On the Money

 

Understanding Energy: Inflation, independence and the global supply-demand picture

May 26, 2022

Vice President & Portfolio Manager Jennifer Stevenson shares her perspective on how the dynamics in energy markets have changed in 2022 given the war in Ukraine and the associated sanctions, as well as the push for energy independence and the integration of renewable energy.

PARTICIPANTS

Mark Brisley
Managing Director and Head of Dynamic Funds

Jennifer Stevenson
Vice President and Portfolio Manager

PRESENTATION

Mark Brisley: You are tuning in to On the Money with Dynamic Funds, a podcast series that delivers access to some of the industry's most experienced active managers and thought leaders. We're sitting down to ask them the pertinent questions to find out their insights on the market environment and navigating the investment landscape. Welcome to another edition of On the Money. I'm your host, Mark Brisley.

Last time I spoke with Portfolio Manager Jennifer Stevens said on this podcast, back in October of 2021, "We were emerging out of the pandemic being our singular daily focus. Our attention now focuses squarely on what the recovery of the global community would look like." Fast forward to today, and recovery likely sounds to many of you as overly optimistic. We all know the topics leading the headlines, highest inflation in 40 years, rising rates, hawkish central banking policies, geopolitical turmoil, the list could go on.

With respect to inflation, recent economic data indicates that a case could be made that inflation is not going away anytime soon. For relevance to today's conversation, the correlation between energy prices and inflation is indisputable. The sustained rising rate environment could, in theory, prop up oil prices for the foreseeable future in energy stocks and other commodity-sensitive sectors could potentially lead the market for an extended period just as big tech did for the past decade.

On one hand, as long as oil prices remain relatively high, from an investor perspective, that bodes well for the performance of major oil producers, drillers, and other companies with exposure to the sector. On the other hand, and I'm sure to most of our listeners, this environment or the real economy is tangibly felt by all of us as consumers. Higher energy prices have a knock-on effect throughout the economy. It pushes up prices for other goods and it rattles consumer sentiment and can absolutely have multiple effects on inflation both directly and indirectly.

I'm glad to have Jennifer Stevens sit back with us today to unpack a whole host of these issues and discuss the opportunities in the energy sector at the investment level. Jennifer is based in the heart of the Canadian energy industry in Calgary, which makes her close to the company she covers and is regularly on the ground in other major global energy hubs. Her extensive energy industry experience spans nearly three decades and always brings the energy discussion into real and understandable terms. Jen, it's great to have you with us today.

Jennifer Stevenson: Great to be back with you, Mark.

Mark Brisley: We know things went a direction we weren't expecting in Europe with the conflict in Ukraine. Before that, we were already talking about high oil and natural gas prices, but this has obviously upended the global energy market. Can we get you to take us just a level deeper than the headlines and talk about how this is affecting, overall, the supply dynamics?

Jennifer Stevenson: There's a lot behind the headlines. I think it's important to just put into perspective how we got to where we were before the Ukrainian invasion and then we can talk about how we're going through that. If we think about where we were before that, demand for energy was rising because we were recovering from the pandemic. We were drawing down inventories of natural gas and oil and refined products. Not so much jet fuel because we weren't flying around as much, but driving for gasoline, diesel to move products around and run industry. Through this period, and even leading into it, the energy industry was under-investing in supply.

You put demand rising, supply not rising, shown by drawing down inventories. When we talked last time, prices were firming up, and then there's the war in Ukraine. We had, for a period of time, a real fear premium in the price of oil because of how much and how quickly Russian oil supply and Russian gas supply would be curtailed. The actual Russian supply curtailment has been a bit less than the worst-case scenario than it could be, but we're not through that yet. We've got self-sanctioning companies and countries saying, "We're not taking Russian oil. We're not participating in Russian gas." That's about a million barrels a day of supply of oil that's off the market.

That's the biggest change in supply dynamics right now. We need to still keep that in mind when we look forward because there's oil still flowing out of Russia, and a lot of that is because it's under contract. The companies or the countries that have contracts are still under that jurisdiction, but as those contracts come up for renewal, then they can be terminated. The risk is that we see continued reduction of the exports of oil from Russia. That will continue to change our supply dynamic from the Russian side.

