The oil market is a great example. A tight supply situation was exacerbated by Russia’s invasion of Ukraine. Prior to the invasion, there was a push toward renewable energy at the expense of traditional oil production. De-investment by large capital pools, such as public pensions and sovereign wealth funds, produced a deficit in new production. Now, take away the Russian supply and the imbalance worsens.

The demand side of the equation deserves some attention also. The global shutdown due to the pandemic threw a curveball, dramatically reducing oil consumption around the world as miles driven plunged. That turned out to be short lived relative to the supply side issues, as demand for oil is now above pre-pandemic levels.

Two recent events suggest that the supply/demand imbalance will not be temporary.

California is planning to give money to each resident so that they can afford gas. That’s well-intentioned but ill conceived. Providing funds for making purchases will keep demand higher than if the funds were not available. Normally, some would choose to lessen their usage as prices rise, but with this extra money, buyers will become less price sensitive, and demand will stay high.

In an attempt to bring prices down by increasing supply, the U.S. government has announced it will release oil from its strategic reserve. But the oil industry sees it differently. The release of oil from the reserves is limited in scope and, therefore, viewed as temporary. The oil producers know this and have stated that they will likely not respond quickly to increase capacity since prices are being manipulated downward. Why spend funds now to grow capacity when the oil will sell for less? Why not wait until the government has reduced its inputs so that prices rise, and then add capacity?

Such well-intentioned acts by governments are doing nothing to fight inflation. Instead, they are only building up the inflationary pressure.

Though the initial shock can be alarming, the longer-term market returns from the point of incursion suggest that the market builds into prices the threat of war before the actual war starts. It is not foolproof as there were times when the market did not fully incorporate the value destruction. The three events (shown above) where the markets continued dropping were post the 2000 technology bubble and the periods involving the OPEC oil embargo. It should give us pause that those have some commonality with the situation we face ourselves today.

The Russian invasion into Ukraine is looking to take on a more lasting impact. Not entirely due to the war but the change in attitude of European leaders. Western Europe’s willingness to placate Putin and to become increasingly dependent on Russia for commodities appears to be ending. European countries had become complacent to the threats of aggression from their eastern neighbor. The last two weeks have signaled a change in that attitude as Germany and other NATO members announced a significant drive to increase defense spending. The graph below shows the average spend on defense by various countries. In the case of Germany’s announcement, they will be doubling their spend.

It should go without saying that we hope that peace will prevail sooner rather than later. The drop in global markets may be short lived but the impact of a changing economic focus by Western Europe is likely to bring about a more lasting result, promoting a stronger defense against authoritarian regimes.

Supporting this argument is the impact from an aggressive move to renewable energy as demonstrated by Germany. The graphic below shows the changes within German energy production. Since the early 2000’s, Germany has been driving an aggressive campaign to renewables, taking share of production from base-level sources such as nuclear and fossil fuels.

This has resulted in Germany power prices being among the highest in the world and, perversely, increasingly dependent on the pricing of fossil fuels as depicted in the scatter plot below.

As investments within the fossil fuel space continue to languish as major sources of capital (sovereign wealth funds and pension funds being two examples) reduce their investment into the space, it is not obvious how this move to higher energy pricing abates.