What’s going on with energy prices?
Authored by RSM US LLP
The cost of energy-related commodities (crude oil, natural gas, coal) has risen dramatically this year, particularly since early September. As economies around the world continue to emerge from COVID-19-induced lockdowns, demand has rebounded more sharply than expected and helped fuel the recent rally. However, an inability and/or unwillingness of producers of all three commodities to markedly increase output are tipping the scales even further, and peak seasonal demand across much of the northern hemisphere is still months away.
It started with gas
Natural gas is at the forefront of the energy crunch and has risen in part due to weather-related phenomena in the U.S. and abroad. The deep freeze in Texas earlier this year created excess demand and resulted in U.S. inventory drawdowns. Then, Hurricane Ida, which shut down nearly all production in the Gulf of Mexico, further upset the supply-demand balance.
In Europe and parts of Asia, a particularly cold and long heating season last winter has left gas storage levels well below five-year lows, and pandemic-induced construction and maintenance delays have hindered the ability to meaningfully boost supply. This problem has been compounded in places like the UK, which generates upwards of 24% of its electricity via wind turbines. Abnormally light winds in recent weeks forced officials to use gas and coal-fired plants to make up the difference, adding to already-high demand and putting additional upward pressure on prices.
When gas is expensive, oil will do
The alternative means of power generation are primarily oil and coal. West Texas Intermediate (WTI), the domestic oil benchmark, was up nearly 55% this year through the end of September and, more recently, traded even higher to levels not seen since 2014, as investors increasingly bet that U.S. producers will be reluctant to add significantly to supply — a situation we discuss in more detail below. Separately, the Organization of Petroleum Exporting Countries together with Russia (OPEC+) decided earlier this month against increasing supply beyond its previously agreed-upon 400,000 barrels per day (bpd) despite calls from the U.S. and other nations to boost output by as much as 800,000 bpd. Not only is it still fresh in many a mind that oil prices in March 2020 turned negative for the first time in history (a scenario unlikely to repeat, but scary nonetheless when your country relies almost exclusively on petroleum revenues), but chronic underinvestment in infrastructure in recent years amid a global push to “go green” has left some cartel members in a position where they may be able to pump more oil out of the ground, but getting that extra crude to market may not be so easy.
And then there’s coal
There have been concerted efforts among many countries to reduce coal use and the resulting carbon emissions. However, coal still accounts for roughly 40% of the world’s electricity, and some are now reversing course on reductions — at least temporarily. Notably, China did an about-face recently after coal inventories used in its power plants reached 10-year lows, leading to rolling blackouts and an unexpected decline in manufacturing activity last month. Despite efforts to procure coal from several other countries after it stopped buying a large portion of its supply from Australia late last year amid political tensions, many Chinese firms have turned to diesel generators as a means of supplementing coal use amid mandatory rationings. A continued rise in energy prices could put further inflationary pressure on goods coming out of the world’s largest exporting nation.
Don’t expect supply-side relief, however. Despite the surge in coal demand, miners are limited in their ability and willingness to ramp up supply. Previously closed mines take significant time and investment to reopen and, given the global trend toward cleaner burning fuels, it’s not a gamble many — if any — are willing to take.
You may be feeling the pinch in your energy bills; however, costs have not risen in the U.S. to the extent seen in many other countries, thanks to greater storage capacity and our position as one of the world’s largest producers of all three energy commodities. Also, the cash cushion many households have from several rounds of government stimulus checks better positions the U.S. consumer to withstand recent increases in their energy costs.
Still, higher energy costs serve as a tax on consumers, who account for the lion’s share of gross domestic product in the U.S. An extended period of higher prices could not only further increase inflation, but also start to weigh on economic growth, a scenario referred to as stagflation. While we don’t dismiss the possibility, we believe the situation would have to be prolonged and excessive, which is not our base case. As Figure 2 below indicates, supply and demand are expected to converge in the beginning of 2022, so we’re cautiously optimistic that price pressures should begin to alleviate early next year.
The implications for foreign economies are not too dissimilar from the U.S., except our domestic production and storage capabilities better enable us to weather severe price swings. Nonetheless, globalization has rendered the U.S. susceptible to economic conditions abroad.
The Energy sector has been the S&P 500 Index’s best performer so far this year, but that may not be the case next year. Starting in 2016, companies ramped up efforts to drill new wells in tandem with rising oil prices. The number of drilled but uncompleted wells — or DUCs — peaked in late 2018, creating a cushion that enabled companies to maintain or increase output this year without having to meaningfully boost capital expenditures. This in turn allowed them to focus on enhancing shareholder value through increased dividends, buybacks and debt reduction. However, firms have drawn on those reserves to the point where levels have returned to near 2016 lows. Consequently, producers will likely need to ramp up drilling efforts next year to increase, or even sustain, current output. With the cost of a new well at roughly $7 million plus ongoing operational and service costs, it’s not a minor outlay; however, if current price levels near $70 per barrel are sustained, they could continue to return capital to shareholders despite the need for additional drilling.
Higher energy prices are likely to result in above-average inflation over the next few months. While consumers are already feeling its effects via higher energy and food costs, core inflation — which strips out those two components — may see a more modest uptick going forward. Consequently, the Federal Reserve (Fed) appears likely to stick to its previously communicated plan to slowly withdraw liquidity through the first half of next year. This would provide continued support for the U.S. economy while market forces continue to work through the supply-demand imbalances. However, rising energy and food prices, should they be sustained, could dampen economic growth, thereby diminishing the need for the Fed to further tighten policy. So, while consumers certainly hope prices come down soon, investors could benefit whether prices remain elevated or retreat, bearing in mind the uncomfortable position in which many firms in the energy space currently find themselves.
This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute audit, tax, consulting, business, financial, investment, insurance, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. Information has been obtained from a variety of sources believed to be reliable though not independently verified. RSM US LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person. Internal Revenue Service rules require us to inform you that this communication may be deemed a solicitation to provide tax services. This communication is being sent to individuals who have subscribed to receive it or who we believe would have an interest in the topics discussed. Past performance does not indicate future performance. The sole purpose of this document is to inform, and it is not intended to be an offer or solicitation to purchase or sell any security, or investment or service. Investments mentioned in this document may not be suitable for investors. Before making any investment, each investor should carefully consider the risks associated with the investment and make a determination based on the investor’s own particular circumstances, that the investment is consistent with the investor’s investment objectives.
Tax and accounting services are provided by RSM US LLP, a registered CPA firm. Investment advisory, aggregated reporting, financial planning, retirement plan advisory and other wealth management services are provided by RSM US Wealth Management LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC) and wholly owned subsidiary of RSM US LLP. Registration as an investment adviser does not imply a certain level of skill or training of the adviser or its representatives.
RSM US LLP is a limited liability partnership and the U.S. member firm of RSM International, a global network of independent audit, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International.
RSM, the RSM logo and the power of being understood are registered trademarks of RSM International Association.
© 2021 RSM US LLP. All Rights Reserved.
Call us at (325) 677-6251 or fill out the form below and we'll contact you to discuss your specific situation.
This article was written by Derek Vasko, CFA and originally appeared on 2021-10-18.
2021 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
Condley and Company, LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.
For more information on how Condley and Company can assist you, please call (325) 677-6251.