In this episode, host Naj Srinivas speaks with Ori Powers of Fisher Investments’ Capital Markets Research Team about the energy sector’s links to major issues like the Russia-Ukraine conflict and the ongoing inflation situation. They discuss how the price of oil influences the sector and the supply and demand drivers that are currently at work. They investigate the differences between Russia’s influence on energy markets and its importance to the global economy. They also explore how energy factors contribute to recently elevated inflation.
Hello and welcome to the Fisher Investments Market Insights podcast, where we discuss our firm's latest thinking on global capital markets and current events.
I’m Naj Srinivas, senior vice president of corporate communications here at the firm.
Today, we'll be looking at a topic that has had wide ranging global implications for investors and consumers generally: energy. The energy sector and energy companies are intrinsically linked to many of the headlines stories we hear about in the media today: the Russia Ukraine conflict and resulting Western sanctions, inflation and so on. Understanding what's going on in this important sector and how it affects stock markets broadly and the economy are very important considerations for investors.
To guide us through this important topic, I talked to Ori Powers. Ori is a capital markets analyst with our research group at Fisher Investments. And his current coverage area is the energy sector.
Before we dive into our interview, with Ori, I'd like to ask you to rate and recommend our podcast wherever you listen to it. In just a few minutes, you can help make this information available to even more people.
Thanks so much for your help. With that, let's dig into our interview with Ori Powers about the energy sector, Russia and inflation.
Well, Ori, why don't you share with our listeners a little bit about what you do as a capital markets research analyst focused on energy here at Fisher Investments.
Sure. Well, my role really as a capital markets analyst—looking at energy—is analyzing the macro environment for the sector. And, you know, while there are a number of important factors that influence energy, you know, a number of different subcomponents of the space, whether it's producers of energy, whether it's companies that help service those producers, whether it's the people that refine that energy into end products—really the major determinant for the energy space broadly is the price of oil and to a lesser extent, the price of natural gas and coal.
So when I'm analyzing the space, really what I'm trying to look at is, going forward what are we seeing in terms of the price of oil, the price of natural gas, the price of coal, and how can that drive the space.
And of course, the two major inputs of prices being supply and demand of gas, oil and coal.
That's exactly right. Supply and demand are the main two determinants there. And when we think about supply and demand, typically it's fairly balanced. But more recently, what we have seen is somewhat of an imbalance, and that's really what's led to, I think, the recent increase in prices.
Whether that imbalance is caused by underinvestment in the space following the pandemic lockdowns or the war in Ukraine with Russia. You know, all of these factors combining to reduce global supply and on the face of a pretty strong resurgence in demand coming out of the pandemic.
And so now that we are seeing that imbalance there with a little bit more demand than supply, I really think that's what's driving prices higher and that's what's driving the energy sector to outperform so strongly both last year and this year.
So we're going to deep dive into some of the current events that are impacting the energy sector broadly and prices of oil, gas or coal. But first, I want to just take a step back and ask you some questions about energy. I mean, energy is one of those sectors that's very frequently in the headlines. It's something that everyone watches. It's something that impacts people's pocketbooks. When you think about things like high gas prices, like we're experiencing in the United States today and elsewhere around the world.
So, let's just take a step back for a moment and maybe you could give us your thoughts as to why and how energy is so important to the global economy.
Well, energy is important to the global economy, simply put, because everything that surrounds us is made of energy. You know, you think about the mic stands that we're talking into right now. Those are made of energy. The headphones we're using; those require energy. The electricity generation. Those all require energy. And so when we think about what keeps the economy moving forward, it really is energy.
There's a little bit of an interesting disparity where, you know, economies are run primarily on energy generation. However, when we think about economies' reliance on energy and even energy place within the equity space, it's a little bit of a disparity there. While energy is a very important driver globally of economies, when we think about economic reliance on energy, it really is falling over time.
If you think back to the seventies and eighties, where it might take two barrels of oil to create $1,000 of GDP in the developed world. We’ve fallen pretty far from that as economies have become more efficient, where now we're really only looking at about half a barrel of oil to create that thousand dollars of GDP. So we're becoming more energy efficient. We're becoming a little bit less reliant on that energy than we were in the past. And when you think about energy within the equity space. Energy right now in the global equity space only represents around 6%. It's kind of a far cry away from something like technology that's in the double digits in terms of its composition of the global equity space.
