Written by J Alex Tarquinio
Predicting the direction of volatile energy markets has never been easy. But experts say the complexity of market forces now brewing in the wake of Russia’s invasion of Ukraine makes it particularly difficult to predict the direction of both energy prices and the industry.
“I’ve never seen such a spicy bouillabaisse of ingredients that could wreak havoc on energy prices,” said Tom Kloza, global head of energy analysis at the Oil Price Information Service. “You must look and say that the world changed on February 24,” the day of the Russian invasion.
A variety of forces could be perpetuating high energy prices, including recent production cuts by producer group OPEC+, the cessation of a US-led program to release oil from the strategic reserves of the United States and other countries, subsidies by several European nations to help citizens to pay higher energy bills and slow industry investment in drilling operations. On the downside, fears of a global recession, the possibility of energy rationing in Europe this winter and efforts by the Group of 7 developed nations to impose a price cap on Russian oil could see prices fall.
Brent crude, the closely watched benchmark for global oil prices, fell nearly 25% in the third quarter to trade around $85 a barrel in September, although it has since risen higher as OPEC+ announced significant cuts. The US government forecasts that oil will trade at an average price of $95 per barrel in 2023.
Funds that invest in US energy companies, which typically mimic price movements in oil markets, rose exponentially along with oil prices in the first quarter of this year. In contrast, these funds fell an average of less than 1% in the three months to September. Energy is the only fund category in the equity sector to post gains on average for the first nine months of this year, according to Morningstar Direct.
Experts say the September 2 G-7 agreement to cap Russian oil prices is creating much of the uncertainty about oil prices. The plan aims to limit Russia’s export earnings while keeping its oil flowing through global markets. However, skeptics say a price cap could be difficult to enforce. Oil embargoes are notoriously leaky, and shippers can use legal measures such as ship-to-ship transfers at sea to try to disguise a cargo’s origin.
Goldman Sachs released a research report on the same day that the price cap agreement was announced, calling oil prices “bearish in theory, bullish in practice” and predicting that Russia would rise about 10% of the 100 million barrels of oil produced worldwide every day, it could retaliate by reducing its exports to drive up global energy costs. That, according to the report, “would make this an additional bullish shock to the oil market.”
On that day, Russian energy giant Gazprom announced that it would postpone the resumption of natural gas flows from Russia to Germany through the Nord Stream 1 pipeline. Later in September, gas leaks were discovered in the Nord Stream 1 and 2 pipelines under the Baltic Sea. The European Union and several European governments blamed sabotage for the damage.
But Yale School of Management’s Jeffrey Sonnenfeld, who has researched the impact of the Russian war on the energy industry through the Chief Executive Leadership Institute he founded at the school, recently wrote a statement expressing his confidence in the G-7 -Plan expresses . In an interview, he pointed out the small number of large shippers and insurers, mostly based in Europe, saying this should make enforcement easier because “you can count on two hands how many parties you need for enforcement”.
He also doubted that Russia would shut down its oil pumps as readily as it stopped supplying natural gas to Europe. Russia has more opportunities to sell its oil, and shutting down wells could create future problems for Russian industry, Sonnenfeld said, so President Vladimir Putin would “poison the Russian economy for years to come.”
Philip K. Verleger, an energy economist who began his career as a policy advisor in Washington 50 years ago, said the output cuts announced by OPEC+ are likely to have less of an impact now that the circumstances are very different. The United States was more dependent on foreign oil in the 1970s, he said, so aggressive moves by OPEC led to gas rationing and pipelines at gas stations. But the United States is now a larger producer, and some drivers are opting for vehicles that use little to no gas.
“Electric vehicles are entering the market so quickly that if OPEC pushes too hard now, it could really accelerate the move away from oil,” Verleger said.
In past economic cycles, higher energy prices have reduced demand and ultimately capped prices. European governments are providing a test case, spending billions of dollars on price controls and direct stimulus payments to offset higher energy bills, while encouraging their citizens to voluntarily turn down the thermostats. French President Emmanuel Macron has dubbed such voluntary energy-saving efforts “energy sobriety.”
But Europe is also investing heavily in new infrastructure to support the import of liquefied natural gas, or LNG, which is subcooled so it can be shipped on tankers. A number of contracts have been signed to build the facilities needed to convert LNG back into gaseous gas in Germany, France, Belgium and elsewhere. US exporters could be among the biggest beneficiaries of this trend. The United States began exporting LNG six years ago and became the world’s largest exporter in the first half of this year, according to the US Energy Information Administration.
Paul M. DeSisto, executive vice president of asset management firm M&R Capital Management, says that regardless of the direction in which energy prices are heading, the big energy companies in the S&P 500 index are a little closer to their 20-year moving average of 8, The market value of the index sees a return of 3%. At the end of September, energy stocks accounted for 4.5% of the S&P 500. “Given the importance of energy to the global economy, I think it’s going to be a bit longer-term again,” he said.
His firm uses two energy-focused exchange-traded funds in client portfolios: the $35 billion Energy Select Sector SPDR, managed by State Street Global Advisors, and the $7 billion Vanguard Energy fund. The composition of the two funds differs slightly as they track different market indices. The State Street fund owns the 21 energy stocks in the S&P 500 index, while the Vanguard fund includes a mix of more than 100 large, mid-cap, and small US energy companies. However, returns after the 0.1% management fee charged by both funds tend to be similar, as Exxon Mobil and Chevron are the two largest holdings in each fund, accounting for more than a third of total assets. The State Street Fund returned 33.76% for the first three quarters of the year, and the Vanguard Fund returned 34.71%.
Ultimately, despite significant geopolitical risks, commodity prices may be most affected by the rate at which companies reinvest profits into their own operations. So far, companies have focused on returning profits to shareholders through dividends.
The Biden administration wants more investment in the energy sector. “Ultimately, our goal here in the United States and around the world must be to increase energy supplies,” Wally Adeyemo, US Deputy Secretary of the Treasury, said at a recent energy conference at Columbia University. He noted that the President has taken steps in this direction, releasing oil from the country’s strategic reserves but also urging the private sector to increase production. “We want to make sure the supply chains are stronger in the United States, but also with our friends and allies.”
But the industry may still be reluctant to cut prices too quickly. Kloza of the Oil Price Information Service said he thinks the industry has learned its lesson from past boom and bust cycles and will not increase drilling dramatically. “You got the message,” he said. “Corporations will not kill the golden goose.”