There is a rule of thumb in commodity markets: “The cure for high prices is high prices.” As prices increase, producers are willing to produce more while consumers are less willing to buy. Supply and demand shift, generating a new equilibrium at a lower price. But with natural gas and oil up by over 100 and 70 per cent respectively by mid-October, the rule doesn’t seem to be working. Some of it is post-pandemic problems. But in large part, it’s a result of the intentional global shift away from fossil fuels and towards cleaner forms of energy.
Some argue the meteoric rise in energy prices is because the shift to renewables has been too quick, but I believe that it only underscores the urgency of shifting from carbon fuels to cheaper alternatives, and developing reliable renewable technology. Leaders will aim to accelerate this transition at the COP26 summit in Glasgow.
For Europe in particular, the current energy crisis is a result of both bad planning and bad luck. Germany decommissioned nuclear plants and other European countries shut coal-fired power stations. The new focus on solar and wind power causes issues when the sun doesn’t shine and the wind doesn’t blow, as was the case over the summer. Add to that depleted gas inventories after last winter, which was the coldest for 10 years, and it is no wonder a crisis has been triggered.
It is less severe in the US, which is now a net exporter of energy. Even so, gasoline is more than $3 per gallon. This is partly because Hurricane Ida in late August shut more than 90 per cent of Gulf of Mexico production. It is also because US producers are under pressure to divest from fossil fuels, and so are not focused on increasing exploration or production.
The Chinese and Indian governments have instructed their energy firms to secure coal and gas supplies at any cost before winter arrives. While Beijing has ordered factory closures in multiple provinces in order to hit emissions targets, it has also demanded coal mines in Inner Mongolia ramp up production.
All told, as world leaders negotiate in Glasgow, major economies find themselves shifting back towards fossil fuels rather than away. The UK’s COP26 president, Alok Sharma, has vowed to “consign coal to history.” But this seems a pipe dream given the current need to plug the energy gap. Success at COP26 could be as simple as acknowledging the short-term supply-side shock that the energy transition will entail, and recognising that the longer we take to start the transition in earnest, the bigger the shock we are storing up. It will create winners and losers, and the losers will need to be compensated.
For investors, the direction of travel towards greener energy is set. The only question is the speed. We are learning that the transition could push up inflation and serve as a drag on growth. It may be too early to dump traditional energy stocks (unless one wants to make a political point), and wise to reset for higher (but still anchored) inflation in a volatile transition to the future. This environment could see equities face headwinds, but should be more supportive of fixed income with higher yields, which could offer some shelter from the storm.
