In-depth Analysis

Energy powers the markets

Markets are being dominated by the energy story, and have been since the turn of the year. In fact, we can even look back further to November 2021 and the COP 26 climate conference in Glasgow. Then the emphasis was on decarbonisation and the move towards a sustainable future for our energy production.

Just four short months later and the focus has now switched to keeping the lights on across Europe and ending the continent’s reliance on Russian oil and gas. 

Realpolitik has replaced climate activism, as Brent crude soared by +48.54% in the last three months alone, whilst European natural gas prices went parabolic, the benchmark Dutch TTF gas price rising by +450%, over the last 52 weeks for example.

Brent crude

Even as Western governments move to isolate Russia and exit from energy supply deals, Brent crude looks to be edging higher once more. With the 20 and 50 period MA lines poised to form a golden cross, where the 20-period line crosses up through the 50-period from below, a sure sign of rising price momentum.

Oil prices have always been associated with the level of inflation in both developed and developing economies and nowhere more so than in the USA. Where oil prices not only drive current inflation levels but also future expectations about inflation among both US consumers and investors.

US consumers and businesses are already feeling angsty about the cost of filling up their vehicles, which have risen steadily and are likely to continue to do so. 

The chart below shows the change in the monthly retail price of a gallon of diesel in the US, since January 2020.

Monthly retail prices for diesel fuel in the United States from January 2020 to February 2022

Higher fuel costs, particularly that of diesel feed directly into US inflation rates. Simply because diesel is what powers the bulk of logistics and transportation in the USA, where freight and goods are moved about the country by truck or train. 

Shippers and delivery companies have little choice but to pass those higher fuel costs on to their customers, who in turn raise the price of their goods and materials to the end consumer. In the normal course of events that needn’t be too much of a problem, because the supply side of the economy would usually expand production in the face of rising prices and demand. However, these are not normal times, in fact, they are far from it, we are just emerging from the pandemic and the global supply chain is still very disjointed and patchy. 

In many cases, industry is simply not able to increase production and output, and that’s as true of automakers as it is oil producers and a whole host of other sectors. Large supply-side shocks to the economy, particularly those that involve energy markets are the breeding ground for an economic disease known as stagflation. The symptoms of which are high and rising inflation, rising interest rates and falling investment returns. 

We are not there yet but economies in the Americas and Europe are exhibiting symptoms. Stagflation is pernicious and hard to remove from an economy, it is mostly associated with the dark days of the mid-1970s. Which in the UK meant labour unrest, power cuts, a three-day working week, and sharp falls in living standards. In a recent research note, Bank of America looked back in time to the 1970s to examine how asset classes performed under a high inflation low growth environment, and under outright stagflation, as seen in 1973/74.

The results are quite illuminating, particularly those from 73/4 where oil was the only asset class to really outperform.

How can traders potentially benefit from these trends, if stagflation re-appears?

It’s often said that history doesn’t repeat itself but it does rhyme. So it’s interesting to note that as of the close on 18th March, the S&P 500 energy sector was up by + 32.40% year to date. Many of the stocks within the sector are what are known as high beta stocks. That is they have a high degree of sensitivity to changes in the underlying index, in this case, that’s the S&P 500.

If a stock has a beta of 1.0 it will broadly move in line with the index, if it has a beta that is greater than 1.0, then it will likely move in excess of the percentage change in the underlying index. Stocks such as Occidental Petroleum (OXY), Valero Energy (VLO), Diamondback  Energy (FANG) and Haliburton (HAL) are all examples of high beta stocks within the S&P 500 energy sector.  And that has meant that they have outperformed many other large-cap US stocks in 2022 to date. For example, OXY is up by + 57.0% over the last month alone, HAL has seen its stock price jump by + 67.74% in the last quarter, whilst FANG has risen by +11.00% over the last 5 trading days.

These stocks should continue to perform well on days when oil prices and the S&P 500 are on the up, and indeed when oil prices are static and the S&P 500 is rising. It follows that they should underperform on days when oil is trading down, and the S&P 500 is moving lower as well. Those are characteristics that can make these stocks of particular interest to CFD traders. 

 

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