Dear Valued Clients and Friends,
In this week’s Dividend Cafe:
- We look at the short-term volatility in oil prices and what it means for markets at large (including the ramifications of President Trump’s speech last night).
- We evaluate the essence of economic growth as “energy transformed” and what that means in both a physical and metaphysical sense in markets.
- And we answer the question of how to think about energy sector investing with all its cyclicalities and ultimately, its non-cyclical thesis!
Let’s jump into the Dividend Cafe …
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Energy Transformed
My friend and brilliant economist, Louie Gave, is fond of saying that “economic activity is energy transformed.” All production can ultimately be reduced to the application of energy to material things. This can be said to be a statement about physics: how energy changes physical components in the universe into more productive forms (fuel driving transportation, fertilizers driving agriculture, electricity driving computers, heat driving steel manufacturing, etc.). But I have also believed (and am certain Louie believes) that it goes much deeper than that. Labor and capital only function with the input of energy. Otherwise, they are dormant. The mere restructuring of atoms is not, in and of itself, creative of economic growth; it is what that physical dynamic makes possible (work, goods, and services) that produces tangible economic growth. The history of economic progress is a history of expanding energy sources and their application to greater and greater production of goods and services.
All of this means that we need energy to grow, but we need more than energy to grow – we need the efficient transformation of that energy into productivity. So, a sine qua non for those who want economic growth is an abundance of energy, and the real kicker to all of this will be how effectively we utilize that energy. Transforming energy presupposes having it. The two-pronged assertion here is that (a) Rich societies HAVE energy; (b) Rich societies know how to USE energy.
I do not want to put words into Louie’s mouth, but what I have learned from him on this subject over many years is that what technology, capital, and labor are essentially doing in these things we call markets is converting energy into productive use. Capital markets matter in how energy is transformed, but they cannot create energy. Capital markets allocate resources. Harnessing and transforming energy drives economic growth.
The Metaphysical Version
In this vein, I am not speaking for Louie but just my own view … The above describes a physical case for the view that energy transformed is the essence of economic growth, but I would argue that, when it comes to the human person, the exact same thing is true metaphysically. Human beings do not do amazing things until they are activated, energized, and catalyzed towards the activities that create economic activity and ultimately bring meaning to our lives. A human being lying on a couch doing nothing is not transforming anything; a human being who gets up (with energy) and does something (activity) participates in transformation. This is outside the physical compounds that we describe when we speak of oil, iron ore, nuclear fusion, electricity, etc., but in a metaphysical sense, it is the same thing. Our being is one of activity, or it is not a very productive being at all. Passivity is the enemy of economic growth.
God created the world with extraordinary potential, but he made it unfinished. Mankind, though, can not bring out the potential of the world without energy. Mankind must innovate and experiment to grow and advance, and that process – that history of building civilization and elevating a standard of living – is a history of “transforming energy” – taking the raw materials of the world, and converting them to something useful. Properly understood, this is the essence of markets and the source of so much quality of life we all enjoy.
Costs Matter
When it costs more to transform energy into productive use, it weighs on economic prosperity. It also limits supply, which weighs on the energy abundance assertion stated above. There are a lot of sources of energy in the world – those things that make up physical sources of transformation to turn something unproductive into something productive. But oil is a big one. Oil is a game-changer. Oil, more than any other energy breakthrough in world history, has converted raw physical material into highly useful goods and services. Coal did this in the Industrial Revolution. Electricity and natural gas are high on the list. But oil created modern transportation and industrial production, which have completely changed the world.
So we are not exaggerating when we worry about the impact of either (a) higher costs or (b) declining supply of oil. It matters a great deal to economic growth, and has for decades. But it has mattered for decades for the exact same reason all energy transformed has mattered for millennia. It is the essence of economic growth.
The Current Moment
As of press time today, WTI Crude Oil is sitting at $113, up a massive +13% after the President’s speech last night, indicating likely continuation and even escalation in the military operation in Iran. What we see in the last two days is essentially a move from $107 or so back to $100 as markets anticipated the possibility of a walk-down in President Trump’s speech, and then a reversal from $100 back to $107 and then right through it when his speech proved to be more hawkish than had been anticipated.
The correlation between bond yields and oil prices over the last month is intense, and the correlation between oil prices and stock prices is quite inverse over the same period. These relationships will not all last forever, but right now the basic package is either higher bond yields/higher oil prices/lower stock prices, OR lower bond yields/lower oil prices/higher stock prices.
So Buy Energy When We Are at War?
The largest Energy company in the United States (ExxonMobil) is up 35% in the last few months. The second largest (Chevron) is up 28%. The largest pipeline companies are up 20-25%. The most significant exporters of Liquefied Natural Gas are up 40%. The refiners are up about 30%. Some of these moves are related to the conflict in Iran. Some of them pre-dated the military operation. But there is no question that higher global oil prices have boosted margins for the big sellers of crude oil, increased demand for moving oil and gas domestically has benefited the pipelines, Qatar being cut off from selling LNG to Asian and European countries has created new revenues for U.S. LNG exporters, and a wide spread in margins for refiners has pushed that downstream group higher. All of these catalysts are event-driven, and they are all reflected in the prices of these various companies and sub-sectors.
Is there more to go? Will they sell off when the Iran conflict ends? Are the moves overdone?
