Forecasting threats to the Gold, Oil, Land Inflation Protection Strategy, and Alliance Resource Partners $ARLP

Oh God, not another Macro Musings Substack!

Hey ChatGPT, please dunk on Substack writers that have the audacity to write “Macro Musings” articles in the style of Lewis Carroll’s Jabberwocky (1871)

Beware the Econ-wock, my friend!

The curves that swoop, the charts that bend!

Beware the Macro-muse's chatter,

And the laughable Phillips batter!

They took their slides with market hands,

Long time the fickle data sought—

So rested they by the Equilibrium tree,

And stood awhile in thought.

And as in hazy graphs they stood,

The Econ-wock, with eyes of flame,

Came whiffling through the burbling wood,

And murmured of the same!

One, two! One, two! And through and through

The marginal blade went snicker-snack!

He left it dead, and with its head

He went galumphing back.

"And hast thou slain the Econ-wock?

Come to my arms, my brilliant boy!

O frabjous day! Callooh! Callay!"

They chortled in their joy.

'Twas brillig, and the Fed's own knaves

Did gyre and gimble in the wabe:

All mimsy were the fiscal saves,

And the GDP outgrabe.

I wanted to take a moment to reflect on the Gold, Oil, Land Inflation Protection Strategy and try to poke a few holes in it.  The basics seem sound, the most likely path forward for the United States is an inflationary one.  However, there is always the chance of a deflationary spiral, or the least likely outcome of all, responsible adults tackle the fiscal problem and we grow our economy out of this mess.

Inflationary Path (Highest Probability): Congress maintains a fiscal deficit that results in increasing the money supply, although roundaboutly through the banking system and the federal reserve. On top of that, the BRICS countries adopting gold and abandoning dollars could exacerbate this with a repatriation of foreign dollars.  Productivity increases, either through AI or otherwise, are not enough to compensate for this increase in the money supply.  Reshoring increases costs of production as well.  And the banking system after years of deleveraging from Basel I to Basel III are now primed and ready to start lending again, expanding the monetary pyramid on top of the expanding base money.  Any decrease in interest rates could cause cash out refinancing to access the trillions in new home equity and the spending would shock us all.

Deflationary Path (Small Probability): Congress selectively defaults on Chinese held treasuries, and declares all treasuries to have no coupon, and other countries retaliate similarly.  The decrease in base money and interest income causes chaotic price decreases, which make the loan default rate increase.  Increasing loan defaults shrink the monetary pyramid, causing a financial crisis, an interest rate spike, and further falling prices.  Falling prices include the prices of public equities.

Prosperity Path (Smallest Probability): Congress freezes spending, and rationalizes entitlements meanwhile cutting regulations and allowing for organic GDP growth.  Profits are normal, life is good, but industries that rely on federal spending such as Defense and Healthcare might suffer.  This restores the US dollar to confidence as a reserve currency, harming gold prices and possibly cryptocurrencies as well.

Regarding Gold, Oil, and Land, if I had to pick one that was the weakest, it would probably be Oil.  The whole point of the commodity supercycle thesis is that an underinvestment in supply causes a revenge of the old economy, but with shale innovation, we have not underinvested in oil or natural gas supply.  It is true that those wells decline quickly, but it is also true that shale is more of a manufacturing process than a traditional materials business, and more innovations are coming every month.  The Artificial Intelligence revolution might drive up energy demand generally, but this might affect coal and uranium more than oil and natural gas due to the difference in supply constraints. 

Gold is strengthened by the BRICS attempting to dethrone the dollar as a reserve currency, but I hate owning companies that are not growing or have low profitability.  For this reason, I love having gold exposure through copper miners with strong gold emphasis such as Hudbay Minerals (HBM), or even companies like Sibanye Stillwater (SBSW) who have high cost gold mines and get no credit for them in their market capitalization.  Pure gold miners, or gold as a commodity, frustrate me due to the high price, low profitability, and management fees.

Land is strengthened by illegal immigration, population density increases land values.  I do not believe that the US has the gall to actually deport millions of people, maybe just a few that are convicted of violent crimes.  So what Biden has done will probably stand, but perhaps the rate of influx will slow.  The only threat to land values that I see would be a sudden breakthrough in flying drone taxis allowing cities to become much taller and more dense.  But I am skeptical of the pace of development of drone taxis due to safety concerns.  There are breakthroughs in agriculture coming, a startup just announced a technology to increase potato yields by 50%, but the effect on agricultural land prices might go either way as decreased demand meets increased production.

There is a fourth category to the inflation protection strategy that I have not mentioned yet, and that is equities generally.  Many people believe inflation will be bad for equities broadly as it was in the 1970s, however, it is important to note that the 1970s were before personal computers and Microsoft Excel.  We just witnessed profit margins expand, not shrink, during this first spike of inflation which hit 9% under modern measurement methods, closer to 12% under the prior measurement methods.  The reason inflation was bad for business in the 1970s was that they could not keep up with marking up their inventory to match the rising costs of replacing it.  Today with computerized inventory management, this shouldn’t be an issue for any firm worth their salt.  So unlike the 1970s, there are good odds that the stock market generally will perform approximately as well or possibly better than Gold, Oil, or Land focused businesses.

