Written by Andrew Cassar Overend
9 min read
Last Updated on September 30, 2021
As pandemic-related concerns abate, the policymakers have something else to worry about: soaring energy prices. Since the start of the year, several energy components have witnessed significant price increases. Underlying these price increases are the combination of a rapid revival of demand following widespread lockdowns, energy supply constraints and a political push towards greener energy production.
Why have energy prices been soaring and can they derail the global economic recovery?
To better conceptualize what is happening, understanding of some fundamental economic concepts is required.
Demand - Energy is a vital input to almost all production of agricultural and industrial goods. Its demand is influenced heavily by the business cycle. This means that once economic activity starts to pick up, there will be more demand for products, which implicitly, leads to more energy demand. During periods of economic slowdown however, people cut back on their spending and this results in a lower demand for energy.
Supply - in the energy markets, supply is influenced by the availability of energy, the number of suppliers, and the willingness and ability of these suppliers to extract and deliver energy.
Not all economies produce energy. The availability of energy requires an economy to have an endowment of natural resources. Economies with natural resources recognize that they have a comparative advantage relative to other economies which do not have natural resources. Thus, they extract these natural resources, convert them into energy and deliver this energy to its domestic economy and export excess supply overseas.
The number of suppliers in the energy market is generally dependent on government policy and competition policy.
These movements reduce the incentive for new fossil fuel suppliers to enter the market, and may also discourage expansionary investment by existing suppliers. This leads to an overall reduction in those who are able to supply fossil fuels, causing the supply curve to move inwards and this should be bullish for the price.
Substitutability between energy sources - energy users tend to substitute between different energy sources depending on price and production requirements. For instance, a sharp hike in gas prices may induce energy users to increase their demand for oil. This in turn may lead to price pressures in oil, which incentivizes energy suppliers to evaluate whether they are able to use other sources of energy. Similarly, when renewable energy sources are unable to produce sufficient energy to meet production requirements, operators resort to traditional fossil fuels.
Speculation - investors speculate on prices. For commodities including oil, coal and gas, there exist what are known as futures markets in which investors are able to bet on the price of commodities in the future. Because of the sharp surge in demand and the inability for supply to keep up, commodities markets are in what is known as backwardation, which means that future prices are cheaper than current prices. That is, buyers are willing to pay a premium for commodities that can be delivered imminently instead of waiting into the future.
As previously mentioned, not all economies are lucky to be endowed with natural resources from which they are able to produce energy. These non-energy producers generally import energy via containers (barrels of oil or Liquified Petroleum Gas (LPG)) or else build infrastructure to enable the transfer of the required energy (gas pipelines).
This means that, unless hedging agreements are in place, these non-energy producing economies have to pay the market price quoted by the energy producing economies, which depends on demand, supply and speculation. This makes energy one of the most volatile components of inflation. Besides, when supplies are scarce, non-energy producing economies also compete among themselves by bidding higher prices to secure the limited supply of energy from energy producing economies. This bidding continues to amplify price increases.
Energy prices have been on the rise since the end of last year, following the announcement that vaccines to combat the pandemic were to be made available.
However, during August and September, energy prices have been escalating significantly. Gas prices in particular have been surging in Europe. After starting the year at $2.64 $/MMBtu (Metric Million British Thermal Unit), natural gas prices have revisited the 2014 highs at $5.89 $/MMBtu. This 127% increase is particularly reflective of Europe's ambition to transition towards an increasingly decarbonized bloc.
Over the past years, Europe has substantially reduced its dependence on fossil fuels like coal by making it expensive for dirty energy power plants to operate and even forcing some to close. This led to a lower supply of coal, putting upward pressure on prices, as shown in the previous chart.
However, this decarbonization process means that Europe now has a less diverse means of sourcing energy. Because Europe is quite far off from full decarbonization of its power production, moving away from traditional energy sources without ensuring that alternative sources are able to make up the deficit was an underestimated risk.
