Inflation, Horsepower and Cowboys
October 13, 2021
Chief Asset Management Officer at BlueOrange Bank
Invest in inflation. It’s the only thing that goes up. – Will Rogers (cowboy)
If you own a car, or have ever thought of owning a car, you will have probably spent some time thinking about horsepower (zirgspēks). If so, then you probably know that horsepower is how we measure the power of a car’s engine. By definition, ‘horsepower’ is the power needed to move 550 pounds by one foot in one second or by the power needed to move 33,000 pounds one foot in one minute. This calculation was created over 300 years ago at the dawn of the industrial revolution as human ingenuity created, then massively improved the steam engines that replaced the heavy work done by horses.
A 2022 BMW 3-series has 255 horsepower. The M340i produces 385 ‘ponies’. Imagine what it would take to feed and take care of that many horses? You would literally have to source tons of hay, not to mention provide space for them to roam, and do whatever else well fed horses do - all so that you could have the capacity to harness the power of over 200 horses whenever you so choose. The capacity for such tremendous power can all be put in a beautiful, comfortable package due the phenomenal energy density of refined crude oil and the internal combustion engine. At least it used to be. Through innovations in electric vehicle technology we have now found a way to put the same amount of energy into car batteries that can generate just as much if not more horsepower than traditional internal combustion engines. Incredible stuff. But where do we get the energy to load such batteries? That’s where things get a little bit more complicated.
The simple answer is that electricity comes from an electric grid that collects and distributes power generated from a number of sources. But how is this electricity generated? In the EU in 2019, 39% of electricity consumed came from power stations burning fossil fuels (mostly coal and natural gas) and 35% from renewable energy sources, while 26% came from nuclear power plants.
There has been steady progress in terms of increasing renewable energy generating capacity, but it is simply not happening quickly enough. The energy equation becomes more staggering when you consider that electricity generated from power plants is only 21% of Europe’s energy consumption, while ‘Total Petroleum products’ come in at 41% and Natural Gas is 21%.
Therefore, not only is over 60% of the energy we consume in Europe derived from fossil fuels, but so too is just under 40% of our electricity, which means that 70% of the fuel that powers our economic prosperity is carbon emitting. This leads to two conclusions: 1) we need to build out far greater renewable energy capacity, 2) we have to continue to invest in sourcing hydrocarbons in the most responsible way possible until our renewable energy capacity is built out.
If you have trouble considering the logistics of taking care of 285 horses, consider the challenge of generating the 2.9 million gigawatts on electricity that Europe currently consumes annually. One horsepower is the equivalent of 745 watts. 1 billion watts are a gigawatt or 1 342 000 units of horsepower. Or 3.125 million solar panels. Or 364 utility-scale wind turbines. And remember, electricity generation is only 20% of our total energy use. Multiply these figures by 3 if you want to replace all fossil fuels. That is a lot of horses.
The reconfiguring our energy consumption and electricity generation is amongst the foremost and most necessary challenges of our lifetimes, but this transition has several perils and we are not keeping pace with the second necessity: sourcing responsible hydrocarbons. A lack of supply leads to higher prices when demand exceeds supply.
Consequently, since the start of the year electricity prices in Europe have increased dramatically.
In August alone, the Eurozone consumer price index for energy rose over 15% on an annualized basis. This is turn contributed to the Eurozone’s headline inflation of 3%. Even though Europe has a stated inflation goal of 2% annually, more expensive energy inputs are purely a tax on consumers and energy spending is around 10% of household budgets. The more consumers are taxed, the less they can spend, and this could derail Europe’s economic recovery. Previously, higher hydrocarbon prices would incentivize exploration and production increases that would lead to lower prices, but Europe’s oil and gas companies have been under severe pressure to become ‘energy companies’ and invest in renewables rather than grow their hydrocarbon businesses. The move to investing in renewables is commendable and necessary, but we are just not there yet in terms of matching supply and demand.
Too bad. The oil era has passed! On to greener pastures! Not so fast.
In Spain, high electricity prices due to rising natural gas prices have already led to government intervention. Socialist Prime Minister Pedro Sanchez leads a minority left-wing coalition that enacted emergency measures to help poorer families that cannot pay their bills by extending grace periods before power can be cut off. Spain’s government also intends to take 650 million euros of “extraordinary profits” from energy companies and “redirect” them to consumers. Without delving into Spanish politics or their utility business, taking profits from energy companies does not tend to incentivize investment to create more robust and diversified energy supply. If fact, Spain’s nuclear power producers threatened to suspend operations in response to the government’s emergency profit redirection measures.
The economic engine of Europe is Germany, whose economy is heavily reliant on manufacturing and exports. Energy prices are a significant factor input into manufacturing which means that higher energy prices would hit profits or even render production unprofitable, thus incentivizing production shut downs. This would severely threaten Europe’s economic recovery and potentially alter its political course. Higher energy prices also make transporting goods for export more expensive, thus diminishing export competitiveness on the global market.
What makes this whole situation all the more difficult to resolve is that global supply chains are still recovering from the Covid-19 related production shutdowns and subsequent demand shock. In mid-September, delivery and logistics expert UPS stated that they anticipate that supply chains will be no less disrupted in 2022 than they were this year. This dynamic also poses massive challenges to manufacturers as it not only impacts how quickly you can produce a given good, but how long it takes to deliver it to the end consumer. How can you build out renewable energy capacity when critical components are still awaiting delivery or are stuck in transit? For instance, in August, Volkswagen, an automobile manufacturer that is making a massive wager on electric vehicles stated that it might have to cut production due to semiconductor chip shortages.
So what is the individual investor to do? Faced with increasing inflation due to higher energy costs, negative rates and a potential deceleration in global growth, there is one sector that still offers considerable horsepower in terms of potential investment returns: North American oil and gas producers.
Since October 1, 2020, the EuroStoxx 600 index has gained 31% (up to September 17th), while the MSCI Europe Energy Sector Index has a total return of 58% - almost double the EuroStoxx 600. Over that same time frame, the price of Brent Crude has increased by 84% and the price of Natural Gas has increased by 102%. However, North American oil and gas producers generated total returns of around 120% (the US Oil and Gas Producers ETF = +119% euro equivalent total return; the Canadian S&P/TSX Capped Energy Index ETF = +122% euro equivalent total return).
The downdraft in oil prices during the Covid-19 crisis threatened the solvency of many North American oil and gas producers. Although these ETFs have more than doubled in value over the past year or so, they are still rising from a very modest base and their component companies are set to report spectacular earnings over the next several quarters. Moreover, many of these companies operate exclusively in North America and are thus extremely low risk from a geopolitical perspective. Many are also embracing the challenge of reducing as much carbon as possible in their operations.
The future on energy is in renewables, but energy prices will most likely continue to rise as we navigate the transition away from hydrocarbons. If you believe that our demand for horsepower will persist or even grow, it might just be time to invest in the North American oil and gas ‘cowboys’.
The Latvian version of this article originally appeared in the October 2021 issue of Forbes Latvia.