Then we are still looking at, we've had this structural underinvestment in oil supplies so that we don't have growth in oil supplies. Every month OPEC meets and every month they've been increasing supply by 400,000 barrels a day. That's the deal that they cut over a year ago and yet, if we look at where they should be producing and where they are producing, they're actually under that level because they just don't have the ability to add it. We've got low spare capacity. We don't have growth coming from the US shale reservoirs, inventories are low and the Russia situation is not easing. The supply dynamics, this is a long answer to your question, but there's so much going on. the supply dynamics continue to be tight.

Mark Brisley: Would that become more complicated in a bit of the recency effect here because today I was reading there's legislation being proposed out of the US around, I guess what they're calling NOPEC.

Jennifer Stevenson: NOPEC.

Mark Brisley: Is that going to complicate matters even worse if that goes through?

Jennifer Stevenson: Absolutely, yes. It makes me scratch my head truly because on one side of their mouth, the US administration is ostensibly calling up Saudi Arabia and said, "Please produce as much as you can. Then on the other side of their mouth, they're saying, "Yes, but we are going to impose legislation that makes it something that's either sanctionable or punishable by lack of ability to access, say, US capital markets or US financial system if you operate as a cartel." That's what the NOPEC legislation would do. You can't have it both ways. It's completely nuts.

Mark Brisley: Let's get to what probably a lot of our listeners are thinking about and only thinking about, which is inflation, the topic of the moment. There's no question. The surge in gas price has been a major contributor here. I think a lot of people have learned the correlation between the two. Is there reprieve on the horizon? What are we looking at here?

Jennifer Stevenson: It's really important to think really broadly about inflation. We all feel it. It's not just when you go to the gas pump, but you go to the grocery store and it's not that fun. You go to Staples and it's not that fun because everything we're used to needing or buying, the prices have gone up. When you think about what's causing that, it's not just high oil prices.

The other thing that's tight that is causing prices to be high is refined products. If you hear people like me talk about something called distillate, that's a part of the barrel, and the refineries make distillate and what distillate is, is things like diesel and jet fuel. The diesel, that's what drives the economy. That's trucking, its industry. It's all of that. In addition to the supply dynamics on oil and distillate comes from oil, but in addition to that, we entered the pandemic with low inventories of distillate.

We've been in an environment over the past few years where unprofitable refineries have been either closed or turned into refineries that make renewable diesel, which is a completely different price point, very high in demand, but a different price point. In addition to the high feed stock or oil price, we've got tight supplies for diesel and that is really driving the price of diesel and that filters into so many different levels of the economy.

Everything in your kitchen, everything in your house gets touched by something to do with a petroleum product, whether it's logistics or a component. Your corn flakes, you've got to grow the crops, manufacture the product, haul the product, and that demand is very sticky. The economic term for it would be inelastic. It doesn't move that much with the price, but those prices will flow down to the consumer. What's the reprieve? How do we ease this?

Some of the levers that have been pulled already would be adding more oil supply to the market. We already talked about, we're not drilling more, so that supply growth is really modest. OPEC keeps adding supply, they can't meet those numbers, so that's really modest. The US and other members of the EIA, the group of oil-producing and consuming nations globally, have released oil reserves from their strategic petroleum reserves and the US released a lot.

It's happening over time, it's about a million barrels a day for six months. That takes the US down to the minimum that they're allowed to hold in SPR, Strategic Petroleum Reserves, under the EIA framework. That's been done, and that's really the only reprieve on the horizon, and it's underway already now, and oil is still over 100 bucks.

The next reprieve will be coming from demand, which means prices need to be high enough for long enough that demand changes. That's why people start to talk about recessions versus the way I look at it is it's more just cooling off because we've had this confluence of events that have made the energy market really tight for this period of time right now.

Mark Brisley: That's interesting because I'm sure, for a lot of people listening, they equate energy wit, filling up their cars and home heating bills. You just said higher food production costs. Food is, you need fertilizer, you need nitrogen fertilizer, and that's made from potash and natural gas, and that's now in short supply. It's fair to say that those contributors are-- people have to be thinking about this.

Jennifer Stevenson: There is no substitute in the petrochemical market for oil inputs. Anything that has to do with plastic of any sort, whether it's your saran wrap in your kitchen or the tube you squeeze your toothpaste out of, or the paint in your house, the list is so long. Those feedstocks, those inputs, those petroleum products, those prices are higher, so the cost of those goods is higher.

