Winter is coming – what should we make of the energy crisis?

investment insights

Winter is coming – what should we make of the energy crisis?

Sophie Chardon - Cross-Asset Strategist

Sophie Chardon

Cross-Asset Strategist

Energy prices continue to make headlines, with a crunch that originated in the gas market now affecting coal, oil and carbon prices. While a clash of supply issues and post-Covid demand implies price spikes could be temporary, a cold year-end could prolong the pain. Spill over effects to oil markets look limited, and we believe we can avoid a prolonged price overshoot in 2022. Yet current dynamics demonstrate the challenges the global economy faces in its shift from fossil fuel dependence. They also imply unavoidable price volatility that governments will need to address.

Recent months have seen high volatility across many commodities, while in some regions, coal, carbon, and gas prices have all hit record highs. In Europe, gas prices are hovering near all-time highs; in the US, they are at seven-year highs. Meanwhile, Brent crude oil is currently trading above USD80/bbl, with year-to-date price increases the largest in 12 years.

Investors are naturally concerned that soaring energy bills could feed through into higher inflation, while tighter consumer budgets, factory shutdowns and energy rationing in some industries could weigh on global growth. All this has fed into the market’s existing ‘stagflation’ concerns.

Investors are naturally concerned that soaring energy bills could feed through into higher inflation, while tighter consumer budgets, factory shutdowns and energy rationing in some industries could weigh on global growth

The story begins with gas

Current circumstances in gas markets largely reflect a confluence of temporary factors and supply bottlenecks. Demand picked up in 2021 after the pandemic lull. A cold spring and extended periods of working from home in Europe and Asia exacerbated the situation. In China, a ‘blue sky’ policy to control air pollution from coal has switched demand to gas, intensifying competition with Europe for supplies. A spat with Australia curbed coal imports, while floods in Chinese mines drove coal futures to record levels on 11 October, pushing demand for gas imports higher.

At the same time, gas inventories are severely depleted, particularly in Europe. Post-Covid maintenance on pipelines and production facilities affected inventory rebuilding over the summer. Sanctions delayed streams coming online from Russia’s Nord Stream 2 pipeline. In the US, gas production has fallen due to lower levels of shale drilling. In Russia, Gazprom has pushed gas production to 10-year highs.

 

Russian roulette

The impact of the current spike will largely depend on how long gas prices remain elevated. The International Energy Agency (IEA) estimates Russia may have enough supply capacity to ease the crunch1, but the situation is far from clear: even if Nord Stream 2 is made operational rapidly, Gazprom has not indicated by how much it can effectively boost global supply. Politics could play a part, and Russia will want to keep domestic supply flowing over the winter.

Meanwhile, the ‘swing’ gas supplier, the US shale industry, is constrained by capital discipline and a focus on shareholder returns. We are thus heading into winter with tight supply-demand dynamics and high uncertainty on prices. With European storage still filling up at a steady pace, it is possible that a mild winter could prove manageable. The worst-case scenario would be a sharp cold wave in the coming weeks that prevents storage capacity from being refilled. Looking further ahead, the hope is that with supplies replenished, maintenance completed, and demand normalising, prices will fall again. With this in mind, we will continue to monitor the situation closely.

The hope is that with supplies replenished, maintenance completed, and demand normalising, prices will fall again

A different impact on coal and oil

The situation in the gas market has also dragged up the price of thermal coal (a substitute) and electrical power (a product). In coal, there is little capacity to ramp up production, as investment has been cut and carbon allowances continue to deter coal generators. Coal demand is in structural decline as power stations (responsible for 90% of US coal demand) close. Austria and Sweden closed their last coal power plants in 2020; others like Portugal will do so this year.

The gas crunch has also spilt over into the oil market. Investors fret about similar supply shortages, e.g. as countries switch to oil-fired power generation. Yet this switch is tricky to make. Saudi Aramco Chief Executive Amin Nasser recently estimated that substitution out of the natural gas market would only add around 500,000 barrels per day of additional crude oil demand (i.e. slightly more than 0.5% of global demand). Furthermore, from a fundamental standpoint, the situation is very different in gas and oil markets. Firstly, oil markets do not display such high seasonality. Secondly, high frequency indicators suggest that oil demand is plateauing; the Organization of the Petroleum Exporting Countries (OPEC) revised Q4 demand expectations down at its October meeting. Thirdly, the supply response is much less constrained for oil than it is with gas. OPEC has ample spare capacity to meet potential additional short-term demand. So even while inventories are low, there is no fundamental imbalance or stress on the market going forward.

