenditure growth. It is really important to keep track of the amount of capital expenditure that is required to keep production constant.

Devon Energy gives good disclosure of capital expenditures and production quantities for each basin where it is producing. (They even give the average horizontal well lateral length for each basin, the only producer we follow that discloses this.)

Their production (BOEs) was up only 7.5% year-over-year from Q2 2022 to Q2 2023, with oil up 7.7% over the same time period. However, their upstream capital expenditures were up 87%. Remember, we call it a "production shortfall" when the production growth is less than the capital expenditure growth. So, Devon's production shortfall metric for Q2 is about 80%, which is quite bad.

Their free cash flow was only $300 million in the second quarter. On their enterprise value of $40 billion, that's a FCF yield of three percent.

These shale companies are drilling so hard even with lower commodity prices and the deteriorating well performance. Devon's BOEs produced are about one-quarter natural gas, and they were selling gas for $1.27/Mcf in Q2. (They actually got a negative gas price in the Williston.)

The Devon shareholder list seems like mostly index funds. This thing is on autopilot just drilling wells even if they have to give away the output. Great for management and the royalty owners.

Occidental Petroleum reported oil production up 5% year-over-year from Q2 2022 to Q2 2023, but it was down 5% sequentially from Q1 2023 to Q2 2023. Their capital expenditures were up 69% year-over-year and up 13% sequentially from the prior quarter. Oxy's oil production in the Permian was up 14% year-over-year and down 1% sequentially, and their capital expenditures in the Permian were up 65% year-over-year and up 17% sequentially.

So there is a production shortfall, but not as bad as what we see at Devon. Something else we noticed is that in the Permian, OXY's ratio of oil to natural gas went from 1.81 to 1.94 year-over-year. Rising water cuts and rising natural gas cuts are warning signs of field depletion.

Oxy's free cash flow for the quarter was $1.1 billion, a 5.4% yield on their enterprise value.

Marathon Oil reported oil production up 2% sequentially from Q1 2023 to Q2 2023. (They had an acquisition that closed in Q4 2022 making the y/y comparison less meaningful.) Their capital expenditures were up 20% sequentially. Their free cash flow for the quarter was $440 million, an 8% yield on their enterprise value.

For the ten shale producers that we have looked at so far, free cash flow totaled $3.3 billion in the first quarter on $263 billion of combined enterprise value; a FCF yield of 4.5%. Three smaller producers had negative free cash flow: EQT, RRC, and AR. (Those three produce almost all natural gas.)

We can see that cash flow dried up for shale producers in the second quarter. The low cash flow and production shortfalls are probably caused by several factors:

• deteriorating resource / basins - rising water cut and natural gas production
  
• labor and material inflation - the PPI is down year over year but up 30% since before covid
  
• deferred maintenance is a possible factor - this would imply that the production shortfalls would get better as the maintenance gets caught up
  

So far what we are seeing is confirming the idea of focusing on royalties and slow decline assets like Canadian oil sands and deepwater.