Mark Brisley: You are a professional investor, and so as a result of a lot of this, oil companies have been a standout area of the market in 2022 with these rising prices. You were a big proponent of the fundamental backdrop heading into this year, and it's only become more favorable. What's your outlook then on this space as an investor and what's your view of the stocks right now in terms of how they look, expensive after this recent run or about where you expect?

Jennifer Stevenson: After this run and taking into consideration the supply-demand fundamentals on oil. We're not pricing in and the market's not pricing in 100 bucks for oil into the stocks, the market's not even pricing in 80 bucks into the stocks. If you want to buy oil in December 2024, the futures contract is $82, but the stocks are pricing in somewhere $68, $70. The stocks in my view, given what we're seeing for the supply, demand, and price backdrop in oil are really attractively valued.

The other thing, as an investor, that we find attractive is that the companies have been so focused through the recovery on, first of all, making sure their balance sheets are robust, so the companies are all extremely healthy. Then secondly, focusing on shareholder returns. These companies are buying back their stock and paying out dividends either in the form of base dividends, or variable dividends. The reason they're variable is they just vary by how much free cashflow the company has, so it's tied to commodity prices. The payouts to shareholders are really, really attractive. That combined with the valuation of the stock, supported by the outlook on the supply-demand fundamentals, we just find a lot of really attractive, high-quality names to own.

Mark Brisley: The discussion on energy independence is pretty pervasive. What does that look like, or what does that really mean when we talking about energy independence with respect to North America and Europe and what kind of investment opportunities would maybe be a result of that if it transpires?

Jennifer Stevenson: Yes, energy independence definitely is a focus and security of supply is also a focus because, in the case of Europe, they were not independent for energy. They never have been, but they had supply because they had supply on the gas side coming in from the North Sea, from Russia. Oil, they have it coming in from the Middle East, from Russia, and then Russia becomes someone that you are unable and unwilling to deal with. All of a sudden, your security of supply is completely called into question. That's turned the whole sector on its head for Europe.

North America is in a much better situation, because when you combine gas and oil for North America, North America has enough energy to supply itself. There's regional supply and demand and logistics issues like there is with any kind of product, but the U.S will import Kenyan gas on pipelines, U.S gas is exported as LNG, which is liquefied natural gas, so it goes in a boat. U.S will export U.S and Canadian gas through pipes to Mexico.

That moves around but when you do the math, we produce enough natural gas and we produce enough oil in North America to feed our needs. Oil is fungible, and it moves around the world not just to meet demand, but also to make sure that it's used in the most economically beneficial way possible because oil is something that's produced in different qualities. There's more or less Sulphur in it. It's gooey or lighter, so it looks more like molasses, or it looks more like maple syrup, or it looks more like gasoline.

That's important because, for example, the U.S refineries along the Gulf Coast are built to run what we call heavy oil. Think of oil that looks more like molasses than gasoline. When I say they're built to run that way, they make the best suite of products from that kind of oil. That oil they get from Canada, they used to get some from Venezuela, they still get some from Mexico, they used to get some from Iran, and the U.S produces lots of shale oil, but that's light oil. That oil is actually more economic to run in a refinery in places like China.

The oil moves around the world. If everything shut down tomorrow, the U.S and Canada have enough energy to meet demand but we're making more efficient use of it by putting the best product into the best refinery. The U.S inventories are low versus demand, global inventories are low versus demand, production is not growing very much. That's a situation that we're dealing with and that's why prices are strong, but we can at least move the oil around and get it to the best use situation.

Natural gas is more of an issue. In Europe it's more of an issue because so much of their natural gas comes from Russia and comes on a pipeline. Even though you read in the paper that U.S. politicians are jumping up and down saying, "Yes, we'll send you more LNG," well, that's really swell. There's two problems with that. First of all, is the LNG so liquefied natural gas facilities in the United States that are able to take natural gas that is a gas and cool it and condensed it into a liquid and put it on a ship and send it around the world.

Those facilities are running flat out, as you would expect, because prices of natural gas in the United States are multiples lower than prices of natural gas in Europe. You can make a lot of money, even though it costs money to liquefy and transport, you can make a lot of money doing that, but those facilities are running flat out. There's facilities that are being built that are coming online, including one on the west coast of Canada, but they're coming online in 2024, 2025, 2026. That's going to take some time.

