It was Earth Day, 1970. The environment had become a national mania, especially among the young.

In Washington, in front of the Department of the Interior Building, twelve hundred young people milled around shouting “Off the oil!” and “Stop the muck!” to protest government leases to oil producers whose operations were thought to cause pollution.

In Bloomington, Minnesota, former Vice President Humphrey urged the United Nations to establish an environmental agency to combat pollution around the world, and at Georgetown University in Washington, Senator Birch Bayh of Indiana called for a national agency “to conquer pollution as we have conquered space.”

The same day, the novelist Kurt Vonnegut, after alluding to President Nixon’s statement that he did not propose to be the first American President to lose a war, commented, “He may be the first American President to lose a planet.”

(Excerpted from The Go-Go Years by John Brooks) 

It took fifty years but the climate has once again become a national mania.  

This interests us because every decade, there is a theme that captures the zeitgeist and turns into an investment mania. It was gold in the 1970s, Japan in the 1980s, Nasdaq in the 1990s, China and commodities in the 2000s, and software in the 2010s. 

Now that climate change has become a political and economic priority, the race to zero emissions and the global energy transition seems to us the investment zeitgeist for this decade.

The US, Japan, and Europe have all committed to a net zero carbon objective by 2050, and China by 2060. 60 percent of global Co2 emissions are already covered by net zero pledges. Consumers and capital allocators are demanding corporate action and boards across industries are forced to focus on it. 

The action plan is simple: we must decarbonize the economy and then electrify everything. But doing that is much more complex. Alp Ercil (CIO, ARCM) and Dan Dreyfus (CIO, Bornite Capital) joined us to examine how to invest amid the new climate zeitgeist. 

Here’s a pared-down version of our salon. You can watch the full conversation here

How to invest 

Alp: What is different today from the seventies is that policymakers, capital markets, and consumers are fully committed to this. There are a lot more data points today than there were 50 years ago about the impact of emissions on the climate. It is a game changer that Democrats have full control and China has committed to not only carbon neutrality by 2060, but peak carbon emissions by 2030. China also does not have any political obstacles to pursue those goals. 

The macro stage is set. The question is, what investment opportunities does this create? 

There are four big investment categories for this theme. First, sectors that are going to have enormous top line growth such as EVs, energy, storage, wind, and solar. These are trading at expensive multiples and are not really an investable opportunity for us. 

The second category, where we have found opportunity, is in the raw material and component suppliers to these industries.

We have to replace 55 to 65 percent of global power generation with new technologies plus add incremental generation capacity as EVs require additional electricity. We also must upgrade the grid. We have to move the production of 90 to 100 million cars annually to EVs. We have to replace various carbon inefficient products, such as old air-conditioning systems, and upgrade manufacturing facilities across many industries, such as steel, to reduce carbon emissions. This is going to be a massive capex cycle.  

This capex cycle is going to lead to incremental demand for many raw materials and commodities including lithium, copper, aluminum and steel. 

The third category is industries where China, as a large marginal supplier, will proactively remove capacity to reduce carbon emissions. This includes steel, aluminum, and parts of the chemical market that are coal based like PVC.

The fourth category is industries that will remain essential but where new capacity additions are very difficult due to ESG issues. The largest and most interesting sector is oil. Everyone is talking about peak oil, but this is unlikely for at least another ten years. Gasoline for cars is only a fifth of global oil consumption. 

Other sectors include coking coal which will still be in high demand for the next five to ten years for blast furnace steel production. Shipping is another area where the management teams were told not to invest a dollar over the last four or five years. Without a clear carbon reduction path, it is difficult for shipping companies to order new vessels.

Why China is leading the race

Dan: China is dealing with two issues. One is a little bit abstract, which is to try to get to zero greenhouse gas emissions by 2060. The other is much more immediate, which is to attack the air pollution in the country. 

