Macro: Sandcastle economics
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Are energy markets coming back to haunt equities?
Peter Garnry
Chief Investment Strategist
Summary: Brent crude hit highest price yesterday since November 2022 marking a rally since late May underpinning inflation expectations which could potentially weigh on global equities. Real capital expenditures in the global energy and mining sector have still not reached their pre-pandemic level and thus we expect long-term to remain constrained putting a floor under oil prices. The global energy sector still has an attractive long-term expected return profile. The recent collapse in Orsted is marking the end of the dreams about offshore wind power while nuclear power is gathering more and more momentum.
Key points in this equity note
- Higher oil price adds risk to the markets bet on lower inflation and it increases the risks of stagflation in the global economy.
- Energy markets are many things ranging from transportation (oil), heating (natural gas), living and manufacturing (electricity), and this winter will test the energy markets and ultimately the global economy.
- Orsted and the offshore wind power industry are in a big crisis while nuclear power is enjoying a positive tailwind.
Highest crude oil since November 2022 could underpin inflation
OPEC+ oil production cuts have had an impact on crude oil prices with Brent Crude hitting $90/brl yesterday. The move higher in crude oil since May has also had an impact on inflation swaps, instruments that price future inflation, and this variable goes into the decision making central banks. Higher oil prices will keep the inflation rate higher for longer so energy markets going into the winter period on the Northern Hemisphere are going to be key to financial markets.
One thing is short-term oil production cuts (positive for the oil price) and electric vehicles adoption (negative for the oil price), but long-term supply will be challenged as global oil and gas majors have still not lifted real capital expenditures back to levels from before the pandemic. This will constrain long-term production and underpin prices. What is the crude oil price that will balance the market? Our Head of Commodity Strategy, Ole S. Hansen, has the view that $100/brl is the upper limit for now giving the current price of refined oil products and the slowing economy. This concern is also reflected among speculative participants such as hedge funds which not significantly moved into long positions in crude oil as the risks to the economy, and ultimately oil, remains elevated.
Energy markets are many things. Crude oil is key for transportation (more than 50% of demand), but energy markets are also about heating (here natural gas prices are key determinant of the price consumers are paying), and manufacturing and households using electricity for production and living. Here the 1-year forward price on baseload electricity in Germany is still sitting 250% above levels observed in 2013. The war in Ukraine has made energy markets more sensitive to adverse developments and the weather this winter will play a crucial role for Europe.
With energy coming back into focus it worth reflecting on the expected returns in the global energy sector. The MSCI World Energy Sector Index has a dividend yield of 4.1% and a buyback yield of around 1%. Even assuming no real earnings growth over the next decade leads to quite interesting real expected rate of return of more than 5%.
Nuclear vs offshore wind
The collapse of Orsted over enormous problems around their offshore wind projects in the US has put offshore wind power into question in relation to the green transformation. To make things worse, Orsted said yesterday that unless it gets more US tax credits will have to abandon some offshore wind power projects. Nuclear power was the best performing energy segment in August and a relative chart between Orsted (one of the world’s largest offshore wind developers) and Cameco (one of the world’s largest uranium miners and nuclear power technology providers) reveals the big shift in sentiment. Our view remains positive on nuclear power as we see policymakers coming to the conclusion that nuclear power is the only zero-carbon large-scale high energy density solution to significantly increase baseload electricity. Given the installed capacity of solar modules this year it looks more and more certain that solar will be the long-term winner among the renewable energy sources. Latest Market Insights
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