Jeff Meli: Welcome to The Flip Side. I'm Jeff Meli, the Head of Research at Barclays. And I'm joined today by Harry Mateer, who runs US Credit Research and covers investment grade energy. Thanks for joining me, Harry.
Harry Mateer: Thanks for having me, Jeff.
JM: Well, Harry, you're joining our milestone 50th episode of The Flip Side. It's hard to believe all the ways that the economy and markets have evolved since we started this series.
HM: No doubt. The world has transformed significantly in the past few years.
JM: Well, I'm looking forward to seeing how the world evolves between now and our 100th episode. But for today, we're going to talk about what role energy prices will play in the global economy going forward. Now, Barclays is forecasting a recession in many developed economies. We think that will start in Q4 of this year in Europe and in early 2023 in the United States. This kind of grim forecast is due in large part to the significantly tighter monetary policy that central banks around the globe have had to enact as they try to combat inflation, which has proven to be very high and very persistent since economies started recovering from COVID.
HM: Well, Jeff, high energy prices have clearly contributed to this dire forecast, and to the tightening we've seen from central banks. While most central banks look through near-term swings in energy prices when setting policy, prices spiked with the invasion of Ukraine and those higher costs are flowing through the economy, contributing to generalised inflation. Prices are so high in parts of Europe in particular that we see them as a major factor behind the coming slowdown.
JM: Well, I definitely agree that the energy prices we're facing have contributed to our forecast. But the question now is, as we get ready for what I think is a pretty grim economic outlook, will the pressure from energy costs continue and affect the severity of any possible recession?
HM: So, I think the answer is yes. I see supply constraints as being the biggest factor behind the high cost of energy. And these are not going away. In fact, some of them are likely to get worse. I expect energy prices will remain stubbornly high regardless of the economic cycle and will play a role in deepening the slowdown.
JM: Well, Harry, I disagree. I think the slowdown we're forecasting is significant enough and widespread enough that demand for energy is going to fall, and it will fall by enough that all of the supply constraints that you're talking about are not really going to be the binding constraint going forward.
HM: Let's start with how supplies experience a perfect storm. I'll go through some of the issues and highlight where I think the pressure is likely to be sustained through the economic cycle. The war in Ukraine has resulted in a material increases in gas prices, most notably in Europe, where they are up over 300% of the peak, and are still 70% higher from the end of 2021. And there's no long-term fix.
JM: Now, just as an aside, when most people talk about gas prices, they refer to what you use to drive your car. But as an energy analyst, you're talking about natural gas.
HM: That's right. Of course, the price at the pump matters a lot to consumers, particularly here in the US. But what matters more right now for the global economy is the price of natural gas, which is used to generate electricity, heat homes, and as a major raw material for industry. Price of natural gas are so high that there are undeniable immediate economic consequences. Higher costs are a big factor in our forecasts of a recession, and manufacturing facilities in parts of Europe are reducing operating rates or even shutting down. Heating bills for consumers are likely to rise so much, the governments are trying to find ways to soften the blow heading into winter, often at the cost of raising significant debt. And we just saw in the UK that there are limits to what governments can do on that front.
JM: No, it is true, Harry, that governments in Europe are trying to get creative about limiting the immediate hit to consumers in the face of high energy prices. But I actually don't think it's quite right to blame the recent volatility in the UK on their energy cap proposal. That proposal actually went over pretty well. It was the combination of trying to cap energy prices and engage in a massive tax cut that seemed to spark the market volatility. Germany, for example, still has really low debt to GDP, and I think can easily afford to sort of ease the burden on households and businesses.
HM: Okay, that may be true now, but I think the situation is likely to worsen. Tension with Russia remains very high, and Russia used to be the single largest supplier of imported gas to Europe. In 2021, Russia alone provided over 30% of Europe's total gas consumption. The Nord Stream 1 pipeline, which runs from Russia to Germany, was shut down in late August, ostensibly for repairs. But since then there have been back and forth allegations of sabotage. So, who knows if or when it will restart? For context, that single pipeline met over 10% of Europe's gas demand in 2021.
JM: Europe did a good job getting prepared for some of the issues that you're raising, Harry. In particular, they did a good job of storing natural gas once the war started. So, for example, Germany reached its 85% October storage target a month early, and its 95% November storage target two weeks early. I think some of the risks that you're talking about around shortages are mitigated by this good planning.
HM: Sure, that buys time for the winter, but what then? This year, keep in mind, they had the benefit of Russian gas still flowing to Europe through most of the summer. Going forward, there's no way to replenish stock. And even those statistics helped make my point. Germany was a month ahead of its October goal, but only two weeks ahead of its November goal.
JM: Well, it's clear, I think Europe is going to have to find new sources of energy. And one obvious candidate, I think, is the US. We have developed increased capacity to export LNG, that's liquefied natural gas, which we have plenty of here in the US given the developments in shale and fracking.
