Issue 12: Year-End Thoughts on Energy

Special Edition: Year-End Thoughts on Energy

Geopolitics dominated the energy sector in 2022
From Russia’s invasion of Ukraine in February to China digging its heels in on zero-COVID policy, geopolitical forces shaped oil and gas markets throughout 2022. Motivating an emerging trend toward deglobalization, we saw government interventions rock the energy sector this year, as Putin weaponized oil and gas supplies to Europe, the US deployed its strategic petroleum reserve in an effort to stabilize gas prices, and G7 countries imposed a price cap on Russian energy. Meanwhile, both the EU and China made significant efforts on the ESG front, with China’s moves against coal power posing domestic challenges and the EU recently passing the world’s first major carbon boarder tax to penalize carbon-intense imports—legislation that risks sparking conflict even among its allies. With China’s reopening potentially hitting hard on the demand side, Saudi-US relations impacting supply, and Russia-Ukraine looming in the background, 2023 promises to be another year in which global energy falls largely to our politicians.

It could be a bumpy road ahead for global oil prices
Fears that the world economy is slowing and the ongoing wave of COVID cases in China have begun to weigh on oil demand since the beginning of 2022. That said, despite the global economy not having fully recovered from the lingering effects of COVID disruptions, we are burning more crude oil than ever, according to the International Energy Agency (IEA). With persistently strong demand and a China reopening on the horizon, we are closely watching oil supply. Some considerations along those lines:

• The US has decided to replenish a depleted Strategic Petroleum Reserve. Since the start of the year, the administration has released more than 230 million barrels from the country’s emergency stockpile to help alleviate supply pressure from Russian invasion. Unfortunately, another byproduct of America’s draining its SPR was to induce US oil producers to reduce drilling activities, thus further limiting oil supply.
• Upstream spending remains weak, in part a result of financiers—motivated by green energy concerns—withholding capital that would normally be used to bring new oil and gas projects into service. Illustrating the dearth of financing in this space, we note that HSBC, one of the world’s largest backers of fossil fuels, has recently pledged to stop providing loans for new oil and gas fields. The upshot is that new supplies fail to come online in time to meet perpetually increasing demand.
• The conflict in Ukraine continues to drag on, with any further escalation in hostilities threatening to bring about additional sanctions on Urals oil—or unilateral cuts in oil exports by Putin, himself. Given its struggles with COVID, China energy demand has been depressed, providing some relief to European consumers of energy, but a reopening would create more competition and undoubtedly bring further pain to European buyers.
• OPEC+ production cuts have turned out to be smaller than the headline numbers they previously announced. The cartel’s decision to shade production cuts suggests it prefers to foster stability in the oil market and avoid adding fuel to the fire with energy-induced inflation and the potential to exacerbate an impending recession.

All told, we believe energy markets will remain tight, despite cooling demand from economic slowdown, given China reopening—which promises to bring new demand of around 3 million barrels/day—as well as the uncertain timeline for a Russia-Ukraine truce, and America’s need to replenish its dwindling reserves.

“Dirty” coal makes a comeback and ESG hits a wall
Global coal consumption reached a record level this year as the war in Ukraine shocked European energy supplies and demand grew across Asia and Europe. One outcome of Russian’s aggression was to spark concerns around the world over energy security, leading some countries that had pledged to quit coal to burn even more of it. This included European nations forced to temporarily switch to coal in response to catastrophic spikes in gas prices as the supply from Russia plummeted. With coal reentering the picture as a cheap, reliable source of fuel for power generators, thermal coal hit record prices. Such developments have, of course, been the source of much frustration to environmentalists, who have watched countries around the world shrink from ambitious green energy targets as they prioritize basic standard of living, with renewables and “clean” sources like LNG too expensive and ultimately unable to quench global energy demand. Indeed, climate resolutions, which had been gaining traction in recent years, have lost steam in 2022, with a Blackrock’s survey of 2022 annual meetings showing overall investor support for green resolutions dropping to 26% from 36%, a year prior.

Despite falling crude prices, oil stocks have soared
All of this was music to the ears of investors in oil and gas companies, which delivered enormous returns and healthy dividends to their investors in 2022, prompting some backlash from governments—including the Biden administration—who accused highly profitable energy firms of profiteering. The gains on oil and gas shares come as oil prices have fallen from early-2022 highs, as the chart below illustrates.

Looking at the divergence between the price of oil and the price of oil companies’ shares, one might expect that either the commodity will rise or the equities will fall. We put our money on the latter, as the shares—which include consideration for all future cash flows—seem to be pricing in a recognition that energy supply faces a structural shortage, in part a result of the push for ESG limiting oil and gas investment, such that fossil fuels will come roaring back as China reopens and the rest of the world eventually emerges from the current tightening cycle. (At least for a decade or so, at which point we may well be charging our cars on fusion power!)