Inflation is the talk of the town.
Price indices around the world are showing sharp year-over-year increases. The benchmark US Consumer Price Index is tracking over 5% per year. That’s high: for over a dozen years we’ve been acclimatized to half that rate. The pull for resource commodities is a big part of what’s driving broad-based inflation.
Consider oil. A barrel of Texas light is selling for over $US 70, again. Only a year ago, under debilitating lockdowns, forty bucks was being offered as the norm.
We’ve seen this movie before. It’s called the Oil Cycle. The protagonist is the petroleum consumer who flaunts excess and drives up demand. Meanwhile, the buyers’ foil is a cartel of global oil suppliers that plots constraint behind the scenes. Supply lags demand and prices keep rising until there is some climax resolution to the scourge of inflation.
Inflation can manifest itself in many ways. Rising prices from earthly sources, such as agriculture, forestry and minerals trickles down to specific goods like food, furniture and batteries. But oil fuels the veins of the global economy, so a rapid rise in its price yields broad-based inflation.
A new episode of the Oil Cycle is in the making. In the near-term, much depends on the villainous COVID-19 side plot. Yet underneath the tragedy of the variants the market is signalling supply-demand tension.
Despite recent ups and downs, bank analysts are sticking to robust, $70-plus outlooks. For some, talk of $100-per-barrel has gone from whispers to published opinion. And when oil goes up, so too does the price of pretty much everything.
Investors, sensing any hints of inflation, typically hedge their bets on the economy by sheltering money into gold, oil, or both. Historically these two commodities have been considered immutable. The absence of substitutes is a necessary trait for value assets. But is this still the case for gold and oil?
Some say cryptocurrencies are the modern substitute for gold. I’ll leave that debate to others.
For oil, there is no question it’s being challenged by substitutes. For the first time in a century, sales of electric vehicles are gaining traction. And the pandemic has shown we can finally ‘telecommute’. Yet we’re a long way from kicking a 100 million barrel a day global oil addiction. But that’s not the point: The view that oil finally has substitutes is enough to make investors think twice about hedging inflation with ‘black gold’.
To be honest, oil prices in the $70 range make for a boring movie. It’s not high enough to cause much drama. Looking back to past episodes, the tension starts around $90-a-barrel. That’s when US gasoline prices start approaching $4.00 for a gallon and customers start vocalizing their fiscal pain. Petroleum users seek alternatives, and this time around the oil cycle there is more choice. Working from home to avoid an expensive commute is now a proven option.
Electric cars are also a new alternative to avoid gasoline, but their adoption is still slow and light duty vehicles represent only 30% of all oil consumption. Physically transporting goods around world, in the supply chains that drive the economy, is still difficult to displace. In other words, oil-driven inflation can take root far faster than the economy can substitute it out.
It’s the supply side that’s different this time. In the past, when oil prices have risen quickly, governments and their representatives like the IEA (International Energy Agency) have called on industry to invest in more oil production to remedy supply shortfalls. Now the script has been rewritten. In their net-zero 2050 scenario, the IEA urges production constraint by discouraging oil drilling in new oil plays.
Regardless of government-led edicts, rising oil prices have always been a magnet for investors. Buying oil company equities served a double purpose: hedge the portfolio against inflation and cash up the industry to go drill for more oil. In previous episodes, the latter has eventually helped ease the world’s supply imbalance.
These days, publicly traded oil companies are attracting some investment, but nothing like they have in past eras of inflation. Despite reporting some of the best financial results ever, US and Canadian oil producers are now relegated to B-grade actors, relegated to the sidelines, keeping their production mostly level in the face of rising consumption.
Meanwhile, divestment edicts, ESG constraints, the potential for rapid oil substitution and a slew of other factors are forcing investors to think differently about how to best hedge against inflation. Nothing seems immutable these days.
There is an irony in this episode of The Oil Cycle: By not investing in oil companies as a hedge against inflation, investors are potentially writing the script for more inflation.