No end in sight No end in sight\images\insights\article\oil-refinery-valves-small.jpg April 28 2023 February 24 2023

No end in sight

The tragic Russia/Ukraine war could keep energy prices and inflation elevated.

Published February 24 2023

Bottom Line

Today marks the first anniversary of Russia’s unjustified, unprovoked and tragic invasion of Ukraine. The war has not gone well for Russia, which initially thought it would capture Kyiv within a matter of days. Instead, Ukraine has staged a valiant effort to defend itself, with help from the U.S., the G-7 nations, and NATO. According to Pentagon estimates, more than 200,000 Russian and Ukrainian troops have been killed or wounded (about 100,000 each), with another 40,000 Ukrainian civilians dead and an estimated 8 million (out of a pre-war population of 44 million) fleeing the country. 

Unfortunately, the conflict is far from over, as Russian President Putin is doubling down. According to the Wall Street Journal, he is adding 200,000 more soldiers for a planned spring offensive despite having lost 2,000 tanks (half of its operational fleet) and hauling Soviet-era equipment out of storage. Already receiving drones and other military equipment from Iran and North Korea, the Biden administration has said China may be considering sending him weapons. Earlier this week, Putin suspended its New START nuclear-arms-control treaty with the U.S., which allowed for periodic inspections of Russian nuclear facilities. Russia has an arsenal of about 2,000 tactical nuclear warheads—nearly 10 times the size of the U.S. inventory of about 230. The threat of nuclear escalation cannot be dismissed.

President Biden has labeled Russia a pariah nation, guilty of war crimes against humanity, and eventually might designate Russia as a state sponsor of terrorism. Russia should be responsible to pay enormous sums to rebuild Ukraine and pay reparations to their people. Putin himself may be brought before the International Criminal Court in The Hague, which prosecutes those accused of war crimes, crimes against humanity and genocide. But in the here and now, there appears to be no end in sight to the heinous conflict.

Energy markets volatile Russia’s weaponization of crude oil has certainly contributed to the volatility of the global energy market. When Biden was elected in November 2020, crude oil (West Texas Intermediate, or WTI) was trading just under $34 per barrel. But over the next 15 months—just prior to Russia’s invasion—prices roughly tripled to $100. Same story with gasoline, as the national average daily price was $2.10 per gallon in November 2020 before soaring 70% to $3.57 per gallon. The situation worsened after the invasion. Crude spiked another 30% to $130 per barrel, but it has since declined 40% to $76 per barrel, with WTI locked in a tight $70-80 trading range over the past three months. Gas rose another 40% to $5 per gallon in June 2022, before declining by a third to about $3.40 today.

Inflation follows energy Nominal CPI inflation was only 1.4% year-over-year (y/y) in January 2021 when President Biden took office, but it surged to a 41-year high of 9.1% in June 2022. It has since declined, falling to 6.4% last month. Core PCE inflation (the Fed’s preferred measure) was only 1.6% y/y in January 2021 before soaring to a 39-year high of 5.4% in February 2022. It has since declined, slipping to 4.7% last month. But the dip in both measures is not the so-called “Immaculate Disinflation” plunge many equity investors expected. As a result, the S&P 500 has corrected 6% over the past three weeks, while benchmark 10-year Treasury yields have soared from 3.40% to 3.95%. 

Fed remains vigilant Higher energy prices and their contribution to still-elevated inflation is likely to keep the Federal Reserve vigilant in its task to reduce core PCE to its target of 2%. While we expected two additional quarter-point rate hikes at its upcoming policy-setting meetings in March and May, financial markets are beginning to recognize that their “Immaculate Pivot” forecast for an abrupt reversal of Fed policy was overly optimistic. In fact, the consensus is now that policymakers will add a third hike in June before pausing at some point in 2024. 

Energy roundtrip in 2023? There’s a mosaic of reasons why crude oil prices may break out of their current trading range to the upside over the course of the next year: 

  • U.S. dollar weakness After nearly two years of strength, the dollar has weakened against the euro, pound and yen over the past several months, as it became apparent in autumn that the Fed would downshift the pace of rate hikes. Commodities like oil tend to trade inversely to the strength or weakness of the dollar.
  • U.S. and EU price caps on Russian crude backfire Russia has reduced oil production and sales to the G-7 nations, and we expect it to cut oil production overall by a half million barrels per day. That’s because they can sell as much oil as they want to the two most populous countries in the world (India and China), who do not share our same environmental concerns.
  • OPEC+ cuts crude oil production by two million barrels per day The largest producer, Saudi Arabia, has targeted a WTI price above $90 per barrel to allow it to meet budget needs.
  • China emerges from Covid lockdown After stumbling to 3% GDP growth in 2022, China has reopened in hopes of getting to the 6-8% range this year. More than doubling its economic growth rate should result in sharply higher demand for oil, forcing prices higher.
  • Warmer winter may give way to warmer summer That meant reduced usage, but how hot and busy will the summer driving season be? Will next winter return to a normal weather pattern? Either could result in stronger energy demand.
  • Strategic Petroleum Reserve President Biden reduced it to 371 million barrels last year, roughly half of full capacity of 727 million, to reduce gasoline prices ahead of the mid-term elections. That puts the supply at a 40-year low, leaving us with perhaps two or three months of capacity in the event of an emergency. The administration plans to replace the oil by purchasing it at $67-72 per barrel in the open market. 
  • Oil companies shift their focus to shareholders Given the Biden administration’s climate policies, domestic energy companies have reduced their emphasis on drilling and focused on share repurchases and dividend increases. In his recent State of the Union speech, Biden said: “We’re going to need oil for at least another decade.” The reality is the need may stretch to a half century or more, which suggests the administration’s continued market-unfriendly energy policies could create a supply/demand imbalance that pushes energy prices higher.

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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Consumer Price Index (CPI): A measure of inflation at the retail level.

Personal Consumption Expenditures Price Index (PCE): A measure of inflation at the consumer level.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

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