Long energy and short tech may have been the trade of 2022, particularly for investors exposed to US equity markets, but also for the commodity traders, who enjoyed massive rallies in the underlying both in March and June of last year.
At HYCM we serve a large contingent of energy investors and have also made the expansion of our stock offering a big priority for 2023. Last year’s big trade, and the question of whether its trend is intact, is still just as relevant to both of the above groups. As we move into 2023 and beyond, is this a trade that’s set to continue in the same way? Or is a reversal in store?
How we got here
Energy commodities dipped into the latter half of 2022 on the expectation of slowing demand as ongoing central bank rate hikes continue to tighten global financial conditions. Crude oil futures are currently down almost 40% from their March 2020 peak. Some of this price action is due to the combination of crude oil becoming massively overbought in the early part of last year, and a very forgiving winter, particularly in Europe, providing a reprieve from the direst predictions of analysts.
The expectation of a tightening in financial conditions, as well as the Federal Reserve actually following through with its planned rate increases, also led to a bear market in tech stocks, with the sector currently down 26% from its peak. The Nasdaq 100 is currently down around 30% from its own peak. The rotation from growth to value, as evidenced by the Dow Jones Industrial Average outperforming the S&P 500, is also partly why energy stocks have held up so well despite a drop in the price of the underlying.
Supply issues versus waning global demand
For 2023 the main question that markets are seeking an answer to surrounds whether the Fed will hold firm to its commitment to keep rates higher for longer, raising them beyond 5% and keeping them there for the entirety of 2023 or whether a degeneration in financial conditions will lead them to pivot and cut rates sooner, as Short Term Interest Rate (STIR) Markets are expecting. STIR markets are currently pricing in 2 rate cuts this year with a current implied rate of 4.46% by year-end. See Financial Source’s interest rate tool here:
Rising global interest rates are contributing to destruction in demand and a general slowing of the global economy, whereas the ongoing war in Ukraine and sanctions against Russian oil are worsening a shortage in energy supply.
China’s reopening is particularly relevant here. Increased demand due to the world’s second-largest economy and the world’s largest population coming back online is expected to exacerbate energy shortages. Aside from driving the cost of energy up, many are expecting bull markets in other commodities, as well as increased demand for goods and services, should China’s voluminous middle class begin traveling again.
Copper is already reacting to this possibility, having recently broken above its 50-week moving average to set its first weekly higher-high for 2023. Meanwhile, more generally, the S&P GSCI Commodity Index has recently bounced off the low it set in the early days of January and has just set its first daily higher-high since late December.
Increased demand from China makes the Fed’s task of fighting inflation more onerous and could lead to them being forced to double down on their current policy, particularly if they manage to hasten a slowdown in services inflation, just as goods inflation begins to pick up again.
Also, keep in mind that a lag between re-opening and a resumption of business-as-usual ought to be expected. China relaxing its zero-Covid policy doesn’t mean an immediate return to pre-Covid activity. The commodity sell-off early in January could have been just such a “sell the news” event. This is confirmed in the US Energy Information Administration’s recently released Short-term Energy Outlook, in which global demand for oil is set to decline in 2023, followed by a pickup in 2024 (driven primarily by India and China).
A counter-intuitive energy dynamic to be aware of
Underinvestment in the energy sector is often presented as one of the main reasons that events such as the war in Ukraine had such a significant effect on the global energy supply. A great deal of this comes down to ESG being favoured by governments over policies that explicitly encourage further exploration of fossil fuels.
In the United States, this is a highly partisan issue, with the Democratic party being largely negative on fossil fuels and companies related to the exploration and refinement thereof. While the Republicans are normally much more constructive on these industries.
An administration that is overtly negative on this sector can directly stifle investment in energy infrastructure without even having to introduce any new policies. Energy projects are enormously costly undertakings, and uncertainty regarding the policy environment in which such projects are to be received can often be enough to discourage the commencement of multi-year-long projects that can cost hundreds of billions of dollars.
The result is that, counterintuitively, the US energy sector has just enjoyed its best year in almost a decade under an administration that has been explicitly negative on fossil fuels. The other side of this coin is that should the Republican party win the presidency in 2024, much of what we’ve seen in 2022 could reverse, with more supply being brought online, which could lead to a bear market in both the underlying commodity and related stocks.