Adviser note: The emerging ‘Global Energy Crisis’ – Its implications and where to from here
By Brad Bugg, Head of Multi-Asset Strategies, APAC
- Recent press has focused on an emerging Global Energy Crisis seeing key oil and gas prices more than triple from their March 2020 Covid-19 lows
- The impact of the rising oil price has seen Energy companies significantly outperform the last couple of months to the benefit of most of your clients’ portfolios
- The direction of the ‘Global Energy Crisis’ is uncertain but if it is prolonged it could bring significant challenges for share and bond markets
- Current positioning of client portfolios should support outcomes continuing to meet their objectives, but they stand ready to take advantage of any opportunities that may emerge from any dislocation arising from a prolonged ‘Global Energy Crisis’.
In recent weeks, news of energy shortages has been increasingly grabbing the headlines. Stories of blackouts in China, as well as snaking lines at petrol stations in the UK, have left many asking what are the longer-term implications of these developments and how might the effects flow into financial markets, and ultimately client portfolios? At this stage, the impact of what has been deemed the ‘Global Energy Crisis’ has been positive for the majority of your clients’ portfolios, but in this article, we explore what could be some of the longer-term impacts of a sustained crisis, the challenges it might bring, as well the opportunities that may arise.
Where have we come from?
To start, it’s worth reflecting on what has brought us to the situation we face today. Not to try and oversimplify a complex situation, but there appears to be an increasing mismatch between the near-term demand for energy in its various forms versus a constrained supply environment brought about by reduced activity and investment since the onset of the Covid-19 pandemic. The demand side has been brought about by the emergence of many countries from their ‘Covid-19 slumbers’ whereby subdued economic activity is set to increase dramatically. This situation is set to be exacerbated by the onset of the Northern Hemisphere winter where Energy consumption will ramp up on increased demand for heating. This increasing demand comes at a time when Energy production has been scaled back to match the reduced activity of the last 18 months, while investment in traditional Energy sources has been scaled back in line with the emergence of capital being routed to sustainable projects (like renewables) versus the more traditional oil and gas projects that have supported power generation.
One of the most notable impacts of this demand/supply mismatch has been the sudden appreciation in many base commodities prices. Both Oil and Gas have seen dramatic increases in their prices, more than tripling from the depressed levels seen in the depths of the COVID crisis back in March 2020, with much of the rise coming in the last couple of months. Energy companies have been a big beneficiary of these developments, resulting in large moves in their share prices. This has come at a time when large parts of the rest of the global equity markets have come under pressure, seeing their prices fall. This has resulted in the Global Energy sector outperforming most other sectors by more than 10% in September alone and contributed to its above 70% return in the last 12 months.
Where to from here?
The drift lower in other parts of the market is also linked to increasing energy prices. If they are sustained at these levels, or potentially even higher, company profitability is going to be impacted due to higher input costs, while future growth will likely be impaired as well as moving inflation higher. Energy companies could well be the beneficiary of such an environment in the shorter term, as an oil price of above $80 means billions in additional cash flow and profits for the major integrated energy companies. However, if prices remain high for an extended period this could have negative long-term implications for both share and bond markets, including Energy, most likely in the form of lower prices and higher yields.
If there is an expectation that oil prices could remain high for an extended period, these costs are likely to flow through to higher prices across the global economy, seeing inflation expectations and interest rates moving higher. To this point equity markets have been relatively resilient to the prospect of higher interest rates, but as 10-year bond yields push through the 2% level, the prospect of some form of equity correction, on the back of a slowdown in the global economy, increases in our view.
Portfolio positioning implications
In the event that these scenarios were to play out, positioning across your clients’ portfolios will likely require some adjustment, notably the Energy company holdings. For the time being, however, the current environment remains conducive to Energy companies being able to generate strong cash flows and profits, in our view. These outcomes are likely to result in share price outperformance relative to the rest of the market, continuing the trend seen in recent months. As such, it is expected that your clients’ portfolios will look to take further profits on these positions and reduce their exposure.
Proceeds from these sales have recently been allocated to the existing investments in quality global companies, and it is likely that this rotation will continue for now. However, in the event of significant dislocation resulting from slower global growth, sustained high inflation, and consequent higher bond yields, other opportunities are likely to present themselves. As always, and consistent with Morningstar’s valuation-driven approach to investing, these opportunities will be assessed to identify the ‘next Energy’ investment that delivers strong, risk-adjusted, long-term returns for your clients whose assets you entrust to Morningstar.
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