Commodity Investments Under Cornucopianism

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 12th largest company in the world (LLY) sells treatments for type 2 diabetes, caused by overeating. The 19th 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. 

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. In his book The Next Two Hundred Years (written in 1976), he predicted that the energy crisis would subside because people would either find a way to produce more oil or else they would use what they did have more efficiently.

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. One consequence of this is that 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.

Implications

• 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.