14 FEB, 2022
By Mark Munro
Inflation continues to surge, having reached 7% in the US and nearing 5% in Europe. A major contributor to higher inflation of late has been oil prices, which have surged by over 50% in the past year as consumption outpaced production. Higher oil prices have historically encouraged greater investment by energy firms, but that relationship looks to have broken down of late.
Despite oil prices rising steeply since early 2020, capital expenditure (capex) has declined sharply over that period (see chart below). This poses an important question: is this a blip or early evidence of a new paradigm?
Historical relationship between oil prices and oil and gas company capex
Source: Bloomberg, Morgan Stanley Research, January 2022. Note: Consensus capex reflects rolling next 12-month estimate
One explanation for the disinclination to invest in hydrocarbons is the pivoting of oil and gas firms to greener energy. As this increasingly plays out, it could create longer-term imbalances that cause higher inflation to become more embedded.
Shell’s decision late last year to pull out of the Cambo oil field west of Shetland illustrates the breakdown of the historical relationship between oil prices and investment. Shell said the economic case for the project was “not strong enough at this time”. This is consistent with our analysts’ assessment that oil majors are now employing higher hurdle rates for new projects. However, withdrawing from Cambo is consistent with Shell’s aim to achieve net-zero emissions by 2050, and the need to evidence progress towards this lofty goal.
Shareholder pressure on energy firms from an ESG perspective may lead to some abandoning further projects and significant reserves being left ‘stranded’. The Institutional Investors Group on Climate Change (IIGCC), whose members account for €50 trillion of assets, recently published an open letter to the EU calling for gas to be excluded from the EU taxonomy for aligning funds to net-zero (1).
The green energy revolution is set to drive broader imbalances in commodity markets beyond oil and gas. The World Bank has suggested that critical mineral mining may need to increase five-fold from current production rates by 2050 if it is to meet the expected demand from green technologies.
Growth in renewables and in electric vehicles will be strong demand drivers for copper over the next 5-10 years. However, sizeable, high-quality copper projects are scarce. It’s a lack of opportunities – rather than desire – that is constraining copper output. The interest from miners in building out copper deposits remains high, especially given prevailing commodity prices. Firms plan to expand projects at existing mines, but development will need to offset the declining ore grade of current production. It will be an uphill battle to meet impending demand.
The dynamics we are seeing in commodity markets could raise inflation for specific products and/or make their price dynamics more volatile, as we have seen with energy prices. This would push short-term headline inflation higher, either directly via higher energy prices or indirectly through higher materials prices feeding into a range of goods.
However, we are cautious about extrapolating this dynamic too far at this stage. Even if we were to see sustained price increases for commodity products, we would not expect that to translate into headline inflation remaining above central bank targets for extended periods. As of yet we don’t have enough evidence to suggest that any supercycle in green or other commodity prices will drive structurally higher inflation. That said, central banks may have to work harder to meet their targets, and such supply-style issues might present unpleasant policy choices.
We expect the shift away from hydrocarbons to be an intensifying theme. Accordingly, in our Investment Grade funds we have reduced gas transmission assets and cut exposure to longer-dated debt issues from oil companies, which could trade at structurally cheaper valuations (i.e. with wider credit spreads) over time.
Meanwhile, investors have increased exposure to transition champions and renewables, particularly with the rise of ESG ‘labelled’ products. We too have sought out such credits, but increasingly there is a need to be wary of the higher valuations (tighter credit spreads) ascribed to such names.
While there is a risk that climate policies and ESG factors could drive further supply pressures in the energy, metals and minerals markets, we don’t yet have enough evidence to believe that headline inflation will become supercharged or structurally higher as a result.
The recent surge in energy prices has resulted from the combination of subdued investment in fossil fuels in recent years, in part due to the increased focus on reducing carbon output, an insufficient supply of renewables, and distribution issues stemming from the Covid-19 shock. We expect the impact on headline inflation from recent high energy prices to peak during 2022. In the meantime, policymakers will likely face substantial political headaches over both energy security and consumer price inflation.
As fixed income investors, we have come through a long period of low inflation in developed economies. Much of the current debate is focused on longer-term themes that could usher in a new regime of structurally higher inflation, which of course is far from ideal for our asset class. Higher inflation for longer naturally calls for a more flexible approach to duration management, and depending on specific client requirements, an increased share of shorter duration and/or unconstrained strategies in the mix.