HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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June 13, 2022

Some Macro Thoughts – All About Energy

Inflation continues to be a global problem, and the United States and Europe face the risk of recession. Stagflation has confounded most economists due to their overreliance on demand factors rather than the supply side. The real-world supply constraint in energy markets and broad money expansion over the last two years have led to price rises with little economic growth.

Measured US CPI came in above the expected level for May, and importantly these were on higher year-on-year comparatives. While many commentators have identified that inflationary pressure should ease into Q2 2022, the timing and extent of this mitigation remain elusive and hard to judge. China not fully opening up, conflict in Ukraine, and the prospect of recession are all factors for investors to juggle in this regard.

Broad money growth has been a feature of the last two years. Previous periods of broad money growth have usually also been periods of increased labour or energy supply (or both), such as the opening up of China to World trade and the development of shale oil in the early 2000s. These factors are currently not in play. Labour and energy are both in short supply in developed markets.

Throughout the 19990s and 2000s, the US and Europe exported manufacturing capacity to China, freeing up labour capacity in the domestic economies and depressing real wage growth. The Chinese labour market is now tapped-out, and we don’t have any obvious new sources of disinflationary growth for the West to tap. Geopolitical issues mean that we are in a period where oil prices, money supply and inflation have become more closely correlated.

To return to a period of disinflationary growth requires a significant fix to the supply side. Critically this entails securing low-cost, abundant energy. But energy prices remain elevated despite some important mitigating factors. The US is drawing from its strategic petroleum reserve, and China is still in partial lockdown, yet the oil price is close to an all-time high of c.$120, it could be much higher. The main limiting factor is the fear of demand destruction, not significant incremental supply.

Energy has become the hottest topic in markets over recent weeks. Oil and gas stocks have been getting a lot of retail investor attention (usually a reliable contra indicator), and Warren Buffett has increased his Chevron stake fivefold year to date. However, unlike the recent retail manias for technology and meme stocks, there is little euphoria in energy company valuations. Large pools of capital remain underinvested in energy. This under-investment has three components:

1. The hangover effect remains from the last energy bull market when companies overexpanded, such as the US shale producers diluting investor returns or worse.

2. ESG has a hold over the institutional asset allocation process, meaning that factors other than traditional value metrics drive decisions.

3. Producers are reluctant to propose new capex plans. Their previous expansionary phase produced negative returns, and energy producers are still fighting the last war. They are fearful of government windfall taxes and shareholder activism thwarting their plans.

Put simply, we are experiencing market failure in allocating capital to energy.

Energy is such a fundamental driver of human welfare it is almost unimaginable that energy supply will be a long-term structural problem. In the 1970s, we contained oil demand through two recessions, improved fuel efficiency, and energy rationing measures. High oil prices brought on new supply from non-OPEC sources. Prices dropped precipitously, creating the conditions for the mid-80s Lawson boom.

John Templeton described the four most dangerous words in investment as “this time it’s different”, but it does feel very different this time. The oil and gas industry has been neutered and is not prepared, willing or able to take the lead on frontier drilling programmes to find the new North Sea or Prudhoe Bay.

Remember when we thought we had an energy crisis last September? A British summer of cloud cover and low wind speeds gave us a wake-up call that alternative energy sources could not provide sufficient base load supply, and we ended up burning coal at a high financial and environmental cost. Little did we know, but the events of 2022 mean we now need a bigger boat.

Fixing our energy supply requires developing locally sourced natural gas and nuclear energy capacity. Unlocking the supply of capital for these projects requires altering the ESG lens and permitting both under our generally accepted taxonomy for sustainable investment. It is worth noting that Hinckley Point is now looking like the energy deal of the decade. The government agreed to pay £92 per megawatt-hour when it starts running in 2027. The wholesale price of gas is currently more than double that.

Jeremy

Ealing

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