If we do have a deflationary spiral, senior secured loans and cash would outperform.  This is one reason why I like Medical Properties Trust (MPW) so much, their master leases are for twenty years, approximately, and if the tenant can’t pay, well, they have less friction to replace them than other commercial real estate.  Having some nominally fixed income is a huge advantage in case of deflation, which I acknowledge is a small threat.  MPW is both fixed income and land, so it straddles and hedges both strategies.

If we have prosperity, most businesses would do very well, so there isn’t too much risk to hedge, but businesses that rely on federal spending, and gold could suffer enormously.  This takes away from gold’s luster in the inflation protection strategy. But if we do have prosperity, copper demand and platinum group metals demand should skyrocket, again why I like HBM and SBSW over pure gold miners, it is internally hedged in the scenario that responsible adults win the day.

I made a commitment that every post would have an actionable investment idea.

Given the probable inflationary path forward for the US combined with the artificial intelligence data center electricity demand, I am coming to like Alliance Resource Partners LP (ARLP).  They are a US focused thermal coal miner, their capital allocation policy focuses on dividends which currently stand at over 11% yield, and given the AI demand for electricity, management claimed that utilities are already contacting them to secure coal supply for power plants that will no longer be shut down on schedule.  If it takes five or more years for natural gas plants to come online, and ten or more years for nuclear plants to come online, then ARLP could pay out a whole heap of cash in the meantime.  I believe that the power generation demand will benefit in order thermal coal first, natural gas second, and nuclear third.  

What is very interesting about ARLP is that when confronted with their sunset industry, they chose to start reinventing themselves as a Permian Basin focused royalty company.  In the last ten years, they have spent $730 million acquiring mineral rights in the Permian, and in these trailing twelve months, those royalties contributed over $123 million to ARLP’s EBITDA.  Another seven years of splitting their cashflows between buying royalties and paying dividends would transform the business to a Permian royalty company, but selling currently at a much lower price than a royalty business.  For example, Permian Basin Royalty Trust (PBT) generated $28 million EBITDA in the trailing 12 months and has a market cap of $520 million, and a dividend yield of 5.98%..  On this comparable alone, $2.2 billion of ARLP’s $3.2 billion market cap would be their Permian mineral rights.

Imagine seven years from now, ARLP could be generating $300 million of EBITDA annually from oil and natural gas mineral rights, just in time for natural gas power buildout to finally start sunsetting thermal coal.  Meanwhile, ARLP will have been paying strong dividends all the while.  They also have an investment in the mining services business as well, providing safety and productivity services to their competitors.  While a nice addition, not my primary reason for liking ARLP.

So for a market cap of $3.2 billion, you are getting a thermal coal business that will likely generate EBITDA of $500 million to $800 million in the near term, splitting cashflows between dividends and buying mineral rights.  Currently 24% of their coal customers are set to retire within in seven years, but as management noted, customers are starting to delay plant closures.  So after seven years, EBITDA contribution from coal could be somewhere between $380 million to $600 million, but by this time, EBITDA contribution from Permian royalties could be in the range of $300 million as well.

ARLP is led and 15% owned by its CEO Joe Craft, who led a management buyout of the coal business of Mapco in 1996, a pipeline company later acquired by The Williams Companies (WMB).  So while there is no insider buying to indicate whether the current price is dear or cheap, there is a strong capitalist at the helm preventing incentive misalignment from bureaucratic creep.  Given that most public coal companies are over one hundred years old, it is rare to find one led by a modern coal baron.

Is the 11% dividend sustainable?  ARLP currently has a 25% operating cashflow yield, so the dividend only represents a 44% payout ratio.  The dividend is sustainable as long as coal prices hold firm, and in the meanwhile, the remainder of the capital allocation is transforming the business into Permian mineral rights, which is likely to be the next sector to benefit from increased electricity demand after coal.

If coal outperforms due to the inflationary commodity supercycle, great.  If oil and gas outperform due to the pattern resembling the 1970s more than I believe it will, also great.  If the US chooses default and deflation, businesses that focus on dividend income over share buybacks will be a great portfolio component.  If the US chooses to enter prosperity, then ARLP will do fine that way as well.  

In my previous posts I have discussed stocks that are “Ten Baggers or Bust” to describe companies that might 10x, or might go to zero.  Now I am introducing a new category called “Probably Not a Value Trap” for companies with at 10%+ dividend yield but are unlikely to cut that dividend.  In that new category so far there is ARLP, MPW, and B Riley Financial (RILY.)  Expect two more “Probably Not a Value Trap” companies next week.