Alma Recurrent Global Natural Resources Fund

Market Review and Outlook

In our many years of energy investing, one of the most commonly-cited relationships is the BTU content of a barrel of oil vs a million cubic feet of natural gas. The two fuels are not readily interchangeable in many areas of life. However, in some areas such as heavy industry, users can easily switch fuel sources as determined by price. Many investors underestimate the impact of fuel on industry, but in some cases fuel accounts for as much as 75% of operating costs. Price dislocations elicit either fuel switching or a regional reallocation of resources. Nowhere has this been more evident than in Europe during and after the Russia/Ukraine conflict, as many energy-intensive businesses have fled Europe’s high cost-per-BTU in favor of lower-cost areas like North America.

Investment Discussion

The diverging costs of energy between North America and Europe is driving huge divergence in industrial productivity
With the discussion of the energy transition evolving, particularly in the context of personal transportation and electric vehicles, the concept of fuel switching – based on price and emission levels – has moved to the forefront. However, fuel switching has been a key issue for heavy industry for many years. Steel, chemical, fertilizer, refining and aluminum industries, among others, require significant energy/power in the process of delivering economic value. As a percent of revenues, natural gas comprises approximately 40% of refiners’ operating costs, 25% of aluminum smelter’s costs, and 70-90% of fertilizer costs! Since natural gas comprises such a large percent of operating costs, these industries are intensely focused on utilizing the cheapest input costs. In many cases, capital is re-allocated on the basis of energy costs alone. As the CEO of The Fertilizer Institute noted, “In the summer of 2022, when the cost of natural gas in Europe soared above $100/MMBtu, we saw 70% of European ammonia production curtailed.”

One way to think about the cost efficiency of different energy sources is on a Price/Unit basis, known as a British Thermal Unit (BTU). On this basis, the energy content of an oil barrel is 5.6 times that of a million cubic feet of natural gas. Therefore, if the relationship between oil and natural gas is higher than 5.6, then the energy content of natural gas is cheaper than oil, and if less than 5.6, oil’s energy content is cheaper. Globally, oil prices are fairly aligned since oil is easy to transport and is easily stored. Divergences in regional natural gas prices are the primary reason for the oil/natural gas relationship to vary regionally.

While this relationship is well understood by heavy industry, geographic differences between oil/natural gas prices/BTU can be the difference between a successful and bankrupt business. In this commentary, we’ll look at the regional price to BTU relationship between oil/natural gas in consideration of the impacts on heavy industry.

From 1995 until the onset of shale in the mid-2000s, the oil/natural gas price/BTU relationship in Asian and European markets is in line with the energy content of the respective energy sources, with short periods of dislocation. During the early stages of the Russia/Ukraine conflict, for example, European natural gas prices rose significantly as Russian natural gas supplies to Western Europe were curtailed. Without the short-term ability to replace supplies, European spot natural gas prices briefly rose to more than $100/MMBTU at the end of August 2022, more than 11x higher than the coincident $9/MMBTU US price! Conversely, in late 2019, European natural gas prices fell below $4/MMBTU due to a mild winter, and the relationship ballooned above 10x.

From an operational perspective, the Asian industrial complex has a much higher level of fuel flexibility, building both oil and natural gas capabilities to adapt to shorter term price/BTU realities. The European industrial complex has not built those capabilities, and as a result is much more exposed to relative regional price differences.

In looking at industrial production data between the US and Europe, the data is quite telling. In the two periods where the regional relationship between oil/natural gas price/BTU content diverged greatly – 2Q 2011-4Q 2014 and 3Q 2021-2Q 2024 – US industrial production grew at a much faster pace than European industrial production, as seen in the charts below.

From 2Q 2011 to 4Q 2014, US natural gas prices were significantly lower than European natural gas prices, and industrial production diverged greatly. Over the 45-month period, US industrial production grew >10% more than Europe, in large part due to the ability for US industries to use significantly cheaper natural gas as a key input.

Since the beginning of the Russia/Ukraine conflict, the divergence between US and European natural gas prices has caused the Price/BTU relationship to break down. Again, US industrial production has grown at a markedly faster pace as a result. For the sake of this discussion, it is worth noting that European industrial production was growing faster through 2022, but as higher early 2022 natural gas prices flowed through to industrial production, European production fell at the expense of US industrial production.

As we have noted in previous monthly commentaries, several companies took noteworthy action to reallocate capital from Europe to the US to improve profitability.

After a brief increase to $3/MMBTU early this summer, US natural gas prices have returned close to $2/MMBTU, well below the European $10/MMBTU equivalent. As a result, we would expect the advantage enjoyed by US industry to continue relative to European industry, with lasting benefits to US chemical, aluminum, fertilizer, refining, paper and steel industries, particularly along the Gulf Coast where natural gas remains abundant with nearby export markets.

Fund

Performance Review

In the month of June 2024, the Alma Recurrent Global Natural Resources Fund fell -5.33% net of fees. Since the Fund’s June 2018 inception, the Fund has risen +8.70% on an annualised basis.

During the month, economically sensitive sectors such as aluminum, chemicals, copper, paper and steel fell more than the broader index, negatively impacting performance. More economically stable sectors such as energy infrastructure and gas utilities rose during the month, adding value relative to the benchmark.