Why Is Energy Being Ignored?

The Real Estate Espresso Podcast

Why Is Energy Being Ignored?

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Why Is Energy Being Ignored?

Welcome to the Real Estate Espresso Podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce. Today, we’re going to talk about something that’s not getting nearly the attention it deserves, and that’s the economic impact of the war in the Persian Gulf.

Sure, there’s been a lot shared in the media, but I think the mainstream media are either dramatizing the war, the political implications, or they’re downplaying the economic impact. Markets, broadly speaking, are treating this as a contained geopolitical event, maybe a temporary disruption, something that will eventually resolve itself in due course.

I believe that view is fundamentally flawed. In fact, even today the President was warning his close advisers that this blockade in the Strait of Hormuz is going to go on longer than planned. For us as investors, it’s not a geopolitical story, it’s an energy story. And energy is the foundation of all economic activity, so we’ve got to start with first principles.

Every economic activity requires work, and all work requires energy. If you strip away all the complexity—the finance, the derivatives, the options, the monetary policy, all of it—what you’re left with is a very simple relationship: energy equals economic output. This is not theory, it’s observable. Historically, there’s a near-linear relationship between energy consumption, particularly oil, and gross domestic product. When energy expands, economies grow, and when it contracts, economies shrink.

So when you hear about the disruption in oil supply, the thing you hear most about is higher gasoline prices. You’re hearing about a direct constraint on household affordability, but you’re not hearing that much about the productivity capacity of the global economy, so we need to talk about the scale of this problem. We’re not dealing with a marginal disruption. The data suggests that the oil output from the Gulf had dropped by about 14 to 15 million barrels a day.

So even if the blockade was to end literally today, under the most optimistic recovery scenarios, we’re talking about 1.6 billion barrels of oil missing over a multi-month period. The only country with a large enough strategic petroleum reserve to absorb that is China. They have 1.4 billion barrels in their strategic petroleum reserve. The US has about 430 million barrels in its strategic petroleum reserve. Japan is less than a hundred. This is not something the global system can easily absorb.

There’s a tendency in markets to assume substitution. If supply drops here, it will be replaced by something else. But energy doesn’t work that way. You can’t just simply turn on a new oil field next quarter. President Trump said, “Drill, baby, drill,” but there’s no new rigs. In fact, we have two fewer rigs now drilling oil in the United States than there were at the beginning of the war. And with the first-year decline curves associated with shale oil, you have to keep drilling at the same rate just to keep production constant. So any idea that production can ramp up quickly to fill the gap of anywhere near this magnitude is simply not grounded in reality.

Even where spare capacity exists, there’s constraints. There’s transportation bottlenecks. There’s refining capacity. There’s reservoir damage from shutdowns. These are not trivial issues. And of course, in the Gulf itself there has been physical damage to production facilities. And if these are complex chemical engineering systems that took years and years to build, they are not going to get repaired in a matter of weeks or months.

So what happens when energy supply drops? Well, yeah, prices rise, that’s obvious. The second-order effect is far more important. Economic activity slows. Factories produce less. Transportation costs increase. Marginal projects become unviable. Consumers pull back and capital starts to retrench.

And this is where I think markets are making a critical mistake. They’re pricing this as inflationary, not contractionary. And this is where it gets confusing because it’s kind of both. You get cost-push inflation at the same time as declining economic output. That’s a difficult environment to navigate. We’ve seen versions of this before. Of course, the oil shocks of the 1970s are a great example. That time led to stagflation.

But today, the system is far more leveraged. The total debt levels are much higher. Supply chains are more complex, and the margin for error is much thinner. For example, most people don’t realize that one of the chemicals used to refine copper—80% of the world’s supply—comes from the Persian Gulf. Not a lot of copper mining happening in the Persian Gulf, but if you’re running a copper mine in Chile or in Mexico or even in the United States, you’re going to need access to that chemistry that today is blocked from exiting the Strait of Hormuz. That will have a material impact on supply of copper, and pricing for copper.

A lot of the news media seem to be focused on inventories, but inventories in the wrong place are not helpful. Commercial inventories across developed economies are already at pretty low levels. They’re not positioned to absorb this kind of a supply shock.

Historically, even small imbalances between supply and demand have resulted in significant price spikes. In 2008, a relatively small supply-demand imbalance pushed oil prices to record highs, and today we’re looking at a disruption that is orders of magnitude larger, and yet, equity markets are not pricing in a meaningful slowdown.

So, why is that? I believe it’s because markets tend to be linear in their thinking. They extrapolate recent trends. They assume continuity. But this is absolutely a nonlinear event. When you remove a critical input from a complex system, the impact is not proportional, it accelerates. And we actually have a hard time seeing where all of those dependencies are as you go through the entire supply chain. We tend to underestimate the speed and magnitude of the changes when systems are under stress.

So, let’s bring this back to real estate, because that’s where, of course, we operate. Real estate is not completely insulated from this. In fact, it’s highly sensitive to economic output. When energy costs rise, construction costs rise. Materials become more expensive, transportation costs increase, labor costs eventually follow. We saw the wage-price spiral in the 1970s. Hasn’t happened yet, but it’s coming.

So you end up with a squeeze on both sides of the equation. You face higher costs and lower demand, and that compresses margins. For developers, that means projects that looked viable maybe six months ago, maybe they’ll be more difficult to get off the ground. For investors, it means underwriting assumptions might need to be revisited. Cap rates might expand, rent growth may stall or reverse. This is not a time to be super-aggressive with leverage; it’s a time to be disciplined.

So focus on projects with strong fundamentals, with conservative assumptions, and sufficient margin for error. And most importantly, maintain liquidity.

Now, I want to be clear, I’m not suggesting the sky’s falling or the world is ending. What I am saying is the risks are underappreciated. This is not a short-term disruption that resolves itself quickly or neatly. Even if the conflict ends tomorrow, this recovery is going to take months, well into next year. Damage to the infrastructure, the reservoirs, logistics networks, is not going to get fixed overnight.

So the question you need to ask yourself is a simple one: are your investments resilient to a scenario where energy is constrained and economic output falls? If the answer is yes, well, that’s awesome. And if the answer is no, you need to reassess. Because this is business, it’s not about brightening the upside case, it’s about surviving the downside.

As you think about that, have an awesome rest of your day. Go make some great things happen and we’ll talk again tomorrow.

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