Wednesday, January 10, 2024

Review of Material World: The Six Raw Materials That Shape Modern Civilization

Ed Conway is a journalist who has gotten interested, in Vaclav Smil fashion, in the materials that underlie our civilization and world. Hence his new book, just published in November: Material World. While Vaclav Smil has argued that the "four pillars of modern civilization" are cement, steel, plastics, and ammonia, Conway focuses on six raw materials that he thinks are underrated: sand, salt, iron, copper, oil, and lithium.

It's not entirely clear that "underrated" is Conway's organizing concept for choosing these six, and one thing we quickly see is that he is not as logically organized, thorough, or data driven as Smil. But his argument seems to be that these are underrated and overlooked since on the one hand they are so important, but on the other hand they are cheap relative to the value they create (copper is under $4 per pound), they are used in enormous volumes (big, bulky, yet overlooked flows), and because they are bulky, producing them requires displacing even more enormous amounts of overburden and ore. Tearing down mountains, and that sort of thing.

Another point that Conway raises is that these raw materials less fungible than the casual observer might realize. Sand, for example, comes in different varieties with important differences in grain size and shape and mineral composition. The sand that is needed for making high quality optical glass is different than the sand that is acceptable for use in making concrete. Sand is also turned into silicon for making semiconductors, but that has more to do with the refining and ingot producing process than the raw ingredient sourcing. If you have ever thought, "how can sand be rare, or important?," the answer is in these idiosyncrasies that make the different types non-fungible.

The iron chapters got our attention because we have been thinking quite a bit about iron, steel, and metallurgical coal. Conway observes that iron accounts for 95% of the metal that we produce and use, and that it is "so fundamental to our lives that it is just as good a measure of living standards as GDP." The most developed countries in the world have an installed base of steel of about 15 tons per capita. (As he puts it, "iron is the bones of our society.") The per capita figure for China is only about half as much. His back-of-the-envelope calculation is that if everyone in the world were to come up to the developed country amount of steel per capita, it would be an additional 144 billion tons - four times the amount that has been already produced in human history.

We had already been thinking lately that, if the GDP per capita of India keeps growing then their use of steel per capita (and oil too, of course) should as well. India is already the largest importer of U.S. metallurgical coal for making steel. India is the second largest steel producer but its per capita consumption and per capital installed base lag far behind the rest of the world. The straightest path forward would be for steel production to continue to grow, resulting in increasing demand for imported metallurgical coal. (Every ton of steel produced requires almost a ton of metallurgical coal to go in the blast furnace alongside the iron ore.)

The writer "Coal Trader" argued recently that "emerging markets appear to be approaching a level of self-sufficiency and mutual support. They no longer seem to rely heavily on the investment and consumer demand from major Western corporations." If Coal Trader is right and their economies are decoupling from the U.S. (the "training wheels are starting to come off," he says) we should see it in their GDP growth figures (e.g. India). And if they decouple it should make demand for these raw material commodities less volatile. (Coal Trader had an interesting observation: "I believe we need to invest as if our offices were in Singapore, or perhaps even Jakarta.")

If these countries continue to develop, they should soon begin consuming much more oil per capita too. Enough to make a big difference to total world oil demand. India is currently something like 5% of world oil demand with per capita usage that’s only about one-third of China. If India develops just to the level of China, it would cause incremental increased oil demand of around ten million barrels per day. An astonishing figure, it dwarfs any possible near-term savings from electric vehicles in richer countries, and the incremental demand would be almost as big as total U.S. oil production. And note that it will take machines built of steel to burn this oil.

People who are short commodities are betting against the up-and-to-the-right GDP trends of countries like China and India. Maybe those trends will continue and maybe they won't, but they are the status quo. Which brings up another point from the book. 

As we have elsewhere observed, there is a great tension between physics-based pessimism (Malthusian) about natural resources and economics-based optimism (some might say cornucopianism) about the ability to respond to higher prices with substitution and invention. As an example, the new lithium-iron-phosphate (LFP) battery chemistry 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. 