China has an epidemic of asthma in kids. There’s also an epidemic of Alzheimer’s. When you breathe in these sub-2.5-micron particulates of air pollution, they get into your lungs and cardiovascular system, and they get past the blood brain barrier. It creates huge amounts of health issues. One of the leading causes of death in China today is related to air pollution.

As the country continues to urbanize, and as the Chinese people want a middle-class life, you need clean air and water. What’s the point of urbanizing if you’re going to raise a family just for everybody to get sick? They must tackle this problem immediately. A byproduct of tackling this problem is China can get up on the global stage and tell the world that they are going to get greenhouse gas emissions to net zero by 2060.

The implications to the supply chain are incredibly powerful, but also misunderstood. China has been a massive source of disinflation for the past twenty years because anything that was in shortage, China would go and build a factory and send cheap goods to the rest of the world. That source of disinflation is now over. The seminal moment was in 2019 when China made this pivot, and now they’re going all in. 

A great example is aluminum. China effectively had zero market share in aluminum prior to the nineties. When they went on their big urbanization spree, they had their plan to lift hundreds of millions of people out of farming communities and out of poverty, build cities for them from scratch, and bring them into middle class. As part of that effort, they built all the materials that they needed to build those cities, and any excess went to the global markets. So, out of a 65-million-ton aluminum market, China went from basically nothing, up to 42–43 million tons. They took market share from everybody and destroyed the market.

China looked at it and said, “Wait a minute, what are we doing exporting millions of tons of aluminum?”

Because they don’t have any of the raw materials like bauxite or alumina domestically, they must import it from places like Africa, Australia, and Brazil. That is expensive to do, especially with diesel fuel rising rapidly and there’s also a large carbon footprint when they are moving these low value materials from all over the world. 

China uses coal fired plants to make aluminum, and then they turn around and ship it out to the rest of the world. For every ton of their aluminum, seventeen tons of carbon are emitted. Comparing that to the Western world, producers that use geothermal or hydro emit one to three tons of carbon per ton of aluminum. Some producers use natural gas, which is about five or six tons of carbon per ton of aluminum. 

China realized that all they are really doing is exporting carbon. So, in their five-year plan they said they are done with that. China has a command economy; they command an industry to do something, and that industry does it. They are going to cap their aluminum production capacity at 45 million tons, which is about where they are at today. 

On the demand side, aluminum is a winner in the “greenification” of the supply chain because we are getting rid of plastic bottles that pollute our oceans and replacing them with aluminum cans that can be recycled. Other sources of demand for aluminum are electric cars because aluminum is much lighter than steel, and battery range is so important for the car that you want as light of a shell for your car as possible to get better battery. We will also need a lot of aluminum for the electric grid because we will have to rebuild a lot of our grids. 

The Western world is not ready to carry the burden and onus to build aluminum smelters. Then there are the politicians and the ESG crowd that says, “Well, if you build an aluminum smelter in our backyard, even a clean smelter, and it emits one or two tons of carbon per ton of aluminum, we don’t want it because it still emits carbon.” So, the ESG and the political crowd are very much against it. 

There’s a lack of understanding on how supply chains really work, and we’re setting up for profound and deep shortages in the “green metals” that are supposed to take us to a net zero world.

The need for a massive capex cycle 

Alp: Another example is steel. Why should China import all that iron ore and coking coal, process it to create steel, create a toxic carbon, export it and over 10 years, make no money throughout that process? When you were a lower income country and need to create jobs, that's one thing, but now China doesn’t really need it.

They are going to take out 50-100 million tons of steel capacity in a seaborne market of about 300 million tons, and no one in the developed world is going to build a massive blast furnace facility given the emissions involved. 

Anything that is sort of power turned into a good, and that power happens to be coal power, you have to look at all those sectors and think about what China’s game plan is for the next five years. I think the question is, will we get the capex response? Will management teams look at short term price signals and respond? I don’t think that is going to be the case. 

It is so important to understand in all these commodity or cyclical sectors, management teams have been in survival mode for twelve years. The guys that rose to the top and run these companies focused on consolidation, cost cutting, limited capex, survival, and trying to get a set of shareholders that would believe in them. Those shareholders came in with the promise of return on capital and return of capital, not necessarily a big capex cycle.  

