Beyond Transitory: Inflation's Sticky Grip and the Rise of the Energy Sector

One of the hottest economic topics since 2021 has been inflation. On one side, we have investors in the “transitory” camp. In the opposite corner, the growing number of those who expect it to persist “higher for longer.” Today, we’ll discuss an area of the markets many seem to have forgotten is intimately linked to inflation and the global economy.

But first, let’s set the stage. Not long ago, you may recall that the Federal Reserve supported the “temporary” thesis. But as of December 2021, it admitted it was “probably a good time to retire the word.”

Now, well over two years later, we see the five-year breakeven inflation rate has markedly risen.

We can also see how, between the Great Financial Crisis and 2021, that number consistently hovered around 1.5%-1.6%... well below the Fed’s 2% target.

While none of this data screams “hyperinflation,” we may be in what internationally recognized Oaktree Capital Management Co-Founder and Co-Chairman Howard Marks called a “sea change” in 2022 – a situation that requires “significant capital reallocation.”

While some of these factors have eased since 2022 – including recession fears – others remain relevant, such as:

• A hawkish Fed

• Sticky inflation

• A more restricted credit window.

Credit conditions for commercial and industrial loans have especially consistently tightened since the second half of 2022.

Although the rate of inflation has fallen, the “higher for longer” argument is gaining traction. That’s certainly what Howard Marks concluded when he updated his aforementioned sea change call last October, writing:

“Recent events have shown that the risk of rising inflation can’t be ignored in perpetuity. Moreover, the reawakening of inflationary psychology will probably make central banks less likely to conclude that they can engage in continuous monetary stimulation without consequences.

“Thus, interest rates can’t be counted on to stay ‘lower for longer’ and produce perpetual prosperity, as many thought was the case in late 2020.”

But this doesn’t mean prosperity is now entirely elusive. It just means investors must reevaluate the economic landscape and analyze the “new norm.”

In which case, one area worth exploring is energy… a key reason why inflation was so much lower before 2021.

Why Oil and Gas Still Matter

In one sense, it’s obvious that oil and gas matter in the inflationary narrative. But too many people don’t understand the forces behind that influence.

Consider the chart below, which compares the price of NYMEX WTI crude oil to year-over-year (all-item) U.S. inflation.

This high correlation was also acknowledged by The Oxford Institute For Energy Studies when it wrote how:

“In the short term, inflation and oil prices are coupled by energy arbitrageurs trading around the mechanical pass-through of retail gasoline prices to the consumer expenditure basket. In the long term, the baton is passed to portfolio allocators and risk parity funds with the direction of causality flipping from inflation expectations back to oil prices. The relationship becomes circular, where the strength in one propels the other.”

Returning to the previous chart, we see that oil prices “imploded” in 2014, leading to subdued levels close to $50 per barrel. This was a true blessing for consumers and the larger economy. It allowed central banks to keep rates low, fostering an overall accommodative policy that benefited growth investments tremendously.

This was all thanks to the shale revolution, which allowed the U.S. to become one of the world’s biggest energy exporters. The country went from producing less than half a million barrels of tight/shale/unconventional oil in 2007…

To almost 8.5 million going into this year, most of it coming from the expansive Permian Basin.

That effect was great while it lasted. But on February 19, The Wall Street Journal wrote a piece titled “America’s Oil Power Might Be Near Its Peak.” It proposed that U.S. crude oil output will rise by just 170,000 barrels a day in 2024.

In 2023, that figure was 1 million.

This makes sense considering the new focus on free cash flow growth. Since the pandemic, an increasing number of companies have begun focusing on buybacks and dividends instead of boosting output.

This is also understandable since shale companies now recognize their previous production growth bonanza created extremely fragile oil prices.

Meanwhile, shale companies are seeing a decline in their best drilling locations. This follows the so-called “Hubbert Peak,” which predicts that even the Permian Basin could hit peak production at the end of this year.

Recognizing all this, U.S.-based producers are being more careful, thereby giving OPEC more pricing power again. And OPEC is more than happy to act on that by keeping voluntary output cuts in place despite the recent uptrend in oil prices.

Coming to Three Logical Conclusions

Based on these details, inflation could easily remain sticky on a prolonged basis. And that makes energy a good place to look into.

Better yet, it’s currently one of the three “cheapest” sectors in the S&P 500.

We’re especially looking at high-quality “upstream” companies that produce and explore oil opportunities. We want to see:

• Deep reserves that allow oil companies to enjoy cheap Tier 1 production when their peers are running out of high-quality inventory

• Healthy balance sheets that allow them to distribute most of their free cash flow to shareholders

• Low breakeven prices that allow them to generate substantial free cash flow at elevated oil prices and remain stable at subdued oil prices

• The ability and intention to distribute most of their cash flow.

One such company is EOG Resources (EOG), which has a major footprint in the Permian Basin. Its capital program is breakeven at $45 WTI, and it plans to return at least 70% of its free cash flow to shareholders.

It hasn’t cut its dividend for 26 straight years and actually accelerated it with the support of premium drilling. This originally meant it was only focused on drilling wells that yielded a 30% or higher after-tax return rate.

But now its goal is at least 60%.

We also like Canadian Natural Resources (CNQ), a Canadian-based major with operations in the Western Canadian Sedimentary Basin.

Because Canadian oil sands have no decline rates, the company’s overall corporate decline rate is just 11%. This indicates its assets have long lives, which also bodes well for production costs.

Another noteworthy detail is how CNQ has more than 40 years’ worth of reserves – with breakeven prices close to $45 WTI. Plus, it achieved its debt target this year…

Which means it will distribute 100% of its free cash flow to shareholders using special dividends and buybacks.

Texas Pacific Land Corporation (TPL) is another company worth considering. Formerly structured as a real estate investment trust (REIT), it owns close to 870,000 surface acres in the Permian Basin.

It does not produce oil and gas. But its customers do. Oil and gas companies who operate on its land pay royalties on the oil and gas they produce.

Texas Pacific also makes money on water needed to drill wells and surface rights. This includes:

• Pipelines

• Everything else related to the process of producing oil and gas

• Solar and wind energy

• Any other activity on its land.

All of this has allowed TPL to turn into one of the highest-margincompanies in the S&P 500. Plus, it features decent downside protection sinceit doesn’t have to worry about oil and gas production costs.

In Closing

Going forward, we’ll continue to monitor inflation and energy trends. Our goal is to highlight viable investment strategies that not only protect wealth against inflation but actively capitalize on it.

Contrary to popular belief, this is far from impossible. It just requires strategic capital reallocation, as investment veterans like Howard Marks have pointed out.

We need to be aware of post-pandemic trends across the board. We’re not living in the same world we once did.

Much of this hinges on energy, a key driver of inflation that’s simultaneously opening up inflation-fighting investment opportunities. That’s why we expect high-quality companies with robust fundamentals to offer stability and growth as long as current trends continue.

‍

‍

‍

‍

‍Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.