Backwardation

Much has been and will continue to be made of what dramatically increased oil prices mean for the economy at large, as well as for the economy and industry of decarbonization efforts. The headline impacts of higher oil and gas prices are relatively clear. Oil prices are currently extremely volatile and have increased by more than 50% in short order, representing the most pronounced and rapid rise ever, both in dollar terms and as a percentage. Near-term, higher oil and gas prices portend inflation for almost everything (everything that doesn’t feature a close-to-entirely digital supply chain, that is). There is certainly regional variability with respect to who’s most exposed to those price increases; in the U.S., companies and consumers will feel the impact of higher prices, but are far more sheltered from the loss of Middle Eastern oil and gas exports because the U.S. itself produces more oil and gas than any other country. Most other regions globally aren’t as well endowed with an embarrassment of natural resources.

Still, globally, higher oil and gas prices will drive near-term and likely medium-term inflation regardless of how soon we see a cessation of hostilities in the Middle East, especially considering that the output of something like an oil refinery or liquefied natural gas processing plant can’t be brought back online as readily as a data center, even if constraining factors like the safety of key shipping straights are shored up overnight.

This leads us to a second point. Much will and is already being made of the idea that this inflation should act as a boon for what at present constitute the “meat and potatoes” of decarbonization, namely cleaner energy alternatives and electrification. It certainly should. EV drivers can and deserve to take a smug victory lap (or three) this week and in the coming weeks as long as oil prices remain elevated. Consumers, companies, and countries that have invested in renewables, fission, and other clean firm power generation resources can and should too. But the longer-term prognosis for the current shock to global energy dynamics may not be wholly, or even close to wholly, positive for energy transition and innovation efforts.

Whether and to what extent current dynamics accelerate decarbonization depends on the duration of this latest war in the Middle East and its ensuant disruptions to oil and gas markets as well as to the flows of countless other essential commodities and products, like fertilizer.

While the current oil price is astronomical compared to where it was two weeks ago, if you look at the curve of oil futures contracts with longer-dated expiry (see below), contracts dating out to the second half of this year still price in considerable normalization, as evidenced by markedly lower prices. This situation, where the longer end of a futures curve is below the front, is known as “backwardation,” the reverse of the typical “contango,” where nearer-term prices are lower than longer-term ones, given longer-term contracts account for the additional implied uncertainty of passing time.

And while the longer end of the curve above in oil futures is now rising as well, indicating a gradual market acceptance that oil prices may not normalize soon, the curve remains steeply inverted from its norm. I raise this for a few reasons. For one, if this current energy shock remains reasonably temporally constrained—i.e., it doesn’t end up lasting all that long—I’m not convinced that it will serve as a massive accelerant to decarbonization efforts, investment, policymaking, etc... To be sure, again, it should. But if current energy market constraints don’t last into, say, the summer, I worry that their acute nature may simply convince stakeholders globally to double and triple down on energy independence efforts, where “energy” means all available sources and includes an invigorated commitment to diversifying oil and gas supply.

European and Asian countries alike will want to expand their options for oil and gas imports from regions less subject to geopolitical pitfalls than the Middle East, paralleling Germany’s record-breaking speed in constructing an LNG import terminal in the wake of Russia’s full-scale invasion of Ukraine in 2022. Asian countries may be even slower to phase out coal stockpiles and power plants that, at present, provide the bulk of their power and heat production. Countries with oil and gas reserves that haven’t yet developed them and/or don’t currently export much to global markets have plenty of pretext to expand their capacity to do so.

To be sure, much of the above likely holds even if current energy market dynamics persist for a while. Russia’s war in Ukraine also should have been a dramatic accelerant to global decarbonization efforts, especially in Europe, which was extremely dependent on imports of Russian gas through 2022. While there’s certainly been more recognition of the geopolitical and physical energy flow-related problems with that dependence, that European countries and many others globally still important Russian oil and gas while simultaneously supporting and aiding the Ukrainian resistance effort—a reality that may now come into even starker relief again as the U.S. and others ease sanctions on Russia in the context of current energy market dislocations—is ample evidence that decarbonization progress remains far too ponderous.

Further, if the energy constraints we’re currently experiencing persist for a while, their impacts on global markets are far too multivariate (and painful) to necessarily benefit any economic sector, including even oil and gas outside the Middle East. If sky-high prices persist for too long, an inflationary regime could flip into a deflationary one; higher costs borne for too long often lead to demand destruction. Once again, the impact and scars of that scenario will and should underscore the benefits of accelerated decarbonization and energy transition efforts. But they also pose many near-term challenges. For instance, to the extent we see spillover from energy markets to financial markets at large, I worry about the IPO window. Even as some companies that are advancing towards an IPO, like Fervo and its geothermal business, offer a medium- and long-term antidote to present-day problems, an oil price-driven inflationary shock to markets tightens capital conditions and dims the mood for everyone.

Similarly, the enthusiasm that has spurred significant investment into a data center and energy buildout for AI is also threatened by even more constrained energy availability and tighter capital conditions across markets. That no small part of the CAPEX for the data center supply chain has been earmarked by investors in the Gulf states and the Middle East doesn’t help that matter. The less long that hostilities in the region and the ensuing price dislocations they give rise to go on, the better. But a lot of damage, both physical to infrastructure and psychic to trust in return prospects over the next 5-10 years and in the U.S. as an ally that can be expected to honor all or at least most parties’ vested interests, has already been done.

Which brings us to the penultimate point: that all the above risks holding true not just at specific stages of fundraising (IPOs) or for specific sectors (higher-risk infrastructure and technology bets). At a certain point, with enough follow-through, system-wide contagions yield capitulating demand at all stages of private and public-sector business building, investment, innovation, and whatever else your favorite catch-all phrase may be. That means everything from early-stage venture capital to grantmaking and debt in all shapes, sizes, and stages. At the end of the day, when risk is really “back on,” especially after long periods where it was probably underpriced, most everyone “sells” most everything.

If there’s any saving grace to all this, it lies in the fact that major repricing events in commodities force a reckoning. The word “commodities” itself is an abstraction for very physical things our world most depends on, ranging from oil and gas to the lumber and steel that comprise the building you’re sitting in, to the core inputs to all the food you will eat today, and the fertilizer that was used to grow it. Too often, wars overseas remain little more than abstractions without anything to ground us personally in a lived experience of their impact. When, however, impacts are felt day-to-day by people worldwide via increased prices, travel disruptions, or the many other such effects we may well soon experience, it all becomes somewhat more real. We exit the paradigm of abstraction and everything that abstractions absolve our conscience of by virtue of what they obscure.

While most of our experiences will assuredly not be as terrible as the death and destruction to which we subject people in the Middle East, ideally, they’ll still lead to sufficient resistance to finally arrest the cycle of endless ill-fated Middle Eastern wars (which, at this point, feels like a case study in the Freudian concept of repetition compulsion), to say nothing of countless other awful foreign and domestic policies.