One of the biggest stories of the year is the rise in energy prices. It's starting to have ramifications beyond the financial markets especially as these costs tend to lead to inflation in nearly every commodity or product due to higher transportation costs.
Globally, there is increasing political tensions in parts of the world due to this and in the U.S., we are starting to see an impact at least in terms of the earnings reports of major retailers. Many of those who are bearish on energy believe that a weaker economy and 'demand destruction' will lead to lower prices.
The bulls believe that supply and demand fundamentals for energy were already tight entering 2022. This is mainly due to demand staying more resilient than expected during the pandemic and already returning to pre-pandemic levels.
On the supply side, the plunge in prices during 2020 was the final capitulation of a brutal bear market for energy. Additionally, the entire calculus may have changed due to Russia's invasion of Ukraine as European countries are expected to fully phase out Russian energy by 2023 even with higher costs.
The backdrop of the supply picture is that CAPEX has been at historically low levels between 2015 and 2022. It finally started to meaningfully rise when prices got above $100. One factor is that future oil prices are about $20 to $30 lower, and there is scar tissue from the last crash. Therefore, E&P companies are using their profits to pay down debt or buy back shares rather than increase production. Production is now rising but the CAPEX cycle has only begun.
On the demand side, the situation is much more mixed. Probably, the best argument for bears would be that a recession is imminent, and demand will drop just as new supply is hitting the market. It's remarkable that so far, there have been no signs of demand destruction even though there is weakness in many parts of the economy. And, this is the case even with China's economy under lockdown in many places.
The bullish argument is that oil demand and prices have been resilient even with this bearish headwind. Of course, at some point, the Chinese economy will return, and this could be the catalyst to lift prices higher.
Like so many arguments in the market, the right trade probably comes down to getting it right on the question of whether or not the economy is going to have a 'soft landing' or a 'hard landing'. In a soft landing scenario, oil prices will likely make new highs. In a hard landing, there will be demand destruction, leading to a sharp drop in prices.
