Alma Recurrent Global Natural Resources Fund

Market Review and Outlook

Investment Discussion

Within the energy industry, one of the most encouraging developments since the outset of the COVID-19 pandemic has been the capital discipline shown by the Exploration and Production (E&P) companies. Since March 1st, the WTI oil price has averaged nearly $67/barrel. Traditionally, oil prices this high would incentivize additional capital expenditures (CAPEX) from US shale producers, and any operating cash flow would generally be reinvested in drilling new wells in order to grow.

Many market observers are encouraged because this time seems different. With elevated oil prices, E&P companies are generating more cash flow than in recent years, and using the proceeds to pay down debt instead of increasing CAPEX.

However, there is one element of the capital discipline conversation worth following. In order to produce oil/natural gas, wells need to be first drilled, and then completed. In shale, there is a statistic which tracks the number of wells which have been “drilled and uncompleted”, known as DUCs. Since the beginning of COVID, the number of DUCs in the US has fallen by nearly 1/3.

While there may be alternate ways to interpret the data, at the core, the number of completed wells is exceeding the drilled wells. In doing so, the cost of turning wells into production during the COVID era is less because the full cost of drilling wells is not incurred – only the completion costs are.

How is this relevant to the capital discipline discussion for E&P companies? In contrast to earlier periods of the shale era, E&P companies are meeting production expectations while keeping CAPEX under control. The decline in DUCs (akin to clearing inventory off of the shelf) signifies a cost-effective method of producing oil and natural gas, but is not sustainable in the long term. Instead, the capital discipline E&P companies are currently being complimented for may actually be a short-term benefit which may not offer a true representation of the capital expenditures needed to produce at the desired levels.

To further quantify the CAPEX savings, we look at the number of DUCs compared to the total wells completed in the US in recent months. In 2021 approximately 35% of completed wells have been from DUC inventory, requiring less-than-full CAPEX cost. Depending on the well, drilling costs comprise up to 50% of the total cost of producing a well. With 35% of wells excluding drilling costs in 2021, CAPEX costs have been as much as 18% lower than a “normal” drilled-and-completed well.

E&P companies’ profits have significantly benefited from elevated oil and natural gas prices. Additionally, in exhausting DUC inventories, companies have further depressed per-well CAPEX and enhanced free cash flow, at least on a temporary basis. Going forward, we expect that this benefit to be short term in nature, and CAPEX will increase by as much as 18% simply to maintain the current rate of well completions, assuming no service cost inflation.

There are 2 likely outcomes from the trend above: first, shale E&Ps are unlikely to aggressively increase activity, given that they will be running 18% faster just to stay still. Second, we expect greater margin expansion in energy companies outside of shale, given shale’s higher CAPEX reinvestment requirements.

During this commodity upturn, we have strived to identify and invest in companies with long-term visibility on maintenance CAPEX requirements, such as Canadian oil sands and pipelines. These businesses enjoy the fruits of the commodity upcycle, with limited exposure to the CAPEX inflation that is likely accompany the exhaustion of shale producers’ DUC inventories.

Fund

Portfolio discussion

In the month of August, the Alma Recurrent Global Natural Resources Fund fell by 1.22% net of fees, outperforming the S&P Global Natural Resources Index’s -1.49% return. Stock selection in the aluminum and paper products sectors added to performance, while stock selection in the oil storage sector detracted from performance.