As every driver knows, the pain at the gas pump has been rising steadily. If you listen to the media and politicians, one might infer that oil companies or the Ukraine War are responsible for the price hikes.
But digging a little deeper reveals a more complex story. Although geopolitical events like the “Putin shock” are important, energy markets were going to be buffeted by a mix of inflationary and deflationary forces regardless. Our diagnosis is one of a tight and unstable oil market where small changes in supply or demand would cause outsized price moves. This is not a replay of the 1970s.
Energy assets have emerged from a multi-year decline, with energy equities outperforming the broader market since late 2020. War in Ukraine has buttressed this outperformance. Energy now represents about 5% of the S&P 500 Index’s equity capitalization while contributing approximately 8% to corporate earnings. Over the past two decades energy as a sector has fluctuated between 2% and the low teens as a percentage of the S&P 500’s market capitalization.
This latest bull move in energy is a reflection of the deep bear market that started in 2014 with OPEC’s decision to regain market share from the US shale producers. It culminated with ESG pressures and the Covid-19 crisis in spring 2020. Before the last downturn, the business model that had emerged from the peak oil narrative was based on aggressive volume growth supported by a low cost of capital.
That model eventually collapsed due to the lack of attractive capital returns. Overly aggressive oil exploration had frightened away investor capital—too much free capital had been wasted and too little returned to shareholders. More recently, environmental, social, governance (ESG) pressure has accumulated, raising the cost of capital for these businesses and forcing many to rein in spending plans.
The 2020 downturn culminated with the trauma of negative oil prices in April 2020 as well as the deafening drumbeat of ESG advocates. All of this led the industry to rethink its business model and to some extent, its role in society. If society’s imperative was to reduce the dependence on fossil fuels, the energy industry would contribute by producing less oil and thus deploying less capital along the way.
This narrative of peak hydrocarbon demand took root at the depth of the Covid crisis. Work from home, electric vehicles, and renewable energy sources would mark the end of the fossil fuel era. This prompted companies to pivot capital investment plans and pledge massive commitments to green energy. Managements responded to their instincts for self-preservation. The inevitable corollary has been higher oil prices.
As the US eventually recovered from the Covid shock, fossil fuel consumption rebounded as well. The market started focusing on the supply side of the equation and came to realize that the industry has materially underinvested along the whole energy supply chain.
As this rebound in demand gathered momentum, it led to a structural decline in global inventories while spare production capacity is at historically low levels. Disruptions and logistical issues caused by the war between Russia and Ukraine only exacerbated the supply challenges.
Private companies and smaller operators have responded to higher oil prices by drilling and completing more wells. However, the major integrateds as well as OPEC have only slowly reacted due to supply chain constraints and labor shortages. In the past year, US producers increased exploration budgets by 20% plus in dollar terms but much of this has been absorbed by inflation in services unit costs.
Gradually, a supply response is emerging. The US rig count has doubled off its 2020 bottom and production is recovering. Midstream pipelines and processing players are lifting their capital budgets while the refining and petrochemicals sector is frantically operating at maximum capacity. The global refining industry closed almost three million barrels a day of capacity globally as the industry rationalized its capital stock during the prior downturn.
Refining is now likely the single largest bottleneck in the global hydrocarbon supply chain especially because of sanctions on exports of Russian refined products. Capacity will gradually be added in Asia, but this is unlikely to accommodate expected demand growth. Unfortunately, new capacity requires capital commitments underpinned by 15-to-20–year contracts from buyers. With policymakers demanding an end to carbon, few are willing or able to make that sort of commitment.
This highlights a sad truth about our energy future. Incoherent and ever-changing government policies are preventing the energy markets from normalizing as they historically have, while making the ultimate transition to a greener future much more expensive.
The current US administration's position that we transition away from hydrocarbons as soon as possible has been an important deterrent to capital allocation decisions. Instead, money is pouring into renewables at an accelerating pace, yet our tight energy markets and the current efficiency of carbon alternatives require hydrocarbons to support this transition. Wind turbines, for example, are the pure embodiment of fossil fuels—50-story structures of cement and steel and resins, all transported and put in place by diesel operated machines.
“Greenflation” is the latest industry slogan to signal the spiraling costs with which green energy is confronted because of the rise in commodity inputs needed to build the required infrastructure. Sadly, the much-anticipated energy transition will be a lengthier and more expensive endeavor unless we can produce carbon cheaply.
Of course, there is growing concern that elevated energy prices and tighter monetary policies will precipitate a US recession. We think this fear is premature. Assuming oil prices have largely peaked, we believe the risk of a US recession is unlikely near term.
Based upon prior cycles, demand destruction usually sets in when energy spending exceeds 10% of GDP. We are not there yet. Gasoline prices at the pump are currently around $5 per gallon in the US versus $6 per gallon inflation adjusted at the peak of the Great Financial Crisis. As a share of consumer income, energy is only half of prior peak levels.
Oil demand is unlikely to peak before 2030 and possibly much later, even in an accelerated green transition scenario. It is likely to be a long upcycle and investments in the energy sector should generate attractive returns for years to come. But society must strike the appropriate balance between private sector capital deployment for fossil fuels and the new green regulatory framework.
For the remainder of 2022, we see more downside than upside risk to oil prices assuming the war in Ukraine ends in a ceasefire before year end. We expect Putin’s hot war to become a frozen conflict for years to come. This implies oil prices below $90 per barrel by December.
With the right incentives and government support, energy companies will gradually invest more capital in both renewables and hydrocarbons. There is growing realization that natural gas and nuclear power are important sources of energy to support the transition to a low-carbon economy. (This week, the EU affirmed both of these sources as “green.”) We believe it’s crucial that the government provide a consistent and long-term regulatory framework, which will facilitate the long-term investments required. Until such a framework is agreed upon, the energy industry will be hard pressed to provide the long-term investments the green transition requires.
We do not anticipate a “commodity super-cycle” in coming years, primarily because current rates of inflation in the major economies are unsustainable. Our diagnosis is not a decade of persistently high inflation, but one in which inflation is much more variable versus the past two decades. This implies some considerable swings in oil prices that require investors to adopt an active and tactical approach.
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