Europe is heavily dependent on gas imports from Norway and Russia, which are also facing supply shortages. In fact, temperatures turned out to be hotter than usual and this impaired the ability for wind farms to generate sufficient energy to supply other Member States. Until Russia and Norway fully meet their domestic requirements, they will be unable to meet external demands. But supply is not the only problem, because Europe also witnessed higher demand for electricity due to more air-conditioner usage, and experts suggest that this electricity demand can only intensify to combat the cold winter months ahead.
In the UK, a different form of energy shortage is building up. Brits are queuing up at the petrol pumps, not because there is a shortage of petrol, but because there is a shortage of heavy vehicle truck drivers (HVDs) . As previously mentioned, following Brexit, the UK adopted a more stringent immigration policy which led to the emigration of several foreign truck drivers. Similar to the toilet paper panic buying which prevailed shortly before the lockdowns hit, this petrol crisis in the UK is causing people to bring forward their future demand, causing a demand-supply imbalance and upward price pressures.
But the energy shortage is not only limited to the Euro Area and the UK. China is also facing an energy shortage. China is the primary driver of global production, so if consumers worldwide demand more products, China must increase its energy-intensive production.
Besides, Beijing is also adopting a greener energy policy, which is also contributing to the move away from coal towards cleaner forms of energy like gas and renewables. This means that Europe and Asia may end up in a bidding war for Russia's gas supply.
With buyers panicking to secure their supplies and suppliers unable to meet the surge in demand, many businesses are worried that they will end up without energy, which will leave them unable to meet production requirements or even worse, force them to shut down. What is for sure is that demand cannot be imminently satisfied and unless Governments intervene to control the situation, the outcome is likely to be:
Panic purchases and speculation by investors, which may lead to persistent energy inflation. As mentioned in our inflation masterclass, a key driver of short term inflation are expectations of future prices. If consumers foresee higher prices tomorrow, they will increase their demand today. Herd behaviour of the sort manifests into a persistent escalation in prices in the short term; or
A cancellation of demand - people will have to live with shortages, be it shortages of food, manufactured goods or power shortages - this means that the demand curve will be forced to shift inwards until the supply curve is sufficiently flexible to accommodate the pent up demand.
Although economic growth is unlikely to be impaired in the short term, over time these higher prices may cause economic growth to decelerate. There are two arguments to substantiate this possibility:
The surge in demand witnessed over the past year was extraordinary because it was driven by behavioural changes and excess liquidity. The inability of people to go out and spend as they usually do caused them to shift their spending patterns towards goods, particularly those of a durable nature.
This behavioural shift was supported by easy liquidity conditions, as borrowing costs were lowered and governments gave direct monetary support to its citizens. This means that this huge spike in demand over the past year should be a one-off which should eventually abate as economic activity and policy normality are restored. Indeed, as governments taper their fiscal support a significant base effect will prevail which will reduce aggregate demand going forward.
This means that unless economic activity picks up sufficiently, economic growth may eventually decelerate and the demand curve may eventually shift inwards to meet the slowly outward shifting supply curve. Because supply responds to demand at a lag, there is a risk that the more supply than necessary is produced, firms end up with a build up of inventories and deflationary pressures kick in the medium run.
Even if liquidity support and base effects are ignored, unless wage growth picks up significantly, incomes will be strained by higher essential energy costs such as petrol, heating and electricity, forcing consumers to adjust their spending behaviour. People are likely to reduce spending on other things, such as goods or recreation.
As firms observe a reduction in demand, they will revise their production downwards, causing electricity demand to also abate. Therefore, as ironic as it seems, higher energy prices may eventually lead to lower prices as consumers reflect their inability to afford these prices by lowering their demand.
This energy crisis couldn't have come at a worse time for the global economy, which is still attempting to find its feet following the pandemic. Some European governments have already started to take action by subsidizing or capping energy costs, but following the massive deficit build up since the start of the pandemic, governments' fiscal space is constrained.
Therefore, while over the medium term these price pressures should indeed abate as supply catches up with demand, the only glimmer of hope to control the global energy inflation crisis in the near term is a warmer winter. But after a scorching hot summer like the one we just experienced, the probability of that happening is low.
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