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Public EquitiesIndustrials
Background
Eric Mandelblatt is the founder and CIO of Soroban Capital. We cover how the global push towards decarbonization could have massive impacts on the industrial economy, the supply and demand forces at work in commodities production, and why energy and materials represent such a small share of the market today.
Date
March 1, 2022
Episode Number
266
Key Takeaways
- Disparity Between Tech Growth and Industrial Economy: In the last decade, while tech and growth sectors have seen substantial growth, the industrial economy has faced a decline. The weight of energy and materials in the S&P 500 dropped from 17% to 5%. This decline was influenced by factors like China's excess capacity in industries such as steel and aluminum and the US shale boom, which, despite benefiting the US, was deflationary for the energy sector. The result? Over an 11.5 year span, the Goldman Sachs commodity index remained flat, while the NASDAQ 100 index compounded at 20% annually.
- Underinvestment in Energy and Materials by Funds: Examining the investment patterns of 30 large hedge funds (with a combined capital of $410 billion), less than 1% was allocated to the energy sector and just over 1% to materials. In stark contrast, Soroban Capital invested 30% of its portfolio in these sectors.
- Commodities Face Long Lead Time and Inelastic Supply Responses: Commodity cycles, unlike digital ones, experience slow supply responses. For instance, global oil and gas capital expenditures (capex) reached $0.5 trillion annually in the mid-last decade, while metals and mining capex amounted to $140 billion annually. These industries have long lead times. For example, building a copper mine can require a 10 to 15-year investment cycle. Despite rising commodity prices, the current cycle shows limited supply response due to factors like decarbonization pressures, ESG concerns, and potential carbon taxes.
- Decarbonization Intensifies Demand but Faces Supply Challenges: The global push towards decarbonization amplifies demand for certain commodities but is met with supply constraints. Electric vehicles (EVs), which currently have a 5% market penetration, are predicted to rise to 30% by the end of this decade and 70% by 2040. This would increase copper demand by approximately 3 million metric tons per decade, given that EVs consume 5-6 times more copper than internal combustion engine vehicles. Yet, the global copper market today stands at about 24 million tons and has seen limited investment in new mines. The large-scale shift to wind and solar power generation to decarbonize will require significant capital, further stressing mineral demands, especially when considering that wind and solar currently make up just 2% of global energy compared to fossil fuels' 82%.
- Railroads as Strategic Assets with High Margins:
- U.S. railroads, especially CSX and Union Pacific, operate at around 70% capacity and have EBIT margins nearing 50%, comparable to tech giants like Microsoft. Their high margins and stable nature make them attractive, with some even issuing 100-year bonds yielding 4%. The rail industry is not building new tracks due to logistical and regulatory challenges, solidifying the position of current railroad oligopolies.
- Despite a decrease in coal shipments (previously 25% of industry revenue, now in high single digits), U.S. railroads are positioned for growth, with potential operating leverage and a resurgence in U.S. industrial production.
- Commodities Market Dynamics and Potential Upside for Producers: The current market scenario shows a deep structural undersupply in many commodities, from aluminum to oil. Demand is robust, especially with the push for decarbonization driving up requirements for certain metals.
- Alcoa, an aluminum producer, stands to benefit significantly. With aluminum priced at $3,200 per ton, Alcoa generates around $12-13 EPS. Predictions suggest aluminum prices might rise to $5,000 per ton, potentially resulting in $27 EPS for Alcoa. Additionally, carbon taxes could further elevate Alcoa's earnings, given its lower carbon emissions compared to many international competitors, adding an estimated $8 per share in earnings.
- Investing in Commodities Amidst Uncertainty: The volatility seen in oil prices from -$37 to $93 is indicative of the inherent uncertainty in the sector. However, this volatility can be an advantage, deterring new entrants and creating conditions for inelastic supply. The absence of leverage on the balance sheets of most producers, due to a 10-year down cycle, adds to their resilience.
Transcript
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