On a podcast a couple of weeks ago with Nick Hubble and Boaz Shoshan, they asked me a good question: what happens to energy stocks during inflation – two key themes that I speak of.
But despite dealing with both of them regularly on their own terms, I had to answer that I really didn’t know.
If I had to offer an excuse, it would be that I’ve never been alive during a sustained period of rising inflation or interest rates. It’s all new to me.
I decided to read up on it, and here’s what I found out.
Energy stocks, of 16 sectors studied, rose the most during periods where interest rates rose.
This would ordinarily be a sign that energy stocks would do well in inflation, but there are some well-argued concerns that while inflation may rise, central banks are going to bend their backs to control interest rates so that debt remains affordable.
That fits the argument that inflation is a tool for debt cancellation, and that governments and central banks know it.
In such a scenario, CPI inflation would rise but rates would not, or would rise slower. It’s called “financial repression”, and has happened before (after WW2, I believe).
But inflation on its own has an effect regardless of rate rises.
Rob Thummel, a portfolio manager with Tortoise Capital, said, “Energy is the best-performing sector in the S&P 500 during periods when inflation rises by 3 percent or higher.”
Well, as you might have seen, financial historian Russell Napier – who has long predicted deflation – has come out and declared his expectation that CPI inflation rates will rise above 4% by the end of next year, 2021.
That doesn’t mean it’s gospel, but it means that the broader market expectations of very low inflation for a long time (based on inflation-linked bond prices and other indicators) might be underestimating it by a wide margin.
And when we speak of energy here by the way, it’s not just my usual beat of renewables and clean tech – it’s actually oil and gas majors which make up the majority of the sector.
And as those are commodities, they respond more easily to inflation.
I think this could be an interesting difference between different forms of energy.
Lots of renewable power plants are premised on long-term financial agreements – PPAs (power purchase agreements).
Someone plans to build a solar farm, and before doing so they get a local government or industrial buyer (Facebook and Alphabet have huge offices run by 100% renewables, for example) to commit to buying their energy from that plant at a fixed price for 20 years.
Obviously, the T and C’s are more complex than that, but you get the idea.
The return is predictable.
And although it seems that most PPAs are inflation-linked, it’s possible that many are not, or have fixed (low) inflation rates attached.
It’s the mortgage prisoner in reverse – they signed on to mortgages before 2007 and are paying 6% or 7%, whereas the market is now offering 2% or 3%, a huge difference to monthly outgoings. As those are fixed, those people can’t remortgage.
A PPA that’s fixed and not inflation linked might find that the £75/MWh price which was agreed turns out to be worth very little indeed in ten years’ time, after a decade of 4-6% inflation (just a wild guess – I have no idea what it’ll be).
The point is that inflation much higher than 2% or 3% will be ruinous for long-term PPA holders (the renewable power producers) if the price they’ve agreed can’t rise in line with it.
Then again, an inflation-linked price can be bad news too.
The Hinkley Point nuclear plant is a famous example of this – back in 2012 it was guaranteed prices of £92/MWh by the government in order to incentivise EDF to build it. Without that guarantee, it probably would not have been built.
But now, after a few years have elapsed, the plant is still unfinished, and already inflation has pushed that agreed price to around £110/MWh when solar and wind prices have fallen rapidly at auctions, and the national average grid price for electricity is in the £40-60 range.
Suddenly, an inflation-linked PPA means that consumers may be forced to pay far higher prices than they could get from another source.
I myself am happily on a seasonally adjusted, renewably sourced bill. I can even choose which form of renewables I’d like my energy to be sourced by, though I’m not sure what difference it makes.
Interestingly, it was comfortably cheaper than the existing provider, SSE, and offers lower costs in summer than in winter (potentially reflecting a higher mix of solar in their generation…).
Maybe there will end up being utilities which are mostly wind and so cheaper in winter, and ones which are mostly solar so cheaper in summer, and some clever algorithm to swap you over each time the clocks changed so you get the best seasonally adjusted prices all year round.
Anyway, back to inflation and PPAs – it seems as though it can go either way. Fail to inflation-link your returns and then as a power producer you may see your real returns diminish over time.
But if you do inflation-link your PPA but at the wrong level, the consumer gets it in the neck, and overcharging consumers is hardly going to be a great way to achieve the energy transition.
What comes next must be better than what comes before, so for power producers in every sub-sector of energy, anticipating and dealing with inflation smartly could be a crucial factor in their success. Something to watch out for, certainly.
Moving on, a key factor in every debate over energy is obviously the price of oil, and increasingly the price of natural gas.
Here’s a long-term price history for Brent crude oil:
Obviously there are plenty of factors at play, and yes there were not one, but two oil supply shocks in the 1970s – the 1973 Yom Kippur War, followed by the Iranian Revolution in 1979.
However, if one ignores all that for a second, there is a clear correlation with inflation. Prices rose dramatically during the 1970s, and fell back after 1980 when inflation started to recede.
And here’s a thought – what if inflation can be thought of as a cause of those things?
We know from the last couple of years what rising fuel prices can do – the French Gilets Jaunes and Chilean convulsions were partly fuelled by the rising cost of fuel. Perhaps inflation drove discontent and panicked policy decisions.
It would also be remiss not to point out that there’s a chicken and egg element here too – the rising oil price was a big factor in driving inflation, as it pushed up costs for business and industries, which they duly passed on to consumers.
An investor with exposure to upside gains from the oil price (even just through energy stocks) would have had a welcome inflation hedge during the period.
Inflation, as we know, steals from savers and gives to debtors, or put another way, it steals from the elderly and gives to the young.
But if oil and gas as key commodities in determining household spending (petrol and home heating) each month go up and up faster than wages or bank rates can keep up, expect more convulsions.
For the oil and gas majors, inflation can be mitigated as a risk more than many companies. But this may not be the best thing for society…
All this feeds into my view that coronavirus is ushering in a new regime.
As you know, I believe that most equity markets, especially in the US, are even more overvalued than they were before the pandemic and lockdowns. I also think that inflation has reached a turning point and will begin its own “long march”.
The transition in the energy system is the third huge shift I see going on.
In the early days of the pandemic, everyone was saying that the oil shock and the market crash spelled bad news for the transition, for renewables and for clean tech.
James Allen, my boss and investment director of our Exponential Energy Fortunes service, immediately disagreed.
He said, and he’s been proven right, that the virus will accelerate the shift. That governments will turn to the transition for help in creating jobs, companies, and industries.
We are seeing this with the EU bailout package which has run into overtime this very morning – as they try to agree on how to allocate the roughly €750bn they are trying to spend.
In order to learn about this new paradigm, and where investors should be refocusing their risk-adjusted lenses, James has organised (and I have hosted!) another online energy investing summit.
One of our guests is very concerned that a huge and popular global movement is risking the kind oil price spikes that drove inflation wild in the 1970s, which is particularly interesting given today’s topic.
It’s up to date, it’s post-corona, it’s going to help you to understand the biggest shift of the next few decades.
From re-forestation to de-carbonisation, electrification to digitisation, I ask my esteemed guests where they see opportunity and challenge in the energy transition.
Join us by clicking this link to sign up.
It’s absolutely free and it’s going live next week, so there’s no time to waste.
See you there,
Editor, UK Uncensored