So, while equity—energy, excuse me—is very important in terms of creating all of the things that surround us. Its impact on economies is falling over time, and its impact on the equity space is still fairly muted, even though it is predominant in the headlines.
So taking a shorter term view, while energy is certainly on our minds and in the headlines, when you look sort of a from a macro perspective and a longer-term view, energy makes up a fairly small amount of the total investable equity universe and a small part of our economy relative to some of those other sectors out there. Is that the basic premise behind what you're saying?
That's exactly right. It's very important. You know, we think about what creates jobs in the economy. It's an important factor in inflation. You know, that's one issue that's really top of mind right now. And, you know, energy makes up about 9% of at least U.S. inflation.
And so when we think about, you know, prices that we as people spend every day in our lives and that does drive economic growth or potentially lead to economic contraction. The amount of consumption that we as individuals make and we think about energy prices being now 9% of at least the inflation basket that we use to track prices in the U.S. You know, it's important factor there and it's important for everyday people when they go to the pump, when they try to heat their homes, et cetera.
So, you know, while it may be a small portion of the equity space, it still does impact everyone's lives. And I think that's why you do see it in the headlines so often.
So let's switch gears here a little bit and talk about what's going on in the world that is influencing energy prices today. Oil, but how that's also affecting the energy sector more broadly. So let's just start with the topic du jour, because I think this has been the impetus for a lot of the wild swings that we've seen in prices.
But what's going on with Russia and Ukraine relative to Russia's contributions to the global energy market?
Sure. So, you know, the impact of Russia and Ukraine on the global energy market is significant. I mean, there's no two ways around that. You know, Russia is one of the largest producers of oil in the world. And as a result of them invading Ukraine, there have been a number of sanctions that global economies have placed on Russia.
Now, Russia produces somewhere around 10% of global oil. They export a vast majority of oil to the global economy as well. So when we think about what we talked about earlier with supply and demand dynamics, Russia is a key player in terms of supply. And what we've seen out of the U.S., out of the UK, out of the EU, out of a variety of different nations, placing sanctions on Russia, trying to hinder their ability to not only produce oil, but also to export that oil to countries. That does reduce the supply that we're seeing globally.
Estimates right now are for a reduction of about 2% to 3% of global supply from sanctions against Russia. I think that likely going forward, we see a little bit less of an impact than that because something we've seen over time as sanctions are simply less impactful than a lot of people think.
You can think back to China during 2018 with the trade war. While it’s impactful, there were ways around that. They could use pilot countries such as Vietnam to transport steel, et cetera. And Russia is finding ways to do that as well, whether they're selling oil to India or Asia, they're finding some ways around these sanctions. So while the impact is important on the global supply space, it's likely a lot less impactful than people expect. And that should lead, going forward, to a little bit of an easing in oil prices.
So Ori, if I'm hearing you correctly, what you're basically describing is that Russia does have an outsized impact on global energy markets—oil being fungible and being able to be transported to other end markets outside of, say, the Western powers that may actually be typical buyers of Russian energy.
But outside of Russia's impact on energy, doesn't Russia have a very small contribution to global GDP?
That's exactly right. So, you know, Russia's impact on energy supply may be 10% in terms of their production scale to global supply, but in terms of their broad-based economy scaled to global GDP, they represent in the low single digits. And post sanctions, where we've cut off a majority of their financial abilities to operate, that's even lower. So, you know, in terms of their ability to knock global markets into something like a recession, you know, it's fairly limited when you look at the scale of their actual economy to the global GDP.
So let's build a little bit off of your last point about Russia starting to export more oil and energy to other countries outside of the Western nations in Europe. How is Europe able to cope with the sanctions that they've placed on energy, and what's the outlook there relative to European growth, given their huge reliance on Russian energy?
Europe recently—at the end of May—announced that they were going to be placing sanctions on purchasing of Russian oil. Now, this is not a full-fledged sanction. It accounts for the oil that they buy by ship, not the oil that they buy by pipeline. So it encompasses roughly two-thirds of the oil that Europe buys from Russia. And that's going to be phased in throughout the course of the year. So it's not an immediate sanction either.