Similarly, because Europe is more set up to receive their gas in a pipeline, they don't have the facilities to receive the liquefied gas. We need to build regasification facilities to warm the gas back up so it turns from a liquid back into a gas so then we can put it in the pipelines and get it to homes and businesses. All of that takes money and takes time. Europe is in a much more difficult position. They are buying as much liquefied natural gas as they can process and use. That means that other areas that we're buying that liquefied natural gas aren't, so Europe has to compete on price, which is why the gas prices in Europe are so much higher than anywhere else in the world, especially in places like North America where we have enough production domestically that we're able to export.

There are certainly lots of investment opportunities not just in the growth in demand and transport for hydrocarbons, including lots of natural gas and the liquefaction of that natural gas, but also for Europe investment in renewables because Europe is in an energy crisis even now and they're looking at just making sure that they expand all forms of energy generation to meet their demand in the face of Russia not being saying it's available to them in the future, period.

Mark Brisley: One question I get quite a bit is, does the retail consumer have much impact on demand? Does that have any concern from your perspective as an investor? I say that, and I don't mean to use humor for this, but I was literally reading a survey from the Tire and Rubber Association of Canada. Yes, that's an actual entity. WHO did a survey and said, 66% of Canadians they surveyed are going to limit or cancel trips and travel as a result of prices. That number climbs even higher in certain age demographics. Does that really impact your thinking or the overall demand picture?

Jennifer Stevenson: What we find in normal times with demand and prices of petroleum products is the price has to be so high for so long that then it causes a change in behavior. I see in normal times that the post-pandemic I think is a bit of a different mindset because I do think that gasoline prices in Canada are expensive compared to what we're used to. Yet are enough family going to cancel their summer holidays now that they can actually go take one, or will they make sacrifices in other areas? Not to use humor in a bad situation again, but people were poking fun.

The Japanese government came out the other day and said, "Okay, consumers, can you please turn off the heating element on your toilets?" Because Japan have wonderful toilet facilities and they're heated seats and people go, "Oh, well, that won't do anything." At least it's something. We could all be turning down our thermostats. We could be making a choice to not drive somewhere and that sort of thing. The prices have to be high enough for long enough for it to affect behavior. It's pretty sticky, that demand, because it impacts so many things. I think it's going to be stickier because we're still coming out of the pandemic and there's pent-up demand to fly and drive places.

Mark Brisley: I don't know if I have a natural segue here to move from heated toilet to renewables. However, I'm going to go there anyway, which is another accelerant that has come out of the pandemic and through what we’re going through now. Further acceleration, they're becoming an interesting part of the overall energy story. You've talked about the mass of runway for growth and a focus area for government policy. We all know about Biden's infrastructure bill and how much that was going to be a part of it. Which areas of renewable energy though stand to benefit the most as the urgency for energy independence quickens in adoption?

Jennifer Stevenson: The areas that are really exciting are wind and solar because it's already being used today. We're not looking at new technology. The technology continues to change and improve and adapt but we use wind and solar on a utility-scale already. There's developments in the wind business where the wind turbines are being placed offshore. The benefit of that is that people complain less because there's not wind turbines in their backyard.

On the east coast of the United States, there's been big offshore wind leases. Companies have paid money to lease the seabed rights to install wind turbines, so those are happening. It's happening in Europe. The North Sea is a spectacularly windy place. You can actually see the impact it has on Europe if they go through a period of a few weeks where the wind is less strong than normal because you see that generation from wind go down and they need to call on other sources. There's lots of opportunities on the wind side.

On the solar side, the big opportunity is on residential solar. It's being used in Europe and in the States onn ew developments. Housing builders are putting the houses already with the solar panels with the batteries in the house already. The adoption rate of consumers, especially in Europe, and again in the US, of putting solar panels on their roof and getting themselves to have energy security and energy independence from the grid by having solar panels on their roof, a battery in the garage so that they can use the solar fuel and charge up the battery so that they've got electricity when it's not sunny.

Mark Brisley: The other thing too is, and you talked about this, when you're thinking about renewable, people will often compare that to the hydrocarbon side of the equation. There seems to be a gap between the performance of hydrocarbon companies and renewable energy companies, in particular, this year. With renewables having such great growth prospects, as you say, why are they lagging on the investment side to the hydrocarbon companies?