Our priorities coming out of the pandemic were to look for the tightest supply and demand over the next two years. And combine that with our view that China’s going to take out capacity in certain sectors. There are a lot of structural and cyclical factors that support these commodities’ related securities. 

When it comes to copper, our view is that over the next two years, we probably don’t have a significant shortage of copper. So, it’s a trade that we can leg into overtime. The commodity itself probably won’t reflect a very bullish forward market, but the equities of copper producers might. The equity names have more of a forward-looking component versus the near-term supply demand of the commodity itself. 

Our focus has been on industrial names where we know there’s a component shortage. 

For example, look at the AC market. Buildings account for 9 percent of global emissions and half of that comes from the AC unit. Most building managers will tell you their AC is 15 years old and a new AC system will reduce emissions by 30 to 40 percent. So, we’ll see an enormous replacement cycle. Most components are made in Japan, Korea, and Taiwan.

Just break down the supply chain. Look at what’s needed to get to where we are trying to get to. There’s opportunity in supply chains of EV, battery, energy storage, steel, AC, and many more. 

Rhetoric versus substance 

President Biden has set a goal to cut emissions in half by 2030—double the goal set byb>Obama—and reach 100 percent carbon pollution-free electricity by 2035. There are no details on how, exactly, the US will achieve those reductions.

Large corporations are finding loopholes through carbon credits. Bill Gates wrote an uninspiring book and said, “I don’t have a solution to the politics of climate change.” Jeff Bezos launched a $10 billion Earth Fund to save the world. Green SPACs have raised $120 billion. Two new funds focused on ESG factors are launched each day.

It’s all lacking substance. More than a quarter of energy in the US still comes from coal. The ambitious plans from Europe and Japan are vague too—except the phasing out of fossil-fuel vehicles by 2030. What if the energy transition is more challenging than many anticipate.

Alp: The base case must be this goal will continuously be disappointed. Moving the production of 100 million ICE cars to EV over the next 10-15 years is going to be an enormous challenge. It will be a challenge for manufacturing, supply chains, components, and commodities. It’s going to be bumpy.

Globally, 50 percent of power generation comes from either coal or natural gas. Moving that over to solar and wind is not that simple. Beyond logistical challenges, the grid has to be changed, energy storage must be installed, and the power system must be run differently. None of this is going to be that easy.

From our standpoint, China achieving its objectives of peak carbon by 2030 could be problematic for the world. What we are trying to do is figure out where the constraints are, where the supply and demand equation looks tight, and then try to get there before the market gets there. I think the opportunities are really in the supply chain.

There will potentially be massive technological change during this time. Take the battery space for example. Toyota is discussing nickel free batteries. Having a ten-year view that you can hang your hat on is really hard because what we are trying to accomplish is very difficult across the board.

On copper reaching $50,000 a ton 

Dan: All the western steel producers, all they are going to be spending their capital on is ways to make their existing capacity less carbon intensive because they don’t want to pay the carbon tax. They have a finite amount of capital, and the shareholders don’t want them to spend. So, they have two choices, one where we are going to build new greenfield; or two, take the existing asset base and decarbonize it. Everybody is going to go for option two because they are going to get ESG points and they are not going to have to pay the carbon tax.

It is possible to cut carbon emissions in half, but it is going to take an insane amount of money and will be highly inflationary. Also, it goes back to the misunderstanding of how supply chains work, so it is going to be incredibly challenging. 

I think there is zero probability that we can reach 30-35 percent global EV penetration by 2030. The supply chain has a 5-to-10-year lead time to build, which means you must get started now to get the 30 to 35 percent EV penetration in 2030. Right now, we are not seeing anything being done to accomplish that. The consequence is a zero percent chance of high penetration rates in 10 years. 

