Last week I delivered a difficult message…the inflation problem is NOT over.
It’s not something anyone wants to hear.
But it’s critical to understand that the underlying problems that created inflation in the first place are still sitting below the surface ready to erupt.
Many blame the post-pandemic re-opening as the CAUSE behind the pushed inflation as high as 9% in the US last year.
This sudden ramp-up in economic activity placed immense pressure on global energy demand.
But central bank intervention through the form of rate hikes has stemmed economic activity, stabilising energy markets.
We’re seeing that play out in lower prices for oil, gas, and coal in 2023.
But does this mean the inflation problem is over?
I don’t believe so.
According to Saudi Aramco, the world’s largest oil producer, the global economy carries just 2% of excess capacity.
Meaning it remains highly vulnerable to demand or supply pressure.
Energy volatility is highly inflationary
While energy makes up just one metric in the Consumer Price Index (CPI) — our official measure for inflation — in reality, it affects almost all elements.
Take food prices — farmers are forced to pay more for diesel pushing up the costs of production. This gets passed onto the consumer increasing CPI.
Similarly, rising energy costs push up prices for rail, shipping, and truck freight…
While the cost to manufacture goods rises on the back of higher electricity and gas costs.
Finally, services go up.
The end consumer losses out along every step.
But the chain reaction of rising CPI starts with energy.
This is what we experienced in 2021 and 2022.
But this is perhaps a small prelude to what comes next. Far from being resolved, the energy supply remains a CRITICAL problem.
This is highly inflationary.
Central bankers have treated the symptom but have NOT cured the inflation disease
As I explained last week, investment into new oil, gas, and coal projects remains at multi-decade lows.
As some prominent oil and gas CEOs have highlighted, their hands have been tied…unable to develop the next generation of critically important reserves.
Political leaders have systematically dismantled oil companies’ ability to grow by restricting exploration licenses, knocking back approvals, and placing ESG mandates over investment firms.
It’s why new discoveries have been in terminal decline for almost 10 years.
Yet, signs are emerging that governments are starting to back down on their hard-line stance against the fossil fuel industries…perhaps an act of last-minute desperation.
Last week, Norway offered 92 new blocks to explore for oil and gas in the Norwegian and Barents Seas.
Late last year, the UK Government announced dozens of new North Sea oil and gas exploration licences to boost domestic production.
Across Europe and the US, oil fields and coal mines are reopening to stave off a looming energy crisis.
Policies have back-flipped dramatically as the political elite wakes up to the energy problem.
Of course, this will all come too late.
Exploration drilling for new onshore and offshore oil wells is time and capital-intensive.
Assuming we can make meaningful discoveries, expect at least seven years before these new finds translate into producing wells.
Given that Rystad Energy reported discoveries sinking to a 60-year low back in 2016 — or a 75-year low in 2021 — a scramble to reopen our traditional energy systems is set to come far too late.
Will renewables save the day?
In terms of rising inflation, central bankers believe the worst is behind them. But they have not considered the consequences of energy shortages.
Perhaps they still hold the notion renewables will take up the slack. So, is that possible?
Given that the International Energy Agency (IEA) estimates the world’s current global base load power accounts for just 28% renewables, it seems unlikely.
Doubling the capacity will be a monumental effort, yet that still won’t be enough to stave off a crisis in energy supply.
Meanwhile, EVs make up a paltry 3% of the entire global fleet of passenger vehicles.
By 2050, we may have the bulk of the world’s fleet dominated by EVs and hydrogen-powered vehicles.
But that is not a solution to an immediate energy problem.
Simple mathematics dictates that renewables will not come fast enough.
But as an investor, how do you prepare your portfolio for future energy shocks that look to arrive soon?
The period from 2021–2022 showed long-term bonds may again hand investors poor returns.
Energy shortages, rising inflation and rising rates will bring on higher bond yields and falling bond prices.
Unleveraged real estate could offer cashed-up investors an opportunity to de-risk their portfolio against wealth erosion. Especially if they focus on properties in cities set to benefit from rising commodity prices — Perth comes to mind.
Utility stocks also present as a possible inflation hedge. While limited in Australia, the US holds several large-cap blue-chip utility stocks offering strong dividend payouts.
Estabilised utilities hold vast infrastructure. These are the assets that will rise in value as inflation makes its way through the economy and prevent competitors from entering the market.
Meanwhile, higher operating costs are passed onto the consumer.
But perhaps one of the best strategies for de-risking your portfolio against an energy crisis is owning stocks with a long-term supply of oil and gas projects.
Oil wells and gas fields have years of production and an active portfolio of upcoming development projects.
Again, the options are somewhat limited in Australia. Jumping into US markets opens up vast opportunities to gain direct exposure to this industry.
Large-cap stocks servicing the oil and gas industry, such as Schlumberger [NYSE:SLB], will also benefit from an energy crisis.
But there is another strategy to de-risk your portfolio from the inflationary effects of limited energy supplies — owning copper stocks or ETFs tied to the major copper miners.
As I shared with you last week, a recent Bloomberg study found that for every 1% rise in the CPI, there was a corresponding 18% rise in copper prices.
You can read that article here.
A simple approach is to invest in the Global X Copper Miners ETF.
Otherwise, you could take a position in copper stocks directly. I’ve just put together a presentation that outlines a strategy for you. You can access that here.
I’ll leave it there for today. Enjoy your week.
Until next time,
Editor, Fat Tail Commodities