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Welcome back. It seems I was wise not to write about the market impact of wise o limit kerfuffle; A ceasefire is ready to end the whole chaos by the end of the year. Like everyone else, I see the price of the U.S. credit default swap rising as these stupid arguments grow, but I always assume it’s ultimately SFSN (words and anger mean nothing). Maybe one day I will be wrong. Email me: email@example.com
Energy prices, inflation and growth
Here is a chart:
It re-established various global fossil fuel prices, six months ago at 100. The only problem with bringing them all together is that natural gas prices are skyrocketing in the UK and liquefied natural gas in Asia is only doubling the price of Chinese coal and natural gas in the United States. The relative 30% increase in Brent crude prices is materially impressive.
The big question about the run-up to global fuel costs is how long it will last. That is, are we looking at a temporary supply / demand imbalance – a much larger version of the US timber price increase, which quadrupled to normal levels in May only to fully reverse its measures by August? Or is it something more lasting?
Depending on the answer to this question, there are two helpful questions: Will these prices further widen inflation? And how big of a pull will they be on global growth?
In the big question, part of the answer is that the supply of fossil fuels has been declining year after year due to low investment in extraction. Here is a chart of capital expenditures, for example, both in terms of fullness and in terms of sales ratio, by energy companies on the S&P Global 1200 Energy Index (data from Capital IQ):
If investments from privately run companies are included, the picture may look a bit different, but I doubt the trend will be the same. A portion of this has come down to efforts to reduce carbon emissions. This is most evident in the case of coal, but governments and investors are generally discouraged new energy projects, and energy companies are listening.
But decarbonization is only part of the story of supply. Another part of this is that the management of energy companies, especially US power producers, is listening to the shareholders, and the shareholders want to return the capital to them without investing in new projects. This is from a notable recent FT interview by Scott Sheffield, who manages Pioneer Natural Resources, one of the largest shale oil producers in the United States:
Everyone [in the industry is] Going to be chained, whether it’s $ 75 Brent, $ 80 Brent, or $ 100 Brent. All the shareholders I have spoken to have said that if anyone goes back to growth, they will punish that company. . .
There are no investors in US Major or US Shell. Now it is the dividend fund. So we can’t just whipsaw people who bought our stock. . .
I received dividends the following year from my stock as my overall compensation. This is a complete change of mindset.
Shows a change of mindset. This is the number of oil and gas rigs operating in the United States since 2000 (Baker Hughes data):
If prices rise further, investors and operators may change their minds about new oil and gas investments. And there may be a change in feeling already. I spoke to Andrew Gilick, a strategist at Energy Consultancy Envers, and he told me that while investors are focusing on capital returns, interest in oil and gas is growing and energy fund managers are raising money again:
Speaking to the Oil and Gas Fund a year ago, they were working on the redemption. Now, those who are still able to invest are overwhelmed by this opportunity as a hedge against inflation and a hedge against a long power change – and because they see operators committed to discipline and capital return.
But big changes in spending will take time. It takes six months to get a new rig up and running. The supply pressure on fossil fuels will not decrease rapidly.
Will higher plateaus of energy prices increase inflation in other areas? Of course, recent expectations of a break-even rate of 10-year inflation (from 2.28 percent two weeks ago to 2.45 percent now) are largely responsible for energy prices. But the relationship is not stable. Consider this chart of Break-Even and Brent Crude:
As Oliver Jones of Capital Economics points out, the early 2000s show that the relationship, although closed, is not stable. At that point, Brent shot up and inflation broke-even shrugged. Here is Jones:
At the time, the integration of China’s dynamic economy with other countries in the world helped drive the products “supercycle,” but also put downward pressure on the prices of manufactured goods worldwide. Meanwhile, there was limited inflation in the United States. The Fed raised the rate to 425bp in two years, and monetary policy was not particularly relaxed. In contrast, China’s economy is slowing down today, and is becoming isolated from the United States. At the same time, we anticipate that domestically produced price pressures in the United States will be stronger in the coming years than in the 2000s or 2010s, reflecting both the impact of the epidemic on the changing priorities of the labor market and policymakers.
As a result, Jones believes that even if energy prices fall as supply and demand rebound, inflation could rise further.
After all, how much of a lasting jump in energy prices can pull the economy? Well, look at the price of US gas and the energy costs of US consumers (hat tip @FrancedDonald):
Now this is a defined relationship. Ian Shepherdson of Pantheon Macroeconomics looks at mathematics here:
People currently spend about 7 7 billion per month on utility energy services and 31 31 billion per month on petroleum, which together accounts for 7.3 percent of the CPI. Total retail sales in August stood at 56 569 billion, so a 5 percent increase in energy prices would disappoint other retailers by up to 0.3 percent, forcing people to cut costs from other products and services. Or at least, that’s what would happen under normal circumstances.
But these are not normal situations. The Americans saved a lot of cash in the epidemic, which Shepherdson graphed:
So maybe the extra cash will only increase the extra cost of gas, and the cost of gasless consumers will be irresistible. The problem, however, is that the extra cash is in the pockets of most of the rich, who tend to save instead of spending increasing wealth. Middle-class and working-class Americans, on the other hand, can feel the pinch from the price of the pump and go back somewhere else. This chart from the Fed Guy blog shows how the wealth accumulated during the epidemic was distributed:
Those Americans who have always been worried about gas prices are now going to be particularly worried, and that will probably be important for growth.
A good read
Speaking of oil, it’s scary.
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