Will energy crisis undermine the economy?

Nobody expected that after last year’s steep drop in prices of numerous daily-use products, the situation would take a U-turn so quickly. Moreover, we experienced such anomalies as negative oil prices on the market, which led to gasoline prices on US gas stations dropping below $2 per gallon. However, this is a thing of the past and now reality is much different. Companies all over the world are halting production due to sky-high energy prices and gasoline prices jumped above $3.30 per gallon. What is actually happening on the global energy market? Is there a way out of the current situation?

Global price increases

It’s been a long time since the whole world had to deal with excessive inflation. Massive stimulus programmes enacted to combat effects of pandemic are one of the reasons behind the situation. Supply-side issues also played a role. Adding to that rising commodity prices we get an inflation shock as a result. What is getting more expensive? Everything! Natural gas prices in Europe surged 500-600% over the past year! Coal prices around the world increased 100-150% during the same period. Oil or US natural gas did not experience such a massive rally but even in those cases prices rose by several dozen percent. Where to look for a reason for such rapid price increases?

Energy commodity prices rallied from 100% to even 600% over the course of the past 12 months! Source: Bloomberg

Story behind energy prices rally

In order to find reasons behind current price increases, we have to travel back as far as 20 years to times when the European Union introduced the CO2 emission trading system. Why was it introduced? To fight global warming. EU member states, followed later on by countries from other parts of the world, want to limit emissions of greenhouse gases with hope of slowing a climate change. Power plants, heating plants as well as industrial companies were granted emission contracts. However, the amount of those contracts is limited. Should a company expect its operations to result in higher CO2 emissions, it will have to purchase additional emissions. Number of available emission contracts is shrinking each year, leading to an increase in price of those contracts and, in turn, in prices of energy as well as goods and services offered by companies.

The easiest way of reducing costs would be to shift away from fossil fuels. This is easier said than done but the process is progressing slowly. Numerous countries decided to switch to natural gas as a means of producing energy. It is a more expensive way but results in two times lower CO2 emissions and a much smaller amount of other waste. Meanwhile, countries are boosting the share of renewable energy sources at the expense of conventional energy sources, especially coal. All pieces seem to fit together. Higher emission prices cause governments to favour energy sources that are less emissive, like renewables or natural gas. However, a problem arose.

The 2020/2021 winter season was a really cold one and natural stockpiles were significantly reduced all around the world. A warm summer period followed that saw increased demand for natural gas as electricity was needed for air conditioning. Let’s not forget about below-average winds in the United Kingdom, a limited suntime in Germany or low water levels in Norway, Italy or Spain. All of those factors have limited the amount of energy produced from renewable sources. To make things worse, Russia is the sole supplier of natural gas to Europe. Stability of those supplies can get impacted by not only political decisions but also capacity of gas pipelines. The latter is a reason for construction of the Nord Stream 2 pipeline. Approval process for the new pipeline is still in progress while the natural gas stockpile refilling season in Europe is almost over.

European natural gas inventories are around 75% full. That’s a decent stockpile but should we experience a cold winter season, demand may exceed supply and prices may continue to rise. Source: Bloomberg

How high will prices go?

Early estimates suggest that energy prices in the United Kingdom will increase almost 30% by 2022. UK energy mix - a complete shift away from coal and high share of wind power - warrants high demand for natural gas. Price gains in other European countries are expected to be smaller. Situation in the United States looks interesting. Natural gas is a few times cheaper than in Europe but households will still pay around 30% more than during the last winter season. Price of electricity is expected to be less than 10% and a high share of nuclear energy can be named as a reason. On the other hand, household that relay on heating oil or propane as means of keeping themselves warm can experience price increases of 40-50%

Unfortunately, this is not the end of woes for consumers. Impact of higher oil prices can be felt already. Oil prices sit near $85 per barrel while in 2020 prices were still below $40 per barrel at the end of October. While oil demand has not fully recovered to pre-pandemic levels yet, current energy crisis is boosting demand for crude. Economies have shifted from coal to natural gas due to lower emissions. However, as natural gas and coal prices sky-rocketed this year, oil is more and more often considered as an alternative to the two. OPEC estimates that high prices of other energy commodities have already boosted daily demand for oil by half a million barrels, or even more. It should come as a surprise given that natural gas for Asian deliveries is often quoted at above $150 per oil barrel equivalent! Of course, it is unlikely and impossible for the whole world to switch to oil or other energy sources but the coming months and beginning of the heating season will be marked by high uncertainty.

Is there a way out of this situation?

A lot will depend on weather conditions. We should not see a shortage of commodities for fuel. However, their prices can be much higher than now. The real issue seems to be whether businesses can cope with those price increases. Companies from energy-intensive sectors were limiting production due energy shortages and resulting higher prices. Smelters in China, India or Brazil halted operations. Even brief, few day-long energy supply issues in China in Q3 2021 resulted in the world's second largest economy achieving the lowest pace of growth in decades (excluding Covid-19 shock at the beginning of 2020). Production halts in various sectors can lead to a similar situation to the one observed currently on the semiconductor market. Chip shortages often force companies to halt production of smartphones or vehicles for a few days.

Summing up, the world is experiencing high inflation and there is also a risk of economic slowdown due to energy shortages. Central banks went all-in with massive stimulus programmes during the pandemic and are reluctant to withdraw this support, what makes it harder to alleviate inflationary pressures. Aggressive rate hikes could undermine real income of consumers.

Given the above, is it possible to boost production of energy commodities? OPEC does not want to pump more oil as it fears slowdown in later periods. Russian Gazprom is not interested in short-term supply increases and rather targets long-term contracts. Meanwhile, European Union plans to implement joint natural gas stockpiles in the future. World will surely look into and try to solve an issue with energy availability after the winter period. However, it looks like it's too late to find a solution for this winter season. Global economy is at the mercy of the weather.

How can investors take advantage of the situation?

It cannot be ruled out that in case of