Transportation is going to be electrified in time because it’s a better product, better for the environment, and will get cheaper with time. The path for us to get there is not going to be the straight path you read in the research reports from the banks where magically we are going to get to 20 percent penetration in 2025, and then 35 percent penetration in 2030. It is going to be very slow to start. There is going to be the mother of all price signals coming to these commodity suppliers of nickel sulfide, cobalt, and copper. 

When China was bringing hundreds of millions of people into cities, and they were all starting to get around in cars, buses and planes, I sat there and said, “Wait a minute, we are going into a real oil crisis if they don’t start building new capacity now.” And nobody did, and eventually oil peaked at $150, which was beyond anyone’s wildest imaginations at the early point of the cycle. It was a seven and a half times move from 20 to 150.

Copper is a long lead time commodity. You need seven to eight years to build a mine, and it is not getting done. So, I don’t see a reason why we can’t have that same seven and a half times move in copper and peak at $40,000–$50,000 a ton. That would stimulate producers to get something done. 

Currently, Goldman is creating the carbon free version of the GSCI, which is going to be metals minus oil, which are tiny markets. They are going to call every pension and endowment fund in the world and say, “You should allocate 3 percent of your portfolio into this new and improved green version of the GSCI.” 

It all sounds great until you realize that the market cap of these things is minuscule, so this passive flow of funds has the potential to just explode these markets.

Lessons from Henry Ford and John Rockefeller

Dan: When Henry Ford invented the Model T in 1914, he figured out how to get the car off the production line in 48 minutes. That was down from 12.5 hours. So, it became a mass market project, and demand went viral. 

What happened was that all the other automakers said, “Wow, we can do this too.” Because assembling a car is a commodity, you just have an instruction manual. Then, you go and do it and slap your brand on it. A century later, Ford is basically a second-rate pickup truck manufacturer that has not created any equity value in a century. 

John D. Rockefeller saw what was going on, and he said, “All these cars are going to need gasoline.” So, he started the Standard Oil Company of California. As the internal combustion engine really took off, his company became big and powerful before the government forced a break up. What spawned out of the Standard Oil Company of California were Exxon Mobil, Chevron, Royal Dutch Shell, and Conoco. All of which became the top companies in the world that created trillions of dollars of shareholder value for investors over the past century. 

Since history rhymes, betting on an EV manufacturer trading at a price to sales ratio of 603 is not what would have made you money during the last Industrial Revolution. When the internal combustion engine was invented, what would have made you money was betting on John D. Rockefeller because that was the pinch point in the supply chain.  

In any new industrial revolution, you must study the supply chain, and you must understand where the pinch point is going to be. If you own the pinch point on whether that production can be compounded, I think you got the tiger by the tail. I have never seen anything like the stocks of these companies that own the pinch point in this critical supply chain, where the end users are getting capitalized at huge multiples and the suppliers to these companies are trading between 4 to 7 times earnings. They are going to rerate.

There are two things that would change my mind. One would be valuation, but we are far away from that. The second is producer behavior. If valuation is not in your favor and producers take their free cash flow to build out new supply, then that is your signal to get out. We saw this happen in 2011. Currently, producers are going the other way and saying there’s no way we are ever building new supply again.  

On the losers from energy transition

Alp: The more simplistic ESG investments that are trading at very high revenue multiples. Those are the companies that actually need the components and commodities we’re talking about. People have assigned very simplistic market penetration rates and margin assumptions to them, and giving them all the credits of what we think we’re going to accomplish. But as we discussed, the path is filled with uncertainty and there are a lot of hurdles to achieve implied growth rates and margins that are built into those stocks. 

Dan: The losers will be companies that require a lot of raw materials, commodities, and labor. Labor is going to become excruciatingly tight. The icing on the cake will be companies that are facing secular headwinds where something structural has happened to their business. The airline industry is an example of this. Airlines are like factories with labor and fuel as inputs. Labor and fuel may become two of the tightest commodities. This is overlaid with the secular change of large businesses significantly reducing their travel budgets.

