Andrew Pyle
October 15, 2021
Forecasting the energy patch is like forecasting the winter
Headlines have been filled with worries about rising energy prices, from what we pay at the pump to what it is going to cost to heat our homes. In a resource-rich country like ours, these worries are not as intense as those being felt in regions like Europe, but they are resonating with households. In talking to clients, there is definitely a concern as to how these higher prices will impact their household budgets and their investment portfolios. To answer these concerns, we need to step back and look at what factors are at play and how long they are expected to play out.
This week, Brent crude oil futures broke above $85/barrel for the first time in three years. It is truly amazing that only 1-1/2 years ago, we were talking about the collapse in prices and, for some contracts, the temporary move into negative territory. From the low in April 2020, futures have rallied close to 340% and returning to that October 2018 high is going to reinforce the view held by some, that oil is going to reach $100 before it is all said and done.
The spike has not been driven by perceptions of peak oil supply, as we saw in 2007, but simply an expected surge in demand for oil in some parts of the northern hemisphere should the winter turn out to be a cold one. Depending on the region, home and business heating will rely on natural gas, electricity or fuel oil. In the case of Europe, natural gas is the prominent source of energy for heating and much of this is sourced from Russia. Some of this heating will come directly from gas or heating oil (as with a furnace), while others will use radiators that are either run independently in the home or business on electricity, or received heated water from a central location. At the end of the day, if there is a shortage of gas or oil, then the price of heating will go up.
Markets operate on the basis of expectation. Temperatures in Europe, Canada and the northern US are quite fine still. If anything, some may still have air conditioners going. However, three months from now is a different story and the more market participants talk up a cold winter, the more demand for future delivery of energy products goes up. Since the market rarely gets financial indicator forecasts correct, to say nothing of weather, it has to rely on climatologists.
I won’t get into a lot of detail as to the various long-range models that are used to predict weather patterns in the North Hemispher, but one of the key factors coming out of late last year and into this year has been a stronger La Nina effect, which basically means that trade winds across the pacific have been stronger than usual, bringing colder waters to the surface of the Pacific ocean. This will tend to produce colder temperatures in Canada and the northern US, but it doesn’t have a direct influence on what will happen in Europe. That is because there are Atlantic weather influences that will often dominate what takes place in the Pacific.
One of the more reliable long-range models is referred to as ECMWF (European Centre for Medium-Range Weather Forecasts) and the current projections actually suggest that Europe will see warmer than average temperatures this winter. These projections will change (likely become colder) as we move into the winter, but nothing suggests such a deviation from normal that it creates a massive crisis. The stronger La Nina effect is expected to subside by the spring, but this will only matter in terms of next year’s winter projections.
I wouldn’t want to dismiss the concerns about a frigid winter outright, but investors need to be wary of forecasts of a continued rally in oil and gas prices because, if this does turn out to be an okay winter, the current demand-supply imbalance could quickly unwind. This could also cut short the recent rally in energy stocks. As you can see from the chart, the S&P500 energy sub-group has almost returned to its January 2020 peak just north of 450. The TSX energy index actually broke above its January 2020 high this week and is trading at its best level since April 2019. In doing so, it has broken above trendline resistance from its 2017 peak.
Some analysts look at the fact that energy stocks and price of crude have marched in sync all year and that, if crude oil futures were to head to $100, this would allow for another 20% upside in stocks. I believe that is a bold projection, as we are still debating the effects on global economic growth from supply constraints, higher input costs and potential normalization in Fed policy. It’s interesting to note that demands for OPEC+ nations to increase their production of oil on top of the announced lift in July, have so far fallen on deaf ears. This is because OPEC believes demand is going to slow in 2022 and that the tightness in supply will alleviate on its own. If they are right, there is one reason not to get overly bullish on crude or the energy patch right now.
Good news!
The Pyle Group will be resuming its monthly conference calls, starting next Wednesday at 7:00 pm. Similar to our calls in the past, participants can ask questions during the call or email their questions to Ally (alexandra.pyle@cibc.com) or myself (andrew.pyle@cibc.com) prior to or during the call. Call details are listed below:
Toll-free dial-in (Canada and the US): 1 800 806-5484
Local dial-in number: 1 416-340-2217
Participant passcode: 1691743#
On behalf of the Pyle Group, have a great weekend
Andrew Pyle