In the book, Conway points out that even as the ore concentration of copper has plummeted over the past century, the price has fallen in real terms. There have been huge fluctuations, having to do with the capital cycle in copper mining, but worse ore grades have not caused prices to rise. The Malthusian and Cornucopian forces have held in balance. (Perhaps the long-run destiny is for these forces to always remain in balance?)

It therefore seems prudent for an investor to make not highly leveraged bets ("torque") on much higher commodity prices, but rather to find ways of benefiting from the status quo of growth, development, and human invention.

So let us talk about ways to do this. As we have observed in the past, owners of royalties on natural resource production make money in status quo conditions, they do well if prices rise, but they can even benefit if the producers foolishly over-expand their capacity and drive down their commodity price (which they have a marked tendency to do throughout history), at least as long as they own a royalty on the new production too. 

The opportunity that we have seen is that these royalty interests in hydrocarbons are bond-like assets priced to give equity-like returns because of ESG investing and because of a brutal bear market, and subsequent investor disinterest, in natural resource production.

We have mentioned both Natural Resource Partners and Pardee Resources in past writing. NRP derives a significant portion of its revenue from royalties on metallurgical coal production, but also from thermal coal production as well as an interest in a soda ash business in Wyoming. While the partnership owns 13 million mineral acres, it does not own any surface acres. In contrast, Pardee owns about 155,000 surface and mineral acres, mostly in West Virginia, with active metallurgical coal production. 

The current market capitalization of NRP at $96 per share is $1.2 billion. NRP has a more complicated balance sheet, with debt, preferred stock, and warrants. (The liabilities keep going up as the share price goes up, because of the warrants.) Depending on the valuation assumptions you make, they probably have $371 million of additional liabilities, less around $80 million potentially earned during Q4, for an estimated current enterprise value of $1.5 billion. 

Assuming the recent level of $80 million of quarterly free cash flow, the FCF/EV yield would now be about 21%. Amazingly, this is higher than the FCF yield of the coal miners, who have to reinvest a significant portion of their cash flows back into production as capital expenditures. It is surprising that the royalty, which is the senior security in the capital structure of the mine, seems cheaper than the producers' equities. 

There is a slide in NRP's investor presentation showing annual free cash flow figures for NRP since 2015. For the year 2016, which was when the coal market crashed and most of the miners in the industry went bankrupt, the partnership still had free cash flow of $76 million. If that were to happen again (a 75% decline from current level), the FCF/EV on the current valuation would still be 5%.

Recently, the producers' cash cost per ton of met coal has been around $100 per ton, with Arch at $97/ton and Warrior at $114/ton. In 2016, the cash cost of met for Arch was only $53/t. With the producers' costs per ton having doubled since 2016, it ought to be difficult for the market-clearing price to drop as low as it did in 2016 (at least for a protracted length of time), and hence it ought to be difficult for free cash flow to drop that much again.

Then there is Pardee, which has a market capitalization of $164 million at $250 per share. Factoring in the end of year special dividend and estimated fourth quarter free cash flow, their enterprise value is probably now around $130 million. (That's $830 per acre of surface.) Pardee generated around $7.6 million of EBITDA in Q3, so that would be an annualized yield of 23% on the enterprise value.

The edge perhaps goes to Pardee at this point based on valuation, as well as the fact that it is "two-pillar" since it is trading (arguably) below the value of the surface. In fact, one thought experiment would be to consider that Pardee could theoretically sell the surface and timber for an amount in excess of the current enterprise value, while retaining the mineral rights (meaning coal royalties) as well as other assets. (Pardee is very unlikely to actually do this; it is just a thought experiment.) Not to say that the land is of exactly the same quality, but Weyerhaeuser just bought land for $2,685/acre in the southeastern U.S.. It is very difficult to find any land with timber in the U.S. for less than $1,000 per acre. Land prices of three digits per acre tend to be swamp or desert.


1 comment:

CP said...

India's share of global oil consumption already rose to more than 5% in 2022, up from 4% in 2021 and 3% in 2002.
By 2030, India's crude oil imports and fuel consumption will command almost as much attention from analysts as China's did a decade ago.
India's petroleum consumption increased by more than 5% last year, above the average for the previous decade.