For Financial Professionals in the US

Assessing Inflation – Energy: A Long Time in the Making

Matt Peron

Matt Peron

Director of Research | Portfolio Manager

Jul 18, 2022

To provide forward-looking perspective on inflation, Director of Equity Research Matt Peron and analysts from our Equity and Fixed Income Research Teams assessed comments made by listed corporations addressing the topic. In a series of articles – also available as a whitepaper – they discuss how select sectors are being impacted by rising prices and what it means for both company profitability and the health of the economy. 

Key Takeaways

  • The disparity between industry capacity and the post-pandemic rebound in demand caused crude oil and natural gas prices to rise more than 40% in the year preceding the Russia/Ukraine war. Upward price pressure has only accelerated since then. 
  • Higher energy prices have not been a windfall for the sector, however, as production companies are dealing with their own supply dislocations.

In nearly any discussion of inflation, the impact of energy typically receives top billing. That reputation is well deserved in this period as higher energy costs have permeated throughout the economy. Rising post-lockdown demand is only part of the story. The origins of the current mismatch harken back to the energy downturn of the last decade that was the result of exploration companies prioritizing growth over market balance and once again overshooting demand with excess capacity. Shareholders revolted, demanding higher returns on capital at the cost of curtailing future investment. Pandemic-related weakness only reinforced the view that capacity had overshot demand that was in secular decline as the global economy took steps to reduce its dependence on hydrocarbons. 

Overlooked was that even during the depths of the pandemic, crude oil demand remained over 70 million barrels per day. Furthermore, consensus forecasts call for oil and natural gas demand to increase – not slip – in the coming decade. With the disparity between industry capacity and the post-pandemic rebound in demand already in place, crude and natural gas prices rose by more than 40% in the year preceding Russia’s military buildup on Ukraine’s border. Since then, upward price pressure has only accelerated.  

Unfortunately for the rest of the economy, the lack of capacity is expected to last for the foreseeable future as there are no large-scale projects on the horizon. In looking for a lifeline, some point to Saudi Arabia possibly raising production capacity toward 12 million barrels per day. Our analysis indicates that such a level would not be sustainable. Regions outside of OPEC and the U.S. have been even more prone to underinvestment, so no help is likely to come from there. Then there are the concerted efforts to remove Russian hydrocarbons from global markets. That’s proving easier said than done given the fungibility of oil in global markets and Western Europe’s dependence on Russian natural gas. With it likely taking years to develop a viable alternative source for Europe’s energy baseload, the region is facing a sustained period of high natural gas prices even though its rebound in demand has lagged that of the U.S.  

U.S. Crude Oil Production and Price per Barrel
Rationalization of crude oil production has left the energy sector unable to meet the surprise rebound in demand for gasoline and energy product demand, a dynamic for which there is no near-term solution. 

Source: Bloomberg, as of 10 June 2022.

Higher energy prices, however, have not been a windfall for the sector. Production companies are dealing with their own supply dislocations. Inputs for fracking – from sand and tubes to other metal components – have been difficult to come by and expensive when available. Multiple management teams highlighted the lack of skilled labor. Many production crews left the industry during the downturn and the pool of potential replacements command wages not aligned with their level of productivity.  

Lastly, as the U.S. is in the midst of its summer driving season, one must ask how demand has been impacted by $5.00 per gallon gasoline. The answer – as of now – is not much. We attribute this to the release of demand pent up during the pandemic. Families are willing to endure high prices just to hit the road. This, however, may lead to an even fiercer pullback in consumer activity in the autumn, especially if fuel prices remain high and the cushion of excess household savings continues to dwindle. 

Energy industries can be significantly affected by fluctuations in energy prices and supply and demand of fuels, conservation, the success of exploration projects, and tax and other government regulations.