HM: So, it's true that the US has increased capacity to export gas. But let me put some numbers around this to illustrate the size of the challenge faced by Europe. The US capacity to export LNG is about 13/bcf a day. That's billion cubic feet a day. For context, 2021 Russia gas exports to Europe were 18/bcf a day, and that's across an entire year. So, it doesn't account for peak winter needs. More importantly, US LNG is being sold into a global market with multiple regions competing for that Gas. Prices are high in Asia too. It's not only Europe. And the lead time is long. Other than restarting the damaged Freeport LNG facility in the next few months, the next meaningful US capacity expansion won't be until 2024.
JM: Now, we have found ourselves in a tricky situation. So, there's obvious longer-term concerns about fossil fuels, which have resulted in more limited development of extraction and export capacity. But now, we find ourselves in a situation where we need it for national security to buffer the economic hit to important allies, and we're suffering from that lack of investment.
HM: That's true. And you're hitting on another longer-term challenge. Investment in energy production is structurally low, and I don't see that changing. In fact, investment in energy production is not sufficient to keep up with expected demand growth. After peaking in 2014 at over $800 billion, global capital spending on oil and gas declined to just $400 billion in 2020, so down by half, $423 billion in 2021, and it's estimated to be just $500 billion in 2022. We think this is insufficient investment to keep up with demand. We think it's most acute for oil. Investment in 2021 was the lowest since 2006, but oil consumption in 2021 was up 11% from 2006.
JM: Well, first of all, Harry, the raw comparisons of investment dollars, I think, sounds somewhat scarier than the reality of the meaning of the investment that's happening. So, for example, the shale revolution here in the US was meant to help produce low cost oil and gas that's easier to extract. The point is it's cheap, so that you don't actually need the same investment dollars to get the sort of same return in terms of product.
And second, I think that we're talking about a situation where prices might remain elevated. Certainly, they're elevated right now. We'll see investment pick up. It doesn't - it's not sustainable for investment to be as low as it is right now, given the potential for companies to earn returns.
HM: There's merit to the argument that shale is cheaper, and it's also shorter cycle, which means it can ramp up fairly quickly after investing. But at the same time, we're a ways into the shale revolution, and in many fields the best acreage is already drilled. Further, we're in an era of extreme inflation. The raw numbers I gave you earlier were nominal, but you need to think about real investment, which makes the comps even worse. And even if investment suddenly climbs back to previous highs, there's still a bill to pay for years of underinvestment.
JM: Harry, I still believe that the biggest constraint on US energy production is political. Our capacity is artificially limited by regional constraints on fracking, on regional constraints, on pipeline construction and capacity. But we're starting to see that high energy prices create a backlash against these politically driven constraints.
HM: Jeff, Even if those constraints are relaxed, we might not get more drilling. There's a real disconnect happening right now in the US between what producers who are publicly traded on exchanges are doing and producers who are privately held. Consider that private exploration and production companies are growing 20% this year, but publics only around 5%. Private operators are actually accounting for nearly 60% of the rig count. That was closer to 40% just a couple of years ago. What we're finding is that publics are resistant to new investment even in higher prices. And the problem is that public E&P companies still represent most of US. output.
JM: Yeah, we've written about this, where there's a possible link between this divergence in behavior and the growth in passive ownership of the public companies, where passive owners may prefer that companies return money to shareholders rather than engage in zero sum competition where they all incrementally drill and then collectively drive the prices down or the cost of drilling up. That that actually is a potential constraint on public investment.
However, as you know, private companies are drilling and we've even seen a reasonably large energy company move from public to private in order to release itself from this sort of pressure from shareholders. This seems to be more about the distribution of who's generating the energy rather than the sort of sum total of the capacity.
HM: Okay. But longer term incentives to invest are still limited as management teams prepare for what we think is an inevitable transition away from fossil fuels.
JM: Yeah, I guess I would go back to my political points, which is to say that I'm not sure how inevitable that transition is. I think we're seeing the consequences in pretty sharp relief. That might shift the narrative. When I think about ESG as an example, I think of it as a framework for assessing trade-offs. Obviously, what we've seen in the past has been a lot of focus on the E, on the environment and the very real consequences of our reliance on fossil fuels for things like global warming.
At the same time, there's a trade off here associated with the S, which I don't think we fully understood. And our society is maybe struggling a bit from our underinvestment in our energy capabilities, and even at times it's playing a role in geopolitics on the international stage as we think about our allies and how they respond to certain threats.
HM: Even if that's correct, chokepoints exist in other parts of the supply chain. Refining capacity declined, notably in the US and Europe, meaning that even if we had enough oil, the ability to convert that into what people and businesses actually use is more difficult.
JM: I have seen actually some media reports about the possibility of rationing heating oil in the US Northeast due to a lack of supply. I will admit that that seems somewhat hard to reconcile with the government releasing barrels of oil at a record pace from the Strategic Petroleum Reserve.
