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Posted by Jeremy Lin on Mar 17th, 2023

(Energy Drawdown) Everywhere All At Once

In just three trading sessions, we saw one of the most significant drawdowns in the energy space in recent memory, with the iShares S&P/TSX Capped Energy Index dropping 10.6%. Markets went into ‘fear, uncertainty, and doubt’ (FUD) mode off the back of Silicon Valley Bank (SVB) and Signature Bank insolvencies leading to potential broad contagion risks and an increased probability of a hard-landing scenario.

The energy sector was hit hard. This isn’t completely unexpected because historically in every recession, oil drops from its highs with demand falling. Markets often trade off history.

Key Takeaways:

  • The real economy is still chugging along, and most people continue to work business as usual.
  • While energy demand will fall in any recession, it’s important to consider the potential recovery and how quickly that demand will return.
  • The energy recovery path has a much more similar setup to the speedier 2000 Tech Bubble rather than the drawn-out recovery of the 2008 Global Financial Crisis.

So, where does energy go from here?

During down days like these in energy, it’s always a good reminder that the real economy is different than the financial economy, but they are connected. In the short term, given the violent drop in the space, the market is over-emphasizing the financial piece of the story and overlooking the fundamentals in the real economy regarding energy supply and demand. The truth is probably somewhere in the middle.

Google keyword search trend for “contagion” in the US

Google keyword search trend for “contagion” in the US
Source: Google

The financial economy is likely tightening…for now. This is not necessarily because a couple of regional banks, an order of magnitude smaller than the top banks, went under. Still, in the short term, the more capitalized banks will likely be more careful until the storm blows over. That said, we are seeing significant deposit inflows to the top dogs (the top five banks own half of banking sector assets).

The long-term ramifications of the Fed backstopping deposits are still unclear. Can the banks stop managing interest rate liabilities in the long run with more sought-after long-term treasuries, causing interest rate risk to become a thing of the past? If that’s the case, it would be highly stimulative in the long run, and in light of Powell’s rate hikes, it feels like they’re simultaneously stepping on the gas and brakes.

Energy demand impact today

The real economy is still chugging along. Inflation remains high, but the unemployment rate remains low, and wage gains are keeping up with inflation. That is not to say there is no headwind to the economy with the wave of job cuts in the tech sector that happened long before SVB/Signature went bust. With many startups and VCs relying on these lenders for growth/payrolls, we will likely see more entrenchment in the space. Still, it will be a continuation of the same theme rather than a new systematic risk posed to the broader economy.

In terms of the boots-on-the-ground energy demand impact today, the reality is that most people will continue to work business as usual. Spending patterns for most Americans probably haven’t changed because a California bank servicing wealthy people with high net worth went bust. The regional banks at the center of the contagion risk discussions have the majority of depositors under the FDIC-insured limit of $250k. So, prior to the fed deposit backstop, a run on the bank was already fairly low.

Future energy demand impact – possible scenarios

To get an indication of what could happen in light of the Fed’s response, we took a look at a couple of past recessions and how oil performed as a barometer and saw three scenarios:

1. 1990 Gulf War

1990 Gulf War
Source: Bloomberg

The Fed held rates before the embargo and cut throughout the crisis. Peak-to-trough, over a 50% decline in price with no noticeable rebound for the year after. Some people think the price drop was due to the Strategic Petroleum Reserve release, but this is incorrect, as the release started in February 1991. Demand did come off globally as energy prices were simply too high to be absorbed by consumers.

2. 2000 Tech Bubble

200 Tech Bubble
Source: Bloomberg

The Fed raised rates before the peak and aggressively cut into the crisis. We also saw a drop in oil prices to a tune of 40% as demand did come off. What’s interesting here is that demand quickly returned, with oil returning to more normalized prices shortly after.

3. 2008 Global Financial Crisis

2008 Global Financial Crisis
Source: Bloomberg

The mother of all recessions, as some would say, the Fed was holding prior before cutting through the crisis. Peak-to-trough, oil declined over 70%, with price at a fraction of the peak 1+ year later. What was interesting about this crisis was that Hurricane Ike hit the Gulf in September of 2008 and knocked out 1.2 million barrels a day of supply for a month. It took another two months to recover, so this was a setup where we also lost supply, AND we still saw the massive drop in pricing.

The Bottom Line

There is no doubt that energy demand will fall in any recession. Period. The question is which ending we will get coming out of the recession. Given the market drawdowns in light of recent events, the market is trading energy like we’re going into scenario 3, the global financial crisis.

However, as we see a booming tech startup sector and VCs have liquidity issues, along with Fed rate hikes going into a recession, scenario 2, the tech bubble, has a much more similar setup, with implied Fed futures pricing in lower rates through 2023/2024. Brent pricing today is already 40% off its highs from the peak in 2022.

Brent Pricing

Brent Pricing
Source: Bloomberg

If the contagion stays within a small segment of the tech sector, and the broader economy continues to chug along, then the energy sector has some compelling upside, given recent weakness. This could be a buying opportunity.

— Jeremy Lin is a Portfolio Manager at Purpose Investments

Sources: Charts are sourced to Bloomberg L. P.

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Jeremy Lin, CFA

Jeremy has over 11 years of investment management experience and has been with Purpose as a Portfolio Manager for 5 years. He oversees many Purpose credit products with Sandy Liang, the Head of Fixed Income, and has sector specialties including oil & gas, utilities, renewables, and petrochemicals. He holds an MBA from University of Toronto, Rotman School of Management and is currently a CFA charter holder.