Maybe, possibly, and perhaps.
And who cares?
I hope my prior paragraph is abundantly clear that I acknowledge a substantial short-term price response to a substantial short-term global event. The Strait of Hormuz being closed, the attacks on Middle Eastern LNG production capacity, and all sorts of geopolitical tensions (events and perceptions) have been reflected in recent price action. But I believe investors make a crucial mistake if they treat the energy sector as some sort of “Middle Eastern war hedge.”
Properly understood, properly sized, and properly allocated, Energy is a core portfolio weighting because it is a Core component of all economic activity. Indeed, energy transformed is the definition of economic activity (whether physical or metaphysical, as explained above).
What You Are Buying
When you buy a U.S. oil company, and just to make things simple, let’s pretend we are only talking about the very biggest and very best, what you are buying is not merely a claim on the energy they produce. You are buying their ability to manage extraction costs versus the price they can fetch for that extraction. It requires significant intelligence and savvy around production levels and enhancing/protecting/defending market share, margins, and other major factors in the business model beyond “the price of oil.” You are buying their ability to find good assets, to exploit them, and most importantly, to manage the supply/demand curve that drives profitability.
I happen to have a lot of confidence in the ability of some to do this, and very little confidence in the ability of others. But it is not just a question of “high oil prices” vs. “low oil prices.”
It gets more complicated, still. You are also buying companies that some activists want to shut down, that some countries want to punitively tax, and that many foreign companies want to compete with using the power of the state behind them (nationalized oil companies competing against our privatized companies). It’s not always a fair fight, but David did beat Goliath, and market mechanisms do often beat sovereign cartels.
Why Not Coal?
The argument for investing in coal producers is that when oil and gas experience a supply shock, coal quickly becomes back in favor as a quick, readily available, highly productive means of meeting energy needs. The argument against it is that it faces even more significant political and activist headwinds than oil and gas. Its investment thesis feels permanently stuck in a volatility cycle of (a) Great margins when everything else is suffering, or (b) Starvation of capital when things are normal.
There likely is a disproportionate (favorable) trade-off between risk and reward here, but that does not mean the risk is not severe. The selection matters, and the appetite for volatility must be extremely high.
Is the War About to End?
I cannot say enough about how this subject is and is not playing into our portfolio allocation. I do not happen to agree with those who believe the President got into this with no plan, strategy, or defined goals. Nor do I agree with those who say it has been perfect with literally zero unexpected consequences. I am entirely convinced that the operation has been a bigger success than many expected, and that at the same time the complexities in the Strait of Hormuz were not fully foreseen or planned for. I am appalled at some of the left-wing coverage of this operation, and at the same time, I do believe that Congress is supposed to authorize these things, and that we have a challenge on our hands to fully see this through. There’s that nuance thing again. No one likes it. But it is my job.
What I would say is that the question, “Is the war about to end?” matters in a certain political sense, sentiment sense, perhaps midterm sense, and short-term volatility sense. I get it entirely. I believe the short-term questions about the re-opening of the Strait of Hormuz matter. I think the last few days give you a feel for where short-term sentiment lies … if people begin to believe it is about to wrap up, markets rally; if people believe it is continuing longer, they don’t. All fair enough. Until it isn’t. But regardless, it is not the right question for a long-term energy investor.
Because the war will end, eventually. And that might be in three weeks, and it might take many more months. But if your ten-year exposures to midstream energy are based, even a little, on ten-day or ten-week headline spurts in Iran, something is wrong.
The Real Thesis, for Those Reading Books Not Newspapers
The energy needs of the world are not going away, with war, without war, with this noise, or without that noise. The constancy of energy need is a truly investible reality. Other trends within this reality supplement the story. We hear all the time about the need for more data centers and more power generation, and yet somehow don’t easily draw the lines to how on God’s green earth people believe that power is going to be generated … Maybe the data center story proves overdone, but if it is not, I assure you the natural gas story is underdone. But I want you to understand what I am saying:
- A proper energy thesis is not about a supply shock in Iran.
- A proper energy thesis is not about a demand boom in data center.
It is about the simple reality of humanity, totally divorced from cyclical, transitory, and even inevitable zigs and zags that take place in the never-ending drama of the human race. It is about transforming the physical universe into goods and services that drive economic growth. That has to be the constant in the investment thesis.
Yes, it will experience occasional cyclical tailwinds, such as Q1 2026, and it will experience severe headwinds as it did in 2020 (COVID demand evaporation combined with ESG insanity). But it is a permanent condition of the human race that requires thoughtful, careful, and confident exposure. It contains embedded inflation hedges (do we EVER have meaningful inflation when oil and gas are going down in price, ever?). It contains geopolitical hedges.
But it provides a true exposure to a permanently investible reality.
Chart of the Week
If nothing else, on a relative basis to the overall economy, this chart provides visual clarity on the opportunity set in the Energy sector, properly understood.
Quote of the Week
“There are no solutions, only trade-offs”
~ Thomas Sowell
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There is so much more to this story than just energy production. There is room to do an entire Dividend Cafe about the electrical grid alone. Transportation and storage of energy are a particular story even outside of exploration and production. In other words, a lot more has to be said. All in due time.
In the meantime, enjoy your Good Friday, your Easter weekend, and all it represents. History has never been the same.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