HM: It does. But keep in mind, those are releases of crude, not end products.
JM: Well, Harry, I don't want to make light of all of these supply constraints that you're mentioning, and I acknowledge that even if I'm right and the politics shifts somewhat, it will take years before any investments that actually do start happening will pay off. But I think the bigger issue is that we've only talked about supply, but demand, I think, is going to drop in a hurry, which I believe will render all of these supply constraints moot, at least when it comes to setting prices.
HM: The economy does feel like it's about to hit a very rough patch. We've certainly seen that in recent earnings, which have been weak in a number of sectors, but some the labor market and growth have held up.
JM: Yeah, that's right. So far, the economic weakness that we're forecasting is still pretty theoretical, but there are enough warning signs that I do think it's coming. And the strength so far, like you mentioned, the labor market just means that demand for energy hasn't actually cratered yet. But I do think that the supply and demand imbalance will be less severe than your comments indicate. I mean, for example, just look that energy prices are already way off the peaks that they hit around the time of the Russian invasion of Ukraine. This is true whether you look at oil, or natural gas, or gasoline prices for your car, whether you look domestically or abroad, everything is off the year to date peak.
So, for example, brent oil, which is one measure of oil prices, went from over $130 a barrel in March, and now it's roughly 30% lower. It's below $100. If supply problems are as intractable as you say, prices should have remained at those levels rather than fall sharply from their post Russia invasion highs.
HM: But those peaks represented panic levels around the invasion. In the short term, the end of the summer driving season, the storage gains in Europe that you mentioned, and the fact that the European sanctions on Russian oil haven't yet fully kicked in have led to lower prices. But prices are still high above what I consider mid-cycle levels, despite the near-term sources of relief.
JM: Well, they've also weathered a cut in OPEC production. I mean, it's hard to see how the supply situation actually gets worse from here.
HM: Okay. But the OPEC cut only takes effect in November.
JM: All right. Sure. But the futures market knows about these cuts, and it's not reflected in futures prices. But a bigger issue, Harry, is that central banks around the developed world are hiking interest rates at a record pace. In the US, Fed funds, the main interest rate set by the Federal Reserve, went from 0 to 300 basis points in a matter of months, and we're expecting another 75 basis point increase this year. Same in Europe. We went from negative interest rates all the way up to 200 basis points now, including a recent 75 basis point hike.
Now, of course, the motivation of all of these hikes is to deal with inflation, which has been just staggering. After being so low for so long that we actually coined a term here at Barclays Research called ‘missingflation’ – of course, it's no longer missing. Inflation's now over 8% in the US and at or above 10% in the UK and Europe. Central banks were caught flat footed. They were initially too slow to respond, in part because they believed that inflation would fall on its own as the effects of COVID waned.
HM: The pace of rate hikes is staggering.
JM: Yeah, it is indeed, And we have not actually seen the economic effects yet. When people talk about monetary policy, they talk about it as affecting the economy with long and variable lags.
HM: Well, we are seeing some initial effects like on the housing market where prices have started falling, in part because mortgage rates are now above 7%.
JM: Yeah, and that's just the start. We're forecasting US, UK, and European growth all to be negative by the start of next year. And we're forecasting slowing growth in some major emerging markets economies like China. If we're right, all of the supply conversation is irrelevant because demand is going to plummet. The recent price declines have happened despite the continued economic momentum evidenced by some of the GDP and labor market statistics you talked about. Just wait until the economy slides first.
HM: I think Chinese demand has already been suppressed because of its Zero-COVID policy. Over the past ten years, Chinese oil demand growth has been over 80% of the world's net oil demand growth. So, what happens when China opens up? Second, Europe and parts of the US are facing shortages that will affect heating oil, not gas. I'm not sure that any reasonable economic forecast has conditions getting bad enough that people don't heat their homes.
JM: Okay, that's true. I don't expect that people will be relying on peat fires in their in their hearths to keep themselves warm over the winter. But let's just put some numbers on this. Business demand for oil is extremely elastic. Recall that in the global financial crisis, so just about 15 years ago, oil prices fell below $30 a barrel as the global economy slowed. It was a massive decline in energy prices, far in excess of anything that supply constraints would have been able to buffer.
HM: Okay. But we're forecast a recession. We're not expecting an economic downturn of anything approaching that magnitude. And even in the GFC, globe oil demand fell by just 2.5%.
JM: Well, first, I would say that shows you just how elastic energy prices can be. Is that just a tiny drop in demand can result in a big swing in prices. And it is true that we're not forecasting anything like the Great Recession in terms of the economic weakness. I think it'll be much less severe and much shorter lived in terms of the economic consequences of these higher rates. But all I need to be right is that oil demand falls by just enough that the supply constraints are no longer binding. Well, anyway, this has been a great debate, Harry, and thanks for joining me on the 50th episode. Clients can get our latest analysis of this evolving topic by following #energycrisis on Barclays Live.
