Energy primed to power through near-term uncertainty

Bottom line up top

• Slipping oil prices could cool inflation, but supply/demand dynamics remain hot. With energy one of the most volatile (and publicized) components of the CPI, this summer’s pullback in prices (particularly gasoline) was the predominant factor for the July inflation moderation (Figure 1). In fact, U.S. average gasoline prices are back below $4 per gallon ($3.93 as of August 17), 22% lower than the mid- June peak of $5.01. This drop reflects a perception that demand for fuel will weaken amid expectations for higher prices and growing recession fears. Despite the conflict in Ukraine, Brent Crude has also traded lower in part due to China’s zero-COVID policy and its shift to importing oil from Russia, which displaced Saudi Arabia in 2022 as China’s top supplier of crude oil (China is the world’s largest oil importer).
• The trend of falling energy prices, however, could be poised to reverse in the U.S. Oil producers, wary of the pain overinvestment caused in prior cycles, did not significantly increase output as prices advanced earlier this year. U.S. rig counts remain below prior peaks, as capital discipline has been prioritized over increasing supply. While some North American energy companies stand to benefit from the buildout of clean energy generation and the shift towards renewables over time (a trend bolstered by the recent passage of the U.S. Inflation Reduction Act), this could mean less investment in the carbon economy.
• We see a similar picture outside of the U.S. OPEC capacity utilization has recovered to a degree, but remains below pre-COVID levels (Figure 2). Energy scarcity is being felt more acutely in Europe, as prices for natural gas (which is primarily used for heating and generating electricity) are skyrocketing to record levels given diminished supply from Russia and continued logistical difficulties importing liquefied natural gas (LNG). Asia has also ramped up LNG imports in preparation for winter, further driving up prices. Energy security and its impact on fuel costs will remain a key theme in the years ahead, creating a stiff headwind to the efforts of lowering inflation back to pre-COVID levels.

Portfolio considerations

High energy prices make the Fed’s job harder, but not impossible. For example, the prices of goods ex-food and energy (21% of headline CPI) declined for a fifth consecutive month as retailers have cut prices to manage inventories. Softness in home prices has historically led a decline in owners’ equivalent rent (24% of headline CPI), providing some optimism for the coming months. But energy prices (only 9% of CPI, yet a much more volatile component) have an outsized impact on the ultimate headline number. If energy supply constraints cause headline U.S. CPI to remain elevated, the U.S. Federal Reserve may have to tighten policy more aggressively to affect the core components of the real economy. Therefore, we believe the market’s anticipation of a soft landing and a likely “Fed pivot” in 2023 toward easing may be overly optimistic. As such, we think it makes sense to remain defensively positioned in portfolios.

To prepare for a more uncertain path of further inflation, we favor productive real assets like private real estate, infrastructure, and farmland that have relatively stable values and cash flows that increase along with inflation. Within fixed income, we continue to advocate for a moderately shorter duration profile, but think it makes sense to maintain strategic allocations to investment grade bonds in case monetary tightening ultimately leads to a hard economic landing. Higher quality is still key when it comes to equity positioning, but energy looks attractive given free cash flow yields of around 15% for some U.S. companies. An energy overweight would also help balance an otherwise defensive positioning.