Is the Energy Price Surge “Transitory” or a Longer-Lasting Trend?

This post is also available in: Chinese (Simplified) French Italian German Spanish

Rapidly rising energy costs have been making headlines this month after building steadily throughout the summer. Crude oil and natural gas prices have reached multi-year highs, with US benchmark West Texas Intermediate crude trading above US$80 a barrel for the first time since 2014 (up from the 2020 pandemic low of US$19.33 a barrel), while natural gas futures rose to their highest level since 2013.¹

In Europe, even faster-rising natural gas and power prices have raised the spectre of an energy crisis heading into winter. Natural gas prices in some parts of the continent reached more than US$30 per million British thermal units (BTUs) as several European countries began to compete more aggressively to secure supplies, including bidding against China for liquified natural gas (LNG) cargoes. In addition to impacting industries that use natural gas as a feedstock—including fertiliser, chemicals and plastics manufacturing—the rally has elicited a rise in switching from natural gas to petroleum and even coal for power generation, which could meaningfully increase demand for oil and provide further support for oil prices.

While Europe has been grappling with a supply crunch, Brazil and other South American countries were contending with a different cause with a similar effect, having recently grown more dependent on natural gas-fired electricity generation as a drought crimped hydroelectric output. The region’s LNG demand has almost doubled in the past year.² Booming demand has been met with lower supply of LNG while small disruptions—some caused by maintenance, others unplanned—have nibbled away at global output. The combined effect has been to cut global LNG supply by roughly 5% in 2021.³

A global natural-gas production deficit, dwindling inventories and a concerted regulatory effort by the Chinese government to slash emissions—substituting lower-carbon fuels such as LNG for coal—all play a role in the current energy supply/demand imbalance. With US stockpiles already running below their five-year seasonal average, growing US natural gas exports could trigger additional price spikes as power plants and factories are forced to compete with rising home and business heating demand as the Northern Hemisphere winter heating season gets underway.

Although US energy producers have historically responded to such market signals with more drilling and production, putting pricing hedges in place before the rally—mostly to lock in prices and cash flow to help reduce debt—have served to limit additional spending and a stronger ramp-up in drilling.

The number of US natural gas-focused rigs has only partially recovered from pandemic lows and plateaued around 100 this summer, which was half of pre-pandemic levels (despite the profit motive of much higher prices).⁴ The public natural gas-levered producers are focusing on shareholder returns instead of growth, partially due to shareholder pressure, thereby muting the supply response. Additionally, several large natural gas-focused exploration and production firms locked in prices with hedges below US$3 per million BTUs and thus were unable to fully benefit from the recent price spike above $5/mmbtu. These factors helped keep overall US natural gas production relatively stagnant at 92 to 93 billion cubic feet per day for the first eight months of the year.*⁵

Oil inventories have declined significantly since the depths of the pandemic and are now below pre-pandemic levels, which has helped support prices. On the supply side, energy companies have continued to embrace spending discipline and shareholder returns while some large integrated oil and gas companies are pivoting away from traditional oil and gas investment in a move toward broader energy strategies that include renewables and other low-carbon fuels. Combined with free cash flow yields above 10% for some companies, compared to a 2% average for companies in the S&P 500 Index,⁶ we believe this presents an attractive investment opportunity.

Supply and Demand Pointing to Sustained Higher Prices

Concerns of slower-than-expected economic growth in the United States and China related to a summer rise in COVID-19 cases, along with China’s efforts to tame commodity prices and reduce emissions, had kept prices constrained. OPEC+⁷ had been taking a measured approach in bringing previously curtailed production back to the market in conjunction with the pandemic recovery in demand, but the consortium thus far has not committed to lift output in a way that might fully compensate for a more rapid recovery in demand.

Once OPEC+ spare capacity is absorbed, which we believe will occur incrementally over the next year, and perhaps much sooner given fuel switching this winter, oil prices will need to remain at levels high enough to incentivise additional investment, which should continue to support producer equity values.

We also believe any further economic weakness tied to the virus’s spread will likely prove to be temporary, and thus from an investor’s standpoint, only represents a short-term headwind for natural resource companies. Vaccination programmes continue apace, while cases have been declining in several countries and appear to be plateauing in others. Meanwhile, and despite goals of limiting property market excesses and moderating commodity inflation while reducing pollution, we think China is unlikely to allow a significant deceleration in its economic growth and may take fine-tuning steps to soften the impact of its policy moves over the past year.

While the above factors may slow demand growth for commodities in the near term, we believe several trends will continue to support prices, such as stimulus-driven consumption and an eventual reduction in global supply chain impediments that should boost manufacturing.

Heading into October, total US oil demand was running nearly 14% higher than a year ago, while commercial crude inventories of 418.5 million barrels were down 15% to the lowest level since October 2018.⁸ US combined production of crude oil and petroleum products were also well below levels at this point of 2019 and 2020.⁹

Meanwhile, long-term demand trends remain firmly in place, with infrastructure and energy transition spending likely to drive consumption of base metals while developing-market demand for both traditional and green energy continues to grow. Alternative renewable sources of energy—solar and wind projects in particular—are not coming on-stream fast enough to replace the deficit between energy demand and supply and have not been reliable in the recent past as some regions experienced unusually calm wind conditions.

As energy prices race higher, risks to the economic recovery are rising and growth could be slower than forecast. Economists say the energy surge is still far from the kind of “oil shock” that could trigger a recession, but the trend is troubling and much higher prices across the economy could spook consumers and slow spending.

A perfect storm of energy shortages and high demand has made the outlook uncertain for energy prices globally. Some analysts say a cold winter could make the problems even worse.

From an investment standpoint, demand and production trends, when combined with ongoing supply limitations, keep us constructive on natural resource equities, including energy. However, selectivity has been critical as commodities can display differing levels of sensitivity to various economic trends. For instance, iron ore prices have declined significantly as the Chinese government took steps to cool inflation and emissions and recent volatility in their property markets may further curtail demand. While this can affect many commodities, construction materials such as steel and its raw materials (iron ore and metallurgical coal) may be disproportionately impacted given the large influence of the Chinese property market. And although copper markets may also be negatively impacted if construction demand slows, inventories are at very low levels and long-term demand trends appear robust as energy transition spending heats up. Meanwhile, oil and natural gas markets, while not immune to such headwinds, should fare better as China represents a smaller portion of global demand and given other influences such as supply limitations and secular demand trends.

What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Growth stock prices may fall dramatically if the company fails to meet projections of earnings or revenue; their prices may be more volatile than other securities, particularly over the short term. Smaller companies can be particularly sensitive to changes in economic conditions and have less certain growth prospects than larger, more established companies and can be volatile, especially over the short term. Investing in foreign companies involves special risks, including currency fluctuations and political uncertainty.

Past performance does not guarantee future results.

Important Legal Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realised. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data.  Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

_________________________

1. Source: Bloomberg. See www.franklintempletondatasources.com for additional data provider information.

2. Ibid.

3.Source: Energy Information Administration (US Dept. of Energy).

4. Source: Baker Hughes, Inc.

5. Source: US Energy Information Administration.

6. Source: Bloomberg.

7. OPEC+ consists of the 13 members of the Organization of the Petroleum Exporting Countries and their allies.

8. Source: International Energy Agency.

9. Ibid.