It all boils down to understanding the supply chain and how it works. From there, it is easy to distinguish the secular winners and losers over the next one to five years. 

The outlook for oil and uranium

Dan: I place oil in the “too difficult” pile because cards are in OPEC’s hands. There is still a lot of spare capacity. There are two sides of the coin. One side is OPEC knows in thirty years, there’s not going to be much demand for liquid hydrocarbons. So, given their lifting costs are $5 a barrel, they can go and flood the market now and bring NPV forward and get it before we transition off. The other side of the coin is needing $70 oil to balance the budget, so they could minimize production to keep supply tight. I think they do the latter. So, oil prices are likely to stay elevated. There are, however, several wildcards like Iran, Venezuela, and shale.  

Alp: The way we describe oil to our partners is oil will trade where OPEC wants it to trade. I don’t think they want $100 oil because that might accelerate the energy transition. If oil is kept at $60-$70, which would be good for the consumer and the producer, then it could extend the cycle a little bit. I think that’s going to be the outcome for the next three to five years. 

Overall, we are not worried about an oil market dislocation on the way down. If anything, we probably get a squeeze in the second half of 2022, and OPEC will determine what they want to do with their limited amount of spare capacity. 

We find Uranium to be in the too hard to get right bucket. Technically, we need a lot of nuclear plants, but the politics around nuclear, especially in developed markets, is not easy. China will build them, and maybe India can build them. But politically, it’s not going to be that straightforward.

Dan: If I could wave a magic wand, I would say, “Let’s get building nuclear power plants all over the world, and let’s get to net zero, ASAP.” The politics have just polluted this process to the point where it’s incredibly sad because we are going to waste trillions of dollars, which could have been used to build nuclear infrastructure. 

I don’t place very high odds on politicians getting it right, especially now that they realize they can use the printing press to print money and build all these projects to greenify the economy and put people to work. I think it’s going to be awfully hard to reverse this trend that we are on.

On the macro implications

Alp: I tend to believe that a combination of energy transition, dual supply chain, fiscal impulse, and infrastructure spend will make things a lot more expensive this decade than they were last decade. If our view is right, then there should be pricing signals across lots of components and commodities. We are talking about a massive capex cycle, which should lead to higher inflation and rates.

The risk in all this is a significant dislocation in the rates market. The real 10-year yield in the US should not be negative 100 basis points. The nominal 10-year yield in 2018 was at 3 percent, a time when there was more slack than today. At some point the Fed may be forced to react very aggressively, maybe in 2023 or 2024. 

Although we are talking about a 10-to-20-year capex cycle with real structural fundamental drivers, it doesn’t mean that we won’t have significant dislocations along the way if we have significant rates volatility. 

Dan: It’s going to be a hell of a tug of war. On one hand, there are these secular and deflationary trends that we have become used to such as AI, automation, the cloud, and Zoom. The other side is the endless money printing. Ultimately, if it continues for long enough it is going to have implications. This is in addition to the inflationary forces discussed earlier. 

I don’t know who is going to win the tug of war. Maybe it’s a tie. The answer could be we have a little bit higher inflation than in the past twenty years. I am not in the camp that all of this is going to lead to a big disaster. I am a big believer in the secular drivers of technology, which is why I have trouble getting behind gold. So maybe it all works out. I kind of think it will.

Closing reflection from Rumi

Little by little, wean yourself.
This is the gist of what I have to say.
From an embryo, whose nourishment comes in the blood,
move to an infant drinking milk,
to a child on solid food,
to a searcher after wisdom,
to a hunter of more invisible game.

Think how it is to have a conversation with an embryo.
You might say, “The world outside is vast and intricate.
There are wheatfields and mountain passes,
and orchards in bloom.

At night there are millions of galaxies, and in sunlight
the beauty of friends dancing at a wedding.”

You ask the embryo why he, or she, stays cooped up
in the dark with eyes closed.

Listen to the answer.

There is no “other world.”
I only know what I’ve experienced.
You must be hallucinating.