Is Energy Inflation Tamed?

Spot WTI crude prices are down about 29% from the Ukraine Invasion peak back in March. Retail gasoline prices have come down about 25% from the peak earlier this year and diesel prices are down almost 13% from the peak. Those are all very meaningful declines, but all three are still quite elevated from a year ago, so we are not out of the woods yet, but we can’t deny that the current trend is encouraging. The question is will it continue?

There is no shortage of reasons for the price of crude oil and oil-based fuels to decline.

Russia has been more successful than expected in selling their oil despite Western sanctions.
China’s Zero Covid policy continues to shut down sections of the country, interrupting production and therefore limiting oil demand.
The Strategic Petroleum Reserve (SPR) has supplied almost 179 million bbls of oil since last year with 107 million bbls coming since the end of April. (See chart below).
Fears of a recession, which would reduce oil demand, have kept a lid on futures prices.
And we are driving a little less, reducing overall demand.

But there are also plenty of reasons to think that we might simply be in a lull and prices are poised to shoot higher.

The severe energy shortage in Europe will need to be at least partially filled by replacing natural gas with oil and coal. Any exports from the U.S. simply make oil less available here at home at the margin.
The SPR is a finite source of supply: The SPR has drained 29% of the total oil reserves over the last year and the SPR is now at levels last seen in 1984. At some point, probably after the midterms, the SPR will cease to be a source of supply and could become a source of new demand as it needs to be re-filled.
At some point, China will abandon the Zero Covid policy and reopen their economy fully, returning their oil demand back to more normal levels.
OPEC+ is already discussing cuts to production due to the recent price decline. It would appear that OPEC has a $90-$100 market price in mind and is willing to act to move prices in that direction.

In our view, oil prices are unlikely to return to the levels of several years ago and what we are experiencing now might be as good as it gets. The main reason that we could be wrong would be a severe policy error by the Fed, sending the U.S. into a nasty recession. Under those circumstances, lower oil prices are certainly possible.

Nonetheless, oil inflation might still be tamed. Prices need to rise on a consistent basis to have inflation. If next year’s prices are the same as today, oil inflation is back to zero. Our conclusion is that oil inflation might be tamed, but don’t expect prices to return to the levels of several years ago.

What About Natural Gas?

Natural gas is a different problem altogether. After many years of natural gas being priced at about $2-$3/MMBTU, current prices remain very elevated at $8+/MMBTU. With natural gas prices in Europe significantly higher than the U.S., the lure of export is overwhelming and LNG providers are falling over themselves to ship to Europe to get those high prices. That has kept gas supplies relatively low here in the U.S. The Freeport LNG terminal, which had an explosion and fire back in June, is not expected back at full operation until March 2023. That facility accounts for about 15% of U.S. gas exports, so having that facility idled will limit exports in the near term and therefore tend to moderate upward pressure on U.S. natural gas prices. Nonetheless, as we approach the end of the injection season, gas storage remains near the low seen over the last five years with the winter withdrawal season rapidly approaching. (See chart below).

Europe, of course, has been effectively cut off from Russian natural gas and prices look to remain very high for some time to come. It seems very clear to us that Europe has no intention of returning to Russia for their energy needs, even if peace were to suddenly break out in Ukraine. It then seems very likely that Europe will be looking to import gas and the U.S. is already the major exporter of gas. Over the intermediate term, that should keep upward pressure on gas prices in the U.S., especially as additional LNG capacity comes on stream over the next few years (see chart below).

It will take some time for Europe to adjust to the elimination of Russian natural gas, and until that is complete, there should be plenty of upward pressure on U.S. prices. The big question here is whether the U.S. energy industry can and will respond. Policy has been a serious obstacle to increasing production in the U.S. and we believe it will require a more accommodative shift in policy to get U.S. production substantially higher.