 

We have revised our Q4 2021 and Q1 2022 oil price expectations up to USD80/bbl; we then expect prices to fall gradually in 2022

While we have revised our Q4 2021 and Q1 2022 oil price expectations up to USD80/bbl to account for current market dynamics, we therefore expect prices to fall gradually in 2022. Fundamentals should eventually come back to the forefront, with additional supply also coming online from Iran (once a deal is finally made, which we now expect in 2022 rather than 2021). The risk of further price overshoots therefore looks limited to us.

 

‘Looking through’ price spikes in Europe

If, as we expect, energy issues do prove temporary, central banks may be able to ‘look through’ recent price spikes, given ‘symmetric’ inflation targets that imply tolerance for over-and under-shoots. Even with a comparatively limited impact, we believe the upward pressure on eurozone inflation from the surge in natural gas prices will not be felt evenly throughout the region. Governments are stepping in to cushion the blow, but higher energy bills are a downside risk to the eurozone’s consumer recovery, particularly in gas dependent countries like Spain, Italy and the UK. A low use of gas, and a reliance on nuclear and renewables for electricity generation, means that France, Switzerland and the Nordics are less exposed. Norway, the world’s third largest exporter of natural gas, could benefit thanks to higher EU export volumes.

Higher energy bills are a downside risk to the eurozone’s consumer recovery, particularly in gas dependent countries like Spain, Italy and the UK

China is a special case

In China, we expect some hit to growth in Q4. Electricity prices cannot rise with coal prices since the former are regulated, leading power plants to stop producing, causing electricity outages. The resulting Chinese growth slowdown, especially when the real estate sector is already under pressure, means that industrial metals exporters (e.g. Chile, Peru) and major trade partners (e.g. Brazil) may suffer. More generally, if lower growth in China weighs on global trade, emerging market (EM) growth momentum might slow more than previously envisioned in our base case scenario. In aggregate, we would expect countries with a higher share of fossil fuels in their electricity mix to be more affected, including Turkey and India. If the spike lasts long enough to un-anchor EM inflation expectations, that would put central banks in a difficult spot. Again, we see this as a rising – yet still limited – risk for now.

If the spike lasts long enough to un-anchor emerging market inflation expectations, that would put central banks in a difficult spot

Climate – the bigger picture

Meanwhile, the current scenario is taking place in the context of a much broader, structural shift in prices. Lower wind generation in Europe and hydropower generation in China have exacerbated energy price spikes. The transition to net zero will require tectonic changes in energy markets, including the need for much more storage ahead. Many participants had pinned part of their hopes on gas to ease the energy transition, as a cleaner ‘bridging’ alternative to coal and oil.

However, IEA forecasts show that even though natural gas can be seen as a short-term substitute, the endgame remains one where its share in the energy mix must be replaced by green hydrogen and batteries. As such, investment in new production capacities has been muted, and adjustments will be made through market prices, implying more volatility ahead.

The same applies to the oil market, with oil majors committed to reducing capital expenditure on fossil fuels and focusing on renewables instead. While OPEC’s spare capacities can help mitigate price effects for now, we note that this could trigger a phase of higher oil prices in two to three years from now - if demand has not already peaked by then. While higher energy prices are key to accelerate the transition, governments will likely need to cushion consumers from higher prices and rethink the safety net for the most vulnerable.

The energy transition is a necessary one, and the scale of the change needed is monumental. Current price spikes indicate that it may not be smooth sailing

It is also worth noting that we are only at the beginning of this transition. While the current energy price squeeze has pushed the price to emit one tonne of CO2 in Europe up to more than EUR60, in many parts of the world it is much lower, or free. China only began carbon trading in July 2021, with a price well below EUR10 per ton. A price above USD100 is needed to spur the net zero shift, according to the World Bank. A price of USD125 per tonne by 2025 is the mid-range of scenarios modelled by the Network for Greening the Financial System, a group of central bankers and policymakers globally. The energy transition is a necessary one, and the scale of the change needed is monumental. Current price spikes indicate that it may not be smooth sailing.

 

IEA chief says Russia has substantial scope to boost Europe’s gas supplies, Financial Times, October 2021

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