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The hottest trade of the year is on hold, as fears of uncontrolled inflation seep into the energy sector.

With year-to-date gains of around 50 per cent, the Canadian oil and gas space has been the market’s bright spot in an otherwise lousy year for the entire financial market ecosystem. Those gains are a big part of the reason the S&P/TSX Composite Index is only down 5 per cent on the year, while the U.S. S&P 500 index has lost 18 per cent.

Over the past month or so, the steady ascent of Canadian oil and gas names has given way to powerful day-to-day fluctuations, as volatility in the market for crude oil has reached new heights.

Soaring consumer prices are the clear culprit. With enough inflation a recession becomes unavoidable, which could, in theory, bring a swift end to the highest crude oil prices in nearly 15 years.

Is this the end of the bonanza in oil and gas stocks? Probably not, considering the potent forces weighing on oil production and supply, including the potential escalation of sanctions on Russian oil.

“While there may be some risks to oil demand, the risks to oil supply are even higher,” ATB Capital Markets analysts wrote in a recent note.

Going into 2022, this was expected to be the final year of the resurgence of global energy demand, as the economic rebound from the pandemic tapered off. Analysts forecasted growth at roughly three million barrels a day.

That estimate has been cut almost in half, and will probably have to be ratcheted down further throughout the year as recession risks grow, said Bill Farren-Price, a director at Enverus Intelligence Research.

Under normal circumstances, that kind of demand destruction would spell trouble for oil and gas companies. But global production is struggling to keep up with supply as it is, which is why global crude oil prices sit at more than US$110 a barrel, and why the average price of gasoline in Canada this week topped $2 a litre for the first time.

Then there is the potential loss of two to three million barrels of daily Russian production, should the U.S. go ahead with plans to choke off the country’s oil industry. That could effectively offset the demand crunch from any inflation-fuelled global recession.

“You’ve got two very big moving parts of this picture at the moment,” Mr. Farren-Price said of the opposing forces of demand and supply. “The million dollar question is, which one wins out?”

Some investors have speculated that the U.S. shale sector could roar back to life and fill the output gap. The industry is certainly accelerating its spending plans, with capital expenditures expected to rise by as much as 45 per cent this year.

But half of that budget is being eaten by rising input prices, according to a report by Scotia Capital analysts. “Production is not increasing nearly as quickly due to widespread inflationary pressures,” the report said. Drilling rig counts for the companies covered by the analysts are up only by 22 per cent from last year.

In recent weeks, U.S. crude prices have dipped on several occasions to around the US$100-a-barrel mark, only to quickly bounce higher.

“The floor around $100 is pretty solid, and that’s really defined by the fact that global oil inventories are well below average levels,” Mr. Farren-Price said.

That translates to windfall profits for the Canadian oil patch. Years of cost cutting mean the average Canadian producer can be profitable with crude as low as US$45 a barrel, implying a huge margin of safety at current prices.

For investors starting to doubt the revival of the Canadian energy sector, the ATB report offered one other bit of comfort – it takes a monumental economic shock to diminish the world’s demand for oil, on the order of the global financial crisis or the pandemic.

“One must never forget how resilient oil demand growth has been over the past 20 years and that only very major economic events have caused oil demand to decline on a year-over-year basis,” the analysts wrote.

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