But, that's really how they are addressing their sanctions of Russian oil until the second point of how are they going to cope with that reduction in purchases. Oil is fungible, simply put. You know, there's of course, different grades of oil, but when we look broadly, it's fairly easy to repurpose oil from one place to another. You can simply put it on a ship and send it over.
It's not like something like natural gas where you need to liquefy it. It's very expensive to ship, to liquefy, to deliquefy. And so with oil, you know, there's other players that can help them. There's the U.S., there's Saudi Arabia, there's, you know, the additional OPEC producing countries out of the Middle East and Africa.
So there are other oil suppliers that can step in and help them plug the gap of the supply where Russia used to play a big part.
So let's talk a little bit about those other producers for a moment, because, you know, once upon a time, I think 10, 15, 20 years ago, there was really only one big swing producer globally of oil, and that was Saudi Arabia. But in today's world, there are, I think, arguably far more swing producers.
Saudi Arabia is still one, but the United States is arguably also a very big producer and contributor to global energy supply. Can you talk a little bit about that?
The U.S. is the largest producer of oil in the world, actually, you know, coming from…
A fact that a lot of people don't really appreciate or know.
No. And, you know, it's something that's somewhat full circle. You know, when we think about oil being discovered back in 1859 by Colonel Drake in the US. And that really sparked what we now know is the global oil trade. And for a large portion of recent history, at least to your point, Saudi Arabia was in mainly the driver's seat of global oil supply and those other OPEC producing countries.
But since the shale boom in the US in 2011, the US has tapped vast resources of oil and it has led us to become that biggest producer of oil.
I mean even the Permian Basin within the US is on its own, the fourth largest oil producer in the world and that's not even the only basin in the US.
You know, the US is producing close to 12% of global oil supply right now. So, you know, they are a major swing factor.
Well, that's a really staggering fact that bears repeating. The Permian Basin, which spans New Mexico—or parts of New Mexico—and Texas would be the fourth largest producer of oil in the world on its own. Is that is that right, Ori?
Exactly. They're producing more oil than most countries.
So Ori, if the United States is the biggest producer of oil in the world, why don't we have more pricing power over gasoline? I mean, that's something that's been in the news quite a bit. People are talking about how high our gasoline prices are per gallon. Why the disconnect there between us being the biggest producer and still having such high gas prices?
I think the natural thought for people is because we're the biggest producer we could simply keep all of our oil here and charge US consumers less. But while oil markets are fungible, they're not entirely fungible. Meaning that, you know, the type of oil you produce does matter in terms of your ability to refine it.
So when we think about the US coming out as this large producer of oil, the type of oil we produce is what's called light sweet oil, meaning it's got low amount of particulates. It's got a low sulfur content, it's very good quality oil. Now because this is somewhat of a recent development—talking about the last decade—most of the US refinery system which is built out in the 1900s, is set up to produce lower grades of oil. Oil that comes out of oil that comes out of Canada, oil that comes out of Mexico. And so because our refinery system is set up to refine these lower grades of oil than we produce in the US, we can't simply refine the oil that we make here at economic scale. We still need to import oil from elsewhere. And so that's one of the reasons why as the US being the largest producer, we can't simply supplant our entire consumption.
Now, the other factor is refinery. Now the other factor is refineries have shut down recently and we talked about oil prices falling through the floor during COVID. Well, that was because oil demand fell through the floor. And so a lot of people not only shuttered their production of oil, but we did have an 8% to 10% shuttering of US refinery capacity. And so when you have this large resurgence in demand coming out of the pandemic and you have lower refinery capacity coupled with the fact that we can't simply refine the type of oil that we produce in the US broadly, that leads to those higher gasoline prices. But, we still are in a little bit better position than places like Europe who really rely completely on external sources for their oil.
So Ori, any time we have seen higher oil prices over the last decade or so, the natural question that comes up is alternatives. What about alternatives to traditional energy sources like oil? What about things like solar or hydroelectric? Like wind power? Geothermal? When did those start to become more attractive? At what price level of oil do you have to hit for those to become attractive on a relative basis?
I think any time you see elevated traditional energy prices—oil, natural gas, coal—you're going to see increased conversations around replacements. Whether it's wind, whether it's solar or whether it's hydroelectric. And I think we are seeing that right now, particularly out of Europe. One of the ways they are looking to deal with less reliance on Russia for things like oil and natural gas is to rely more on alternate energy sources.
But I think when we look globally, economies do have to walk before they can run in terms of alternate energy sources. These things take time. It's not as if we can replace oil and gas place in the economy overnight. And I think last year was a good example of that in terms of Europe, who is more reliant on alternative energy sources than a country like, let's say the US.
But they did run into some problems because of that in the last year, the UK had some historically low winds in the North Sea. They had low hydroelectric power generation. There was some weather-related factors for solar as well, and it led to a very low production of renewable energy for the UK and European continent. So because of that we saw the initial run up in natural gas prices as they had to switch over to those more traditional sources and it led to again increasing prices for heating, for industrial production, et cetera.
So I think when we think about alternative energy sources, there's plenty of room for the discussion and I think high energy prices definitely incentivize that. But there are some hurdles in terms of the actual efficacy of some of these technologies in replacing oil and gas more broadly.
So let's talk a little bit about inflation next. Inflation has obviously been a big headline driver of late, but can you talk a little bit about how higher energy prices actually impact inflation in this country? And is high energy prices a major driver of the inflation figures we're seeing here? Or is it just kind of one of several drivers that are contributing to the elevated inflation levels we've seen of late?
Simply put energy is an important driver of US inflation. I mean, it represents around 9% when we think about the basket that makes up the consumer price index that most people talk about when we think about inflation. But it is one of many factors.
Some of the other drivers of inflation are things like transportation, things like food, all related to energy. Because, you know, as we've talked about a number of times during this conversation, you know, energy is an important input for a lot of factors in the economy. So when we think about transportation, we think about creating food, the processes that it takes to move cars, move busses, move trains, and also the processes that it takes to take farmed plants and turn them into food. It all requires energy. So that rising energy inflation not only shows up in terms of a stand-alone factor in the core inflation numbers that we see, but also a factor in some tangential areas such as transportation and food.
What about the year-over-year effects? Because my understanding is that some of what we're experiencing here in terms of the headline kind of eye popping inflation figures are simply a byproduct of the year-over-year calculation.
There's some impact of the year-over-year calculation in terms of creating higher inflationary numbers. And when we think about where we're at in terms of the recovery from a pandemic, you know, most of 2020 was marred by widespread economic shutdowns. It brought prices a lot lower.
Think about, you know, the driver of prices being both supply and demand, but also things like, from a monetarist perspective, too much money chasing too few goods too quickly.
Well, there wasn't a lot of money chasing a lot of goods during the pandemic because people couldn't go out and spend that money.
And so while you did see stimulus happening, a lot of that stimulus was saved. Not a lot of it was spent, and a lot of economic activity was shuttered. So you had money going into people's pockets, but it wasn't being spent. It led to a reduction in terms of that inflation, really soft prices.
And so what we've seen now over the past call it 12 months is a recovery from that where we've had a strong surge in demand. And when we think about too much money and chasing too few goods too quickly, it's really that too few goods part that is driving things up right now. You think about supply-chain issues causing shortages of goods and strong demand for goods, where maybe before the pandemic there was a little bit more demand for things like services.
So we've seen a shift in terms of consumer spending towards goods versus services. At the same time, we've seen supply chain issues impeding companies’ ability to produce those goods that people are pursuing. And so we are seeing that as a major driver of inflation right now. But one thing that we are seeing is those supply-chain issues are starting to ease.
It's these things take a little bit more time than a lot of people would like, but they are starting to ease. And so that should, over time, reduce some of that inflationary pressure, at least in terms of the goods and services impact on things.
So two related follow up questions to that, Ori. One, is it reasonable, though, to expect that many producers would have ceased investing in expansion of energy production amid a period like 2020 and part of 2021 where demand was so depressed and that is a driver of some of the higher prices that we're seeing today.
But then, too, the second question, as a follow up, there are often long lead times relative to investment in new production and when you actually do get greater production. So one of the things where the United States has been to your earlier point about being one of the biggest producers or the biggest producer of oil in the world, we often saw in the past were very high oil prices or eventually brought down by U.S. producers, U.S. and North American producers broadly producing more to bring prices down.
So can you just comment on those two factors a little bit?
I think there's two important factors at play when we think about U.S. oil supply. One is more obvious. One is a little bit less obvious. The obvious one is what you brought up, which is that the pandemic shuddered a great amount of supply, particularly out of places like the US. I mean, at one point, U.S. oil prices were actually negative, which was somewhat of a technical, idiosyncrasy, but it did happen.
So when you have this great depression in terms of oil prices, companies do shutter. U.S. companies have higher breakeven prices, which is the price that they need to make in terms of making their oil investment economical. But, because prices were so depressed during 2020 during the pandemic, a lot of them shuttered production and that takes time to come back online.
It's very easy to shutter production. It's a little bit more difficult to bring that production online. There is that lead time that you talk about. We saw investment in oil and gas, at least among the major players, fall about 30% year-over-year in 2020. That's a very dramatic shift and it's hard to maintain the same kind of oil production when you're spending 30% less.
So that's the first factor, I think, is the reduction in oil prices leading to that underinvestment that we saw in 2020 and that does take a little bit of time to rebound.
The second factor, which I think is little talked about but is very important, is the changing in executive incentive structures among the energy producers as a result of 2020. You think back to the shale boom of 2011 through 2019, and a major incentive for energy executives was production growth. Something like 90% of all exploration and production companies had incentive structures tied to production growth. That shifted because of the 2020 pandemic, because of the crash in oil prices, because energy companies had been losing money for about ten years pretty consistently—we saw a shift in terms of executive incentive structures among the US producers. Where before 80 to 90% of companies had incentives tied to production growth, now that's down to closer to 40% now executive compensation is tied to things like free-cash-flow generation return-on-invested capital—a lot of profitability metrics.
Now this is something that not a lot of people talk about, not a lot of people appreciate, but it's a major driver in terms of U.S. oil production. If the executives aren't as incentivized to grow production simply put, they're not going to.
Now, to your last point of high prices or really increasing that incentive to produce, we are starting to see that. I talked about investment falling the dramatic 30% in 2020, but it's starting to rebound. This year, we have seen a meaningful increase in investment about 20% next year there's an expectation for about ten to 15% increase. So the money is flowing now back into oil and gas production.
You can see that in a number of ways you can look at the number of oil rigs that are out there being up 60% year over year. You can look at U.S. production which is increasing albeit a little bit more slowly than in past cycles. But there are a number of factors that indicate to us that oil production is “on the way” out of the U.S., although it has taken a little bit longer to respond than in previous cycles. Again, in large part due to those incentive structures.
Ori, thank you so much for being here and sharing your perspectives and insights with our listeners. Do you have any other thoughts you want to share on the energy sector?
Well, Naj it's been excellent talking with you today. I appreciate the opportunity.
You know, in terms of the energy sector, I might be biased here, but I think it will continue to be one of the most interesting spaces to watch. When we think about over the next 12 to 18 months, you've got geopolitical tensions, you've got interesting supply-and-demand dynamics, you've got economic drivers such as underinvestment and high prices leading to increased investment so there are many factors looking forward that I think will be interesting to keep an eye out for.
And I'd love to talk to you again. If you'd have me back.
We'd love to have you, and I'm sure our listeners would as well. So maybe we'll check in in a couple of months on the state of the energy sector.
Ori Powers, Capital Research Analyst here at Fisher Investments. Thank you so much for your time.
Appreciate it, Naj.
Well, that was our interview with Fisher Investments Capital Markets Research Analyst Ori Powers about the energy sector and its connections to Russia, Ukraine and the world's ongoing inflation concerns. A very big thank you to Ori again for joining us and sharing his perspectives if you want to learn more about the topics we discussed, you can visit the episode page on our website, Fisher Investments.com.
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Until then, I'm Naj Srinivas. Thanks for tuning in.
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