Jennifer Stevenson: That's key. The renewable companies had a big run when they were accelerated by the excitement when Biden was campaigning and got into office and the Build Back Better Bill. The market treated them almost like technology stocks because they are such high growth. Then when you saw a sector rotation away from technology stocks, the renewable companies, a lot of them got caught up in that, which is unfair because they have a completely separate tailwind from the technology sector because wind turbine companies, hydrogen fuel cell companies, battery storage companies, residential solar companies are driven by this global need for more energy and for energy that will assist the world to meet a reduction in carbon goals and help us with the climate.

They're starting to segregate themselves now from technology, not every day, but most of the time. We're looking at the outlook for these companies now and thinking that their valuation is certainly attractive and really like what these companies are doing because they were able to pass through their price increases. They have such huge growth rates that they had pre-ordered components and pre-planned for the growth. They're quite insulated from these logistical and labor and other challenges that other industries are facing. They're in a really good position right now.

Mark Brisley: I'm sure a lot of people listening, and we're inundated with the commercials now. There isn't a car manufacturer that isn't talking about going electric. I know electric vehicles or what we call the EV space isn't an area that you've been a big investor in, but do you consider electric vehicles or EVs, is that an energy play or something else from an investment perspective?

Jennifer Stevenson: Electric vehicles are a growth area, for sure, but we're not interested in buying the car manufacturers, but we are certainly interested in and invested in the companies that are making electrification of mobility happen. Either the companies that are making the batteries that you can install in your house to charge your EV, the companies that are setting up the EV charging stations down the road, whether it's at a gas station or at a grocery store or at a shopping mall or along the highway because this is certainly an area of growth.

I think you'll see the adoption rate of electric vehicles improve now that the car manufacturers are really rolling out the selection for the consumer. The more those vehicles are not something that the consumer has to change their habits to own and get used to driving, et cetera, I think the better the adoption rate will be. We're invested in what feeds into that car business as opposed to the car business itself because that's a whole other world, the car manufacturing business.

Mark Brisley: Jen, I wish we could keep going and we could. This has been insightful, and like you said, there's a lot to unpack, but maybe one final question and I'm going to tap into your decades of experience in the energy space.

If one of our listeners was to Google energy crisis, it's staggering that I think for a lot of us we would think of the 1970s or maybe 1990, the Gulf War, but it's unbelievable what is considered to be an energy crisis over history, and how many there have been or impacts on the energy sector. What do you consider this to be right now? Is this a, we've seen this movie before, or it's different this time, and what's your advice to someone who's a little more rattled about what we're going through right now?

Jennifer Stevenson: This is an energy crisis for some people, and I'm thinking of people in some parts of Europe that are certainly at risk of shortages of whether it's natural gas or diesel at certain times of the year. I do think that governments are acutely aware of this, and are doing everything they can to prevent that, but it's definitely a worry in certain parts of the world.

The cessation of what is a material exporter, in the case of Russia, is an impact. It's not as material as the Gulf War was, or the Arab oil embargo was as far as the percentage of current production, but when inventories are low, supply growth is low, demand is strong, anything even at the margin, even a million barrels a day from Russia has an impact on price.

These prices are legitimate. I think the $100 we're at, that to me is more fundamental. The $125 we were briefly at, that had a level of fear mixed into it. Calling this an energy crisis, from a hydrocarbon standpoint, I think in the near term it's more of a crunch because the natural gas supplies in a couple of years will be able to get where they're needed because we will have finished building out the liquefaction projects in places like Qatar, or Qatar as some people pronounce it, and the US and Canada, for example, and there's also, Nigeria has got some big projects going on. That will help.

The oil production is going to stay tight, but it's not that it doesn't grow. It's just the companies are very prudent about use of capital and shareholder returns and making sure that they're not investing too much today in long-dated resource given that we are in the midst of an energy transition over the next several decades. I think right now it's fair to say it's an energy crunch, but I don't see us reverting back to pricing like we saw in the good old days, say pre-pandemic, just because of where we are on supply, demand, and inventories today and going forward.

Mark Brisley: Jen has always great insights and a lot for us to think about. Really appreciate you being here and look forward to you joining us at On the Money again soon.

Jennifer Stevenson: Thanks so much.

Mark Brisley: To all of our listeners today, thank you for joining us. You can find all of the editions On the Money on both Apple and Spotify, as well as on our webpage at dynamic.ca in the Insights section, where you'll find more podcasts that are relevant to the environment we find ourselves in, plus a lot more. Thank you once again for joining us. You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic and our complete fund lineup, contact your financial advisor or visit our website dynamic.ca.

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