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Welcome back. It seems I was wise not to write about the market implications of the debt limit kerfuffle; a truce is set to put the whole mess off until the end of the year. Like everyone else, I watch the prices of US credit default swaps rise as these dumb arguments escalate, but always assume it is ultimately SFSN (sound and fury signifying nothing). Maybe one day I will be wrong. Email me: firstname.lastname@example.org
Energy prices, inflation, and growth
Here’s a chart:
That’s various global fossil fuel prices, rebased to 100 six months ago. The only problem with putting them all together means that the absolutely bonkers rise in the prices of natural gas in the UK and liquid natural gas in Asia overshadow the merely staggering doubling of Chinese coal and US natural gas prices. The objectively impressive 30 per cent rise in Brent crude prices looks positively limp by comparison.
The big question about the run-up in global energy costs is how long it will last. That is, are we looking at a temporary supply/demand imbalance — a much larger version of, say, the wild rise in US lumber prices, which peaked at four times normal levels in May only to retrace their steps entirely by August? Or is this something more lasting?
Depending on the answer to that question, there are two subsidiary questions: how much will these price moves spur inflation more broadly? And how big a drag on global growth will they be?
On the big question, part of the answer is that fossil fuel supply has been falling for years, because of lower investment in extraction. Here for example is a chart of capital expenditure, both in absolute terms and as a proportion of sales, by energy companies in the S&P Global 1200 energy index (data from Capital IQ):
If investment from privately held companies were included, the picture might look a bit different, but I suspect the trend would be the same. Part of this is down to efforts to reduce carbon emissions. This is most obvious in the case of coal, but governments and investors are discouraging new energy projects generally, and energy companies are listening.
But decarbonisation is only part of the supply story. Another part of it is that the management of energy companies, particularly at US energy producers, are listening to shareholders, and shareholders want capital returned to them, rather than invested in new projects. This is from a remarkable recent FT interview with Scott Sheffield, who runs Pioneer Natural Resources, one of the biggest US shale oil producers:
Everybody [in the industry is] going to be disciplined, regardless whether it’s $75 Brent, $80 Brent, or $100 Brent. All the shareholders that I’ve talked to said that if anybody goes back to growth, they will punish those companies . . .
There’s no growth investors investing in US majors or US shale. Now it’s dividend funds. So we can’t just whipsaw the people that buy our stocks . . .
I’m getting as much in dividends off of my stock next year as I am in my total compensation. That’s a total change in mindset.
The mindset change shows. This is the number of active oil and gas rigs in the US since 2000 (Baker Hughes data):
If prices increase more, investors and operators could have a change of heart about new oil and gas investments. And there may be a change in sentiment already. I spoke to Andrew Gillick, a strategist at the energy consultancy Enverus, and he told me that while investors are focused on capital returns, investor interest in oil and gas is rising and energy fund managers are raising money again:
Talking to oil and gas funds a year ago, they were dealing with redemptions. Now, those that are still able to invest are excited about the opportunity both as a hedge against inflation and a hedge against a longer energy transition — and because they see operators commit to discipline and capital returns.
But a big shift in spending will take time. It takes six months or so to get a new rig up and running. The supply pressure on fossil fuels will not abate quickly.
Will a higher plateau in energy prices feed inflation in other areas? Certainly, the recent hop in 10-year inflation break-even rates (from 2.28 per cent two weeks ago to 2.45 per cent now) has been widely attributed to energy prices. But the relationship is not determinate. Consider this chart of break-evens and Brent crude:
As Oliver Jones of Capital Economics points out, the early 2000s show that while the relationship is close, it is not fixed. At that time, Brent shot up and inflation break-evens shrugged. Here’s Jones:
Back then, the integration of China’s booming economy with the rest of the world helped drive the commodities “supercycles”, but also put downward pressure on the prices of manufactured goods globally. Meanwhile, there was only limited inflation generated within the US. The Fed hiked rates by 425bp in two years, and fiscal policy was not particularly loose. In contrast, China’s economy today is slowing, and decoupling from the US. At the same time, we think that domestically generated price pressures in the US will remain stronger in the coming years than in the 2000s or 2010s, reflecting both the effects of the pandemic on the labour market and policymakers’ changed priorities.
As a result, Jones thinks inflation may pick up more even as energy prices fall back as supply and demand rebalance.
Finally, how much might a sustained jump in energy prices drag on the economy? Well, look at the US gas price and US consumer spending on energy (hat tip to @francesdonald):
Now that’s a determinate relationship. Here is how Ian Shepherdson, of Pantheon Macroeconomics, sees the maths:
People currently spend about $7bn per month on utility energy services and $31bn per month on gasoline, which together account for 7.3 per cent of the CPI. Total retail sales ex-gasoline stood at $569bn in August, so an incremental 5 per cent increase in energy prices would depress other retail sales by up to 0.3 per cent, by forcing people to divert spending from other goods and services. Or at least, that’s what would happen under normal circumstances.
But these are not normal circumstances. Americans saved a lot of cash in the pandemic, which Shepherdson graphs like this:
So maybe the excess cash will simply sop up the extra spending on gas, and non-gas consumer spending will be unaffected. The problem, though, is that the excess cash is mostly in the pockets of the rich, who tend to save rather than spend incremental wealth. Middle and working class Americans by contrast may feel the pinch from prices at the pump and cut back elsewhere. This chart from the Fed Guy blog shows how the wealth accumulated during the pandemic was distributed:
Those Americans who have always worried about gas prices are going to be particularly worried now, and that will probably matter to growth.
One good read
Speaking of oil, this is scary.