Autumn dawns and the living doesn’t get easier
The recovery keeps hitting speed bumps caused by supply side disruptions. The latest is the surge in energy prices. Demand for energy is inelastic so higher prices reduce disposable income and spending on other goods and services. We don’t need that right now. However, the risk of this having a more profound economic impact isn’t priced into financial markets. A mid-cycle correction in growth seems more likely to be a source of market volatility than a bond crash.
The price of a barrel of oil has doubled over the last year. Today the spot price for Brent crude is hovering just below $80 per barrel. It was briefly below $20 in the first wave of the pandemic and has not been this high since 2014. The market price of natural gas has gone up by five times on European markets since this time last year. Coal prices are up by 100% since September 2020. These price increases are adding to concerns about inflation and have been a key factor behind the most recent increase in inflation break-evens in the bond market. It’s certainly something else for investors to worry about. It would not be a good combination if energy prices and interest rates were to continue to rise. The ratio of real growth to inflation has already turned lower and historically this has not been a great sign for equity markets.
Commodity prices are always sensitive to even marginal changes in supply and demand. That’s why oil and other commodity traders keep a close watch on high frequency inventory data. Shortfalls in supply or surges in demand can often lead to sharp price increases. Organisations like The Organization of the Petroleum Exporting Countries (OPEC) have used this to their advantage in the past – only having to discuss potential cuts in production to put a floor under prices. Given that many markets are experiencing supply difficulties it is reasonable to suspect that the current spike in energy prices is the result of improved demand related to the economic recovery from COVID-19 combined with ongoing pandemic related disruptions to production. The result has been much lower stocks of natural gas than is the norm. Supply of natural gas from Russia to Europe has been running lower ahead of the Nord Stream 2 pipeline getting regulatory approval and coming online. But storage shortfalls and supply problems are evident in North America and Asia as well. A shortage of natural gas and higher prices mean power users turn to alternative sources of energy – hence the surge in oil and other fuel prices.
Running on empty
These markets are complex and COVID-19’s impact is likely to have been significant – after all drilling activities, refining, and maintenance of refineries and pipelines need people and workers in these sectors have not been immune to the disease. At the consumption end, at least in Britain, we are seeing how a COVID-related shortage of tanker drivers is impacting on the distribution of petrol. Port capacity has been impacted which has probably had a knock-on effect on trade in liquified natural gas (LNG) as well. The US is a large exporter of LNG to Asia in particular. There are lots of reasons why prices are up now.
Energy transition and pricing
There must be a risk that energy prices could remain high beyond some of these shorter-term COVID-related reasons. The shift to a low carbon economy involves important structural trends. On the demand side, demand for renewable energy as a source of fuel for electricity generation and in a range of industrial processes is increasing. This is gradually replacing fossil fuels, although demand for oil is still rising. On the supply side, investors are starting to allocate capital away from oil and gas companies to finance renewable energy technologies and investments. If low-carbon driven shifts in investment start to raise the cost of capital for the oil and gas sector, making new capacity economically less viable, then the ability of oil and gas companies to raise capacity will be constrained. However, the two things aren’t happening at the same pace. Renewable energy is not there in sufficient quantity yet to be the dominant source of energy but at the same time investor, political and long-term economic pressures are impacting on global fossil fuel capacity. Today’s energy price rises might be related to short-term factors but, conceptually, one can see how the dynamics of the energy transition can also lead to elevated energy prices. If renewables were already able to meet extra demand, prices would not be rising.
Renewables investment needs to keep growing
Advocates for increased use and investment into renewable energy will argue that the cost of producing renewable electricity has fallen in recent years and is cheaper in many cases than electricity derived from fossil fuels. That is clear and the trend will continue as technology advances, as the cost of capital for green technology falls and as a global (and higher) price for carbon emissions evolves. Yet as long as demand for oil and gas is still rising then supply constraints in either renewables or traditional energy markets will make prices go up. The marginal investment dollar is more likely to go to renewables going forward than to oil and gas which could mean a more inelastic supply and a tendency for prices to react sharply to fluctuations in demand. The good news is that this will encourage more rapid investment and use of renewable energy. It will be cheaper and less volatile (hopefully). At some point the dominance of renewables will be such that oil and gas prices won’t matter as much. But we are not close to that point yet and that means energy price volatility could be a feature of the energy transition. It is clear that renewable capacity, storage and distribution still needs a lot of investment.
Take energy profits?
The oil and natural gas markets are in backwardation, meaning future prices are lower than spot prices. This is a classic signal of a short-term supply squeeze. It suggests that prices will fall. The energy transition points to reduced demand and lower oil and gas prices in the future. This undermines the long-term case for investing in energy companies that don’t diversify. Yet this year, having an exposure to energy companies has been financially rewarding for investors. The S&P500 oil and gas exploration and production index has risen by 67%. In the global corporate bond market, the energy sector has outperformed the overall index. Now might be a good time for ESG conscious investors to divest a little more from fossil fuels. What the futures’ market is saying about prices and what one should expect in terms of policy and carbon prices in the wake of COP26 suggest further reductions in exposure to traditional energy companies. Of course there are different ways to do that and few investors are taking a blanket approach to exiting fossil fuels. However, the case for exiting the worst companies in terms of business diversification and environmental impact from continued oil and gas production is very strong.
More reasons to be cautious
The short-term macro outlook is complicated by the energy price spike. If it is temporary, then it is consistent with the argument for inflation falling back in 2022. The US break-even inflation curve has been negative since the start of the year, so the market is still running with the transitory view. However, the broader concerns about supply chains suggest economic data and production could continue to be disrupted over the winter. From an equity market point of view, in my opinion, concerns about supply and how disruptions could impact on revenue and earnings guidance is more of a threat than significantly higher bond yields. We have already seen a softening in the consensus 12-month growth rate for EPS in the US and in Europe and earnings revision balances are starting to turn down. Macro and fundamentals have weakened recently so let’s see whether liquidity is enough to sustain market levels.
Timing is everything
At one of this summer’s cricket test matches between England and India, England captain Joe Root had the opportunity to call for a review of the umpire’s decision to rule an Indian batter “not-out”. Joe took his time deciding to call for the review and, in the end, did not manage to signal before time ran out. Analysis subsequently proved the batter would have been out, but the umpire’s decision stood, the batter went on to make a big score, arguably changing the direction of the match. India won the series. When I look at Congress and the discussions over the US debt ceiling, I expect that a deal will be reached before time runs out. The gamesmanship of running it right to the wire is part of the American political drama. Markets are not unduly worried at this stage. Imagine, though, if Congress made a Root-like mistake and didn’t do the right thing in time? From leading the US recovery and delivering strong investment returns, a Treasury default would send US markets into chaos. Keep an eye on the clock people! (and apologies to those of my readers not familiar with the nuances of Test match cricket).
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