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War colliding with recession risks leave energy markets on uncertain path


A convoy of Ukrainian troops moves toward the frontline near Yatskivka, Ukraine, on Oct. 3, 2022.

By J. Alex Tarquinio


Forecasting the direction of the volatile energy markets has never been easy. But experts say the complexity of market forces brewing now, in the wake of Russia’s invasion of Ukraine, makes it especially difficult to predict the direction of both energy prices and the industry.


“I’ve never seen such a spicy bouillabaisse of ingredients that could wreak havoc on energy prices,” said Tom Kloza, the global head of energy analysis at Oil Price Information Service. “You have to look and say that the world changed on Feb. 24,” the day of the Russian invasion.


A variety of forces could sustain high energy prices, including the recent production cuts by the producer group OPEC+, the winding down of a U.S.-led program to release oil from the strategic reserves of the United States and other countries, subsidies by several European nations to help citizens pay higher energy costs and slow industry investment in drilling operations. On the other hand, prices could fall on fears of a global recession, the potential for energy rationing in Europe this winter and an effort by the Group of 7 industrialized nations to impose a price cap on Russian oil.


Brent crude, the closely watched benchmark for global oil prices, fell almost 25% during the third quarter, finishing September trading around $85 a barrel, although it has since moved higher as OPEC+ announced significant cuts. The U.S. government forecasts that oil will trade at an average price of $95 a barrel in 2023.


Funds that invest in U.S. energy companies, which typically mimic price movements in the oil markets, rose exponentially along with oil prices in the first quarter of this year. By contrast, those funds fell by an average of less than 1% in the three months that ended in September. Energy is the only stock sector fund category that posted gains, on average, in the first nine months of this year, according to Morningstar Direct.


Experts say the G-7 agreement on Sept. 2 to cap the price of Russian oil is generating much of the uncertainty about oil prices. The plan aims to limit Russia’s export revenues while keeping its oil flowing through global markets. Skeptics, though, say a price cap may be difficult to enforce. Oil embargoes are notoriously leaky, and shippers can use legal measures like ship-to-ship transfers at sea to try to obscure the origins of a cargo.


Goldman Sachs issued a research report the same day as the price cap agreement was announced, calling it “bearish in theory, bullish in practice” for oil prices and predicting that Russia, which pumps about 10% of the 100 million barrels of oil produced globally each day, might retaliate by cutting its exports to drive up global energy costs. That, the report said, “would turn this into an additional bullish shock for the oil market.”


That day, Russian-owned energy giant Gazprom announced that it would postpone restarting natural gas flows from Russia to Germany through the Nord Stream 1 pipeline. Later in September, gas leaks were discovered in the Nord Stream 1 and 2 pipelines under the Baltic Sea. The European Union and several European governments blamed sabotage for the damage.


But Jeffrey Sonnenfeld of the Yale School of Management, who has been studying the impact of Russia’s war on the energy industry through the Chief Executive Leadership Institute that he founded at the school, recently wrote an opinion piece expressing his confidence in the G-7 plan. In an interview, he pointed to the small number of major shippers and insurers, mostly based in Europe, saying that should make enforcement easy because “you can count on both hands the number of parties you would need to enforce it with.”


He also cast doubt on the idea that Russia would switch off its oil spigots as readily as it had stopped sending natural gas to Europe. Russia has more options to sell its oil, and shutting down wells could create future problems for the Russian industry, Sonnenfeld said, so President Vladimir Putin “would be poisoning the Russian economy for years.”


Philip K. Verleger, an energy economist who began his career as a Washington policy adviser 50 years ago, said that the production cuts announced by OPEC+ are likely to have less of an impact now because the circumstances are quite different. The United States was more dependent on foreign oil in the 1970s, he said, so OPEC’s aggressive moves led to gas rationing and lines at filling stations. But the United States is a bigger producer today, and some drivers are choosing vehicles that use little to no gas.


“Electric vehicles are beginning to penetrate the market so rapidly that if OPEC pushes too hard now, they could really accelerate the move off oil,” Verleger said.


In past economic cycles, higher energy prices have reduced demand, ultimately putting a lid on prices. European governments are providing a test case by spending billions of dollars on price controls and direct stimulus payments to offset higher energy costs while encouraging their citizens to voluntarily turn down the thermostats. President Emmanuel Macron of France has called such voluntary conservation efforts “energy sobriety.”


But Europe is also investing heavily in new infrastructure to support imports of liquefied natural gas, or LNG, which is supercooled so it can be shipped on tankers. A flurry of deals have been signed to construct the facilities required to reconvert LNG to vaporous gas in Germany, France, Belgium and elsewhere. U.S. exporters may be among the biggest beneficiaries of this trend. The United States began exporting LNG six years ago and became the world’s largest exporter in the first half of this year, according to the U.S. Energy Information Administration.


Paul M. DeSisto, executive vice president of the wealth management firm M&R Capital Management, says that whatever direction energy prices take, he sees the big energy companies in the S&P 500 index returning to something closer to their 20-year average of 8.3% of the market value of the index. At the end of September, energy stocks represented 4.5% of the S&P 500. “Given how important energy is to the world economy, I think it will return to something closer to the longer view,” he said.


His firm uses two energy-focused exchange-traded funds in client portfolios: the $35 billion Energy Select Sector SPDR, managed by State Street Global Advisors, and the $7 billion Vanguard Energy fund. The two funds have a slight difference in composition as they track different market indexes. The State Street fund owns the 21 energy stocks in the S&P 500 index, while the Vanguard fund includes a mix of more than 100 large, midsize and small U.S. energy companies. But the returns after the 0.1% management fee charged by both funds tend to be similar because Exxon Mobil and Chevron are the two biggest holdings in each fund, representing more than one-third of the total assets. The State Street fund returned 33.76% in the first three quarters of the year, and the Vanguard fund returned 34.71%.


Despite the substantial geopolitical risks, commodity prices may ultimately be most influenced by the rate at which companies choose to invest profits in their own operations. So far, companies have been focused on returning profits to shareholders through dividends.


The Biden administration is keen to see more investment in the energy industry. “Ultimately our goal here in the United States and around the world has got to be to increase the supply of energy,” Wally Adeyemo, U.S. deputy secretary of the Treasury, said at a recent energy conference at Columbia University. He pointed out that the president has taken steps in this direction by releasing petroleum from the country’s strategic reserves, but also by calling on the private sector to increase production. “We want to make sure that supply chains are stronger in the United States, but also among our friends and allies.”


But the industry may still be reluctant to risk lowering prices too quickly. Kloza of the Oil Price Information Service said he thought the industry had learned its lesson from past boom and bust cycles and wouldn’t dramatically ramp up drilling. “They’ve gotten the message,” he said. “The companies are not going to kill the golden goose.”

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