So Bad, It’s Good
Market volatility continued in July due to the same old players, inflation and the Fed. The month saw yet another inflation reading above expectations, forcing the Fed to again raise short-term rates by 0.75%, to 2.50%. The news on inflation, and just about every other economic datapoint, was so bad it was viewed as a positive. The markets spent the last week of the month with their rally caps on. The S&P 500 and the Russell 2000 (US small cap) both moved up by ~4.5%. Even bonds had an exciting week, with the US Aggregate Bond Market index increasing by ~1%. The underlying reason for the shift in sentiment is the market assuming that the Fed has done all the economic damage necessary to bring inflation under control.
Now things get interesting. Is the recent rally just another bear market head fake, or is this the start of a new, durable, uptrend? The answer, as has been the case all year, rests with the inflation trend and softening demand from consumers and businesses. If inflation has peaked and is now convincingly downward trending, then the Fed has an excuse to resume its normal role as equity market cheerleader. If not, it will be forced to increase interest rates above current expectations and leave the markets to find their own way.
Many factors influence inflation; the cost of energy is one of the most impactful, visible and fast-moving. Energy prices need to be in a sustained downtrend if inflation is going to fall as quickly as the market bulls now hope. The main topic of this communication is the US energy market, an increasingly popular area of interest in recent client conversations.
The Energy Market
US energy firms have been on a wild ride for the past 40 years. In 1980, seven of the top ten largest firms in the S&P 500 were energy firms. Today, only Exxon and Chevron find themselves in the top 20, and neither is in the top 10. In 1980, the fifth largest firm in the S&P 500 was Schlumberger, an oil field services firm. Today, it’s Tesla.
US oil production has increased by 40% over the past 40 years as new technologies have allowed energy firms to extract oil and gas from solid rock. Fracking is the process of extracting oil and natural gas from rock formations underground with the use of chemicals, pressure, water and sand. Fracking now represents 60% of overall US energy production. The process is expensive to develop and maintain. The production level of fracking wells declines much more quickly than traditional wells. Analysts estimate that fracking is only profitable with oil above ~$70 per barrel. Saudi Arabia’s cost of production is estimated to be $25 per barrel. This has left the energy sector reliant on easy access to inexpensive capital to finance projects and subject to financial stress should the price per barrel fall below the break-even point.
In the years following the financial crisis, both requirements were met. The industry became overly optimistic with the development of new oil fields and the use of debt to fund operations. In 2013, nearly a trillion dollars was invested in oil and gas production in the US (that number was $380 million in 2021). The resulting overproduction saw oil prices fall from $105 per barrel to $35 per barrel in 2015, as the Saudis increased their own production to force US oil and gas producers out of business and retain market share. As a result, the US energy sector experienced severe financial pressure. Thirteen percent of US energy firms were forced into bankruptcy by 2016, surpassing the previous high of 9%. The pain was not over. COVID-19 caused another collapse in the price of oil, forcing 16% of remaining US energy producers into bankruptcy in 2020. The energy sector experienced two rounds of depression-level bankruptcy events in a five-year period.
Longer-term energy demand should fall as consumers shift to electric cars and respond to environmental concerns by adopting alternative energy sources. The transition to alternative energy will be long and complicated, but even the CEO of Exxon believes that electric cars will account for all passenger cars sold in 2040. With the writing on the wall, investment dollars are not flowing into energy firms as freely as in the past several decades. This drives up the industry’s cost of capital and reduces the financial incentive to bring new production online. The energy sector has a terrible track record of responsible capital management, poses environmental fears, and faces an uncertain demand picture.
And this is the sector that will save us from inflation?
When Russia invaded Ukraine, the benchmark price for US oil (WTI), spiked to $123 a barrel. The market has since retraced much of that move higher. Energy is currently trading for ~$93 a barrel, or 30% above the start of the year. Russian oil is still flowing into the global market, but more severe sanctions are likely coming as the war continues. The US and Eurozone have been discussing various sanction methods that would hurt Russia financially without increasing oil prices. It will be a challenge to accomplish both, and the situation is very fluid. For oil prices to fall, someone will need to produce more oil to offset the impact of any further Russian sanctions.
There has been a great deal of political pressure on US energy firms to increase production. At these prices, history suggests that they would be happy to do so. Not today. The industry is capital constrained, conservatively managed and suffers from several years of underinvestment. There is little reason for oil firms to invest in large scale production increases in this environment.
The responsible thing for energy firms to do is pay down debt and return capital to shareholders in the form of share buy-backs and dividends, despite record profit levels this year. Why spend money on risky projects to increase production when long-term demand is likely to fall? Energy firms are facing the same challenges from supply chain issues and labor shortages that the rest of the economy is confronting. The sector’s financial incentive is to modestly increase production and invest in only low-risk projects. It is not to sow the seeds of the next oil bust.
The outlook for expanded US energy production and substantially lower prices in the coming year is poor. The story from foreign energy sources is relatively similar. OPEC+ is dealing with the same challenges and market dynamics as US firms. Saudi Arabia is the only producer that analysts suspect has spare capacity. Actual production capacity is a state secret. One of the best ways to estimate future oil prices is to peg the price level that balances the fiscal budget of Saudi Arabia. That number is around $95 per barrel. When the world’s dominant energy producer needs an oil price of ~$95 a barrel to balance their budget, it’s a good idea to expect oil will trade around that price. Further, Chinese energy demand has declined this year due to COVID restrictions and the slowest economic growth rates in 30 years, outside of 2020. Global energy demand, and prices, will increase when (if) the situation improves. China is the second largest oil consumer globally. If the current equity rally is dependent on inflation falling quickly due to lower energy prices, we can expect the market to get a dose of reality over the coming months.
Falling energy prices may not lead inflation lower in a sustainable way. But there are glimmers of hope elsewhere. Supply chain issues are easing, and shipping costs have been falling significantly. The new orders index in PMI data has been falling for several months on the back of a weakening economy. US GDP has contracted over the past six months. All these aspects support the idea of lower inflation levels.
However, as shown in corporate earnings this quarter, firms are still able to pass along price increases and maintain profit margins at a level that has surprised the market. Even though consumer sentiment data is near the lowest levels on record, consumer spending remains high and continues to defy logic and expectations. Accordingly, inflation expectations moved higher in the last week of July, reversing the downward trend, and further complicating the Fed’s job.
The most likely outcome is a shift in the underlying drivers of the recent rally. Technology firms have led the charge higher in recent weeks. The more value-oriented sectors of the market have lagged. It’s likely that this scenario will reverse as the Fed pushes back on the premise that they are ready to lift the “Mission Accomplished” banner on interest rate increases. Inflation will fall from current levels, but not like a stone as the bulls now expect. We can expect the bulls and bears to continue their battle, with volatility being the result.