There’s a ton of focus in financial media about how high energy prices will go, or how low they will fall. However, I think a lesser-understood aspect of this current energy and inflation problem relates to time.

The Integral of Energy Prices

One reason I’ve been structurally bullish on energy stocks is that oil and gas prices don’t even have to keep going up for them to be super profitable from current levels. If oil and gas prices merely chop around sideways from here for a long time, energy producers would be in great shape financially . The same is true for midstream energy transporters. For an illustration of that, this is energy producer EOG’s free cash flow and net debt charts, and it shows how troubling the prior decade was for them, and how profitable the current period is for them.

The red area represents negative free cash flow, and the green area represents positive free cash flow. During the red period of time, the company were aggressively spending on new production that was not particularly profitable, while issuing debt to do so, which investors were happy to finance. The past decade was quite an anomaly where investors and companies were willing to give consumers oil at structurally unprofitable levels, but that era is behind us now. This naturally has inverse implications for the typical consumer of energy.

Suppose that crude oil, natural gas, and gasoline prices double tomorrow for a couple weeks and then quickly come back down.

Oil and the American Consumer

As I write this, WTI crude oil is over $100 per barrel. This is despite the US Strategic Petroleum Reserve actively selling oil into the market to try to suppress prices, and this is despite China still doing partial lockdowns and thus using an unusually low amount of jet fuel and other types of fuels on an ongoing basis. natural gas prices of $4.64 per thousand cubic feet in 2022 and $3.88 in 2023.

Many analysts are modeling for oil to return to low prices and remain there, both explicitly when analyzing energy companies, and implicitly when analyzing non-energy companies. During periods of structural undersupply, prices go up and attract new production and transport capacity, and the big projects take years to fully come online. Eventually, the industry overbuilds, resulting in a structural period of oversupply, low prices, and subsequently little new investment for a long time. It takes years of grinding through that oversupplied period to start causing a period of undersupply again.

Existing wells start to dwindle, emerging markets keep up ticking their energy usage, and eventually we get to the next cycle of undersupply, which I think we’re in now. With the combination of persistent currency debasement and these cyclical commodity capex cycles, we get a big stepwise permanent change to a «new normal» of oil prices every once in a while. After a steady period in the postwar 1950s and 1960s, the 1970s saw a big stepwise change to permanently higher levels, as US oil production reached a structural peak and as the US went off the gold standard. The 1980s and 1990s saw another steady period as the supply problem was alleviated at this new level, but by the 2000s, a decade of currency debasement and a new period of undersupply kicked in, resulting in another boom to permanently higher levels.

The 2010s saw another steady period, and prices even briefly dipped down to the prior range during the global lockdowns of 2020 , but other than that brief time, this represented a new permanently higher range of prices. My concern, and indeed my base case, is that we’re entering a new round of price discovery to a new persistently higher level again during the 2020s decade, much like the 1970s and 2000s decades, and that a lot of things will need be re-adjusted to that new normal. When we look at the the price of oil in a unit of account that doesn’t debase much over time , we see that oil prices are pretty normal right now, right around the historic midline, and yet these price levels are causing tremendous difficulty for a lot of businesses and households.

Summary Thoughts

There are many cyclical factors that can drive energy prices higher or lower in a given year, but underlying increases in the currency supply and major production/transport capex cycles dictate where the «normal» price for energy is in any given longer-term period. The world enjoyed a multi-year period of high energy abundance, due to the sharp rise of unprofitable shale oil on top of supply/demand situation that was otherwise rather balanced, and this resulted in a significant period of oversupply. Emerging markets continue to grind higher in terms of energy demand, as they use a small but growing fraction per capita of what the developed world uses. Consumers and analysts likely have to adjust to persistently higher midline energy prices going forward, and this has implications for how we should value certain sectors compared to others.

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Source: LYN ALDEN | LYNALDEN.COM