United States

What’s going on with energy prices?

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The cost of energy-related commodities (crude oil, natural gas, coal) has risen dramatically this year, particularly since early September. As economies around the world continue to emerge from COVID-19-induced lockdowns, demand has rebounded more sharply than expected and helped fuel the recent rally. However, an inability and/or unwillingness of producers of all three commodities to markedly increase output are tipping the scales even further, and peak seasonal demand across much of the northern hemisphere is still months away.

Figure 1

Energy Prices Spiking

Natural gas is up more than 200% from the start of the year; a barrel of oil is 55% more expensive, and coal has spiked more than 250% to record highs.


It started with gas

Natural gas is at the forefront of the energy crunch and has risen in part due to weather-related phenomena in the U.S. and abroad. The deep freeze in Texas earlier this year created excess demand and resulted in U.S. inventory drawdowns. Then, Hurricane Ida, which shut down nearly all production in the Gulf of Mexico, further upset the supply-demand balance.

In Europe and parts of Asia, a particularly cold and long heating season last winter has left gas storage levels well below five-year lows, and pandemic-induced construction and maintenance delays have hindered the ability to meaningfully boost supply. This problem has been compounded in places like the UK, which generates upwards of 24% of its electricity via wind turbines. Abnormally light winds in recent weeks forced officials to use gas and coal-fired plants to make up the difference, adding to already-high demand and putting additional upward pressure on prices. 

When gas is expensive, oil will do

The alternative means of power generation are primarily oil and coal. West Texas Intermediate (WTI), the domestic oil benchmark, was up nearly 55% this year through the end of September and, more recently, traded even higher to levels not seen since 2014, as investors increasingly bet that U.S. producers will be reluctant to add significantly to supply — a situation we discuss in more detail below. Separately, the Organization of Petroleum Exporting Countries together with Russia (OPEC+) decided earlier this month against increasing supply beyond its previously agreed-upon 400,000 barrels per day (bpd) despite calls from the U.S. and other nations to boost output by as much as 800,000 bpd. Not only is it still fresh in many a mind that oil prices in March 2020 turned negative for the first time in history (a scenario unlikely to repeat, but scary nonetheless when your country relies almost exclusively on petroleum revenues), but chronic underinvestment in infrastructure in recent years amid a global push to “go green” has left some cartel members in a position where they may be able to pump more oil out of the ground, but getting that extra crude to market may not be so easy.

And then there’s coal

There have been concerted efforts among many countries to reduce coal use and the resulting carbon emissions. However, coal still accounts for roughly 40% of the world’s electricity, and some are now reversing course on reductions — at least temporarily. Notably, China did an about-face recently after coal inventories used in its power plants reached 10-year lows, leading to rolling blackouts and an unexpected decline in manufacturing activity last month. Despite efforts to procure coal from several other countries after it stopped buying a large portion of its supply from Australia late last year amid political tensions, many Chinese firms have turned to diesel generators as a means of supplementing coal use amid mandatory rationings. A continued rise in energy prices could put further inflationary pressure on goods coming out of the world’s largest exporting nation.

Don’t expect supply-side relief, however. Despite the surge in coal demand, miners are limited in their ability and willingness to ramp up supply. Previously closed mines take significant time and investment to reopen and, given the global trend toward cleaner burning fuels, it’s not a gamble many — if any — are willing to take.

Economic impact

You may be feeling the pinch in your energy bills; however, costs have not risen in the U.S. to the extent seen in many other countries, thanks to greater storage capacity and our position as one of the world’s largest producers of all three energy commodities. Also, the cash cushion many households have from several rounds of government stimulus checks better positions the U.S. consumer to withstand recent increases in their energy costs.

Still, higher energy costs serve as a tax on consumers, who account for the lion’s share of gross domestic product in the U.S. An extended period of higher prices could not only further increase inflation, but also start to weigh on economic growth, a scenario referred to as stagflation. While we don’t dismiss the possibility, we believe the situation would have to be prolonged and excessive, which is not our base case. As Figure 2 below indicates, supply and demand are expected to converge in the beginning of 2022, so we’re cautiously optimistic that price pressures should begin to alleviate early next year.

The implications for foreign economies are not too dissimilar from the U.S., except our domestic production and storage capabilities better enable us to weather severe price swings. Nonetheless, globalization has rendered the U.S. susceptible to economic conditions abroad.

Figure 2

World liquid fuels production and consumption balance - million barrels per day

Investment implications

The Energy sector has been the S&P 500 Index’s best performer so far this year, but that may not be the case next year. Starting in 2016, companies ramped up efforts to drill new wells in tandem with rising oil prices. The number of drilled but uncompleted wells — or DUCs — peaked in late 2018, creating a cushion that enabled companies to maintain or increase output this year without having to meaningfully boost capital expenditures. This in turn allowed them to focus on enhancing shareholder value through increased dividends, buybacks and debt reduction. However, firms have drawn on those reserves to the point where levels have returned to near 2016 lows. Consequently, producers will likely need to ramp up drilling efforts next year to increase, or even sustain, current output. With the cost of a new well at roughly $7 million plus ongoing operational and service costs, it’s not a minor outlay; however, if current price levels near $70 per barrel are sustained, they could continue to return capital to shareholders despite the need for additional drilling.

Conclusion

Higher energy prices are likely to result in above-average inflation over the next few months. While consumers are already feeling its effects via higher energy and food costs, core inflation — which strips out those two components — may see a more modest uptick going forward. Consequently, the Federal Reserve (Fed) appears likely to stick to its previously communicated plan to slowly withdraw liquidity through the first half of next year. This would provide continued support for the U.S. economy while market forces continue to work through the supply-demand imbalances. However, rising energy and food prices, should they be sustained, could dampen economic growth, thereby diminishing the need for the Fed to further tighten policy. So, while consumers certainly hope prices come down soon, investors could benefit whether prices remain elevated or retreat, bearing in mind the uncomfortable position in which many firms in the energy space currently find themselves.

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