On the Brink of Demand Destruction

TUE 07 JUN 2022

An observation we made late last year prior to the conflict in Ukraine was that the arithmetic of energy was fairly straightforward. Resources are depleting fast because the easier and cheaper to extract have already been extracted. At the same time, the global population is still growing and therefore energy consumption is also expanding. In that context, starving fossil fuel producers of capital might not have been a very wise decision. Unfortunately, the war in Europe has amplified these pre-existing trends.

Over the past 20 years, governments’ have spent around $5 trillion on “green energy.” While that has reduced the fossil fuel share of energy from 86% to 84%, world oil consumption has increased from around 77 million barrels per day to around 100 million barrels per day. Consensus estimates suggest oil consumption will continue to increase to around 107 million barrels per day by 2030. Currently, public listed companies contribute around 50% of global supply, but if future capital spending is constrained by the ‘Net Zero’ target and reduced supply from Russia, non-public companies (primarily from OPEC) will likely be required to increase supply. The bottom line is oil prices might increase rather than decrease as a result of the climate pressure on public oil companies. Of course, that might also accelerate technological innovation and the pivot away from fossil fuels. Therefore, the prevailing bias on trend demand could be wrong.

Capital spending from public listed energy companies has halved over the past decade. On the positive side for shareholders, this has contributed to a material improvement in return on assets (chart 1). The free cash flow yield has also improved over the period to almost 9% or a 3% premium relative to global equities. Of course, reduced capital spending will eventually constrain future returns. However, with energy prices elevated, producers can earn super normal profits.

As we have often noted in the past, you should not value a commodity producer based on spot prices. Nevertheless, the performance of the energy sector tends to be correlated with spot prices (chart 2). On the positive side, the sector has a value bias while energy prices remain elevated, capital spending remains constrained and the free cash flow yield of 9%. The episode in energy is also another example of stimulus supported demand encountering limited supply due to pandemic related bottlenecks and gaps in the global supply chain. These trends were clearly amplified by the war in Ukraine.

While the energy sector has outperformed global equities and “innovation” stocks over the past few months, there is probably room for further outperformance given the strength in spot prices. On the negative side, the best leading indicators of global growth have started to deteriorate and there appears to be a meaningful divergence between ISM new orders and spot price performance (chart 3). The last time that occurred was ahead of the 2008 crisis when high prices likely started to contribute to a phase of demand destruction. In that context, we are not inclined to increase exposure to the sector, given the potential for demand destruction later this year and in spite of the sector’s value characteristics (value is always conditional on future profits and cash flows).