Pump Up Defense Against Inflation With Energy

Inflation, led by rising commodity prices, has been surging, reaching multiyear highs. That complicates life for all investors.

Responding to inflation, the Federal Reserve and other central bankers are taking a tougher stance on monetary policy. But there are limits to what they can achieve. At most, tighter money will put a mild dent in the commodity uptrend.

Inflation will moderate but not by much, because energy and other commodities like copper face fundamental scarcities. To stamp out the commodity uptrend, the Fed would have to be willing to risk bringing on a major recession.

Inflation Won’t Go Away Easily

Keep in mind that the developing world, by a wide margin, is now the world’s largest consumer of commodities. Only the recent pandemic was enough of a shock to slow down global commodity demand. Even during the 2008-09 meltdown, global commodity demand remained uptrended thanks to the developing world.

Adding to inflationary pressures, labor costs, especially in the U.S., are rising because of a shortage of skilled workers. An economic slowdown would hardly incentivize subsidizing more workforce education and training.

Assume, then, that while inflation may ease somewhat, it won’t be by a lot. Even a sharp market sell-off in conjunction with a major recession would simply lead to a replay of what we’ve just gone through, i.e., the Fed once again turning the printing presses on full force, setting the stage for another cycle of high inflation further down the road.

In sum, investors face a world in which inflation and volatility are facts of life.

Oil Prices Likely to Trend Up

We are in an environment in which oil prices are much more likely to rise than decline, and that puts upward pressure on inflation. Sure, ten­sions in Ukraine may have tacked on a few extra dol­lars. But it’s fundamental factors of supply and de­mand that point to higher and possibly much higher oil prices.

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From oil traders at commodities trader Vitol to the head of Saudi Arabia Aramco, there is strong agreement that the sharp fall in Western capital spending on oil has left the world vulnerable to a major decline in yearly oil production.

At the same time, projections of oil demand have risen sharply as analysts become more aware of the critical role fossil fuels must play in the transition to renewable energies. The International Energy Agency (IEA) recently reported that there have been mistakes made in calculating oil demand. It turns out that over the past 15 years, the use of oil in making petrochemicals has been underestimated by about 3 million barrels a day.

The bulk of the miss has come in the past few years and reflects accelerating demand for petrochemicals from the emerging world. The strong implication is that oil demand will continue to rise over the longer term.

Buy the Dips

For investors in energy, this means buying dips is a good strategy. For those looking at energy as a macro indicator, it suggests that inflation, as the Fed recently affirmed, isn’t going away anytime soon. Of course, this outlook could change if the world goes into recession.

However, despite tougher talk by the Fed and other central banks, the world is simply too vulnerable to a recession that feeds on itself to the point of total catastrophe to permit tightening too aggressively.

The worrisome side of oil’s uptrend was made clear by the head of the world’s largest oil company, Saudi Aramco. His comment, echoed by Bloomberg’s leading oil commentator, was that without a lot more capital investment, oil supplies could decline by as much as 30 million barrels a day, or 30% of supply, in the next decade, a decade in which green initiatives are likely to increase oil demand. Forewarned is forearmed. Let’s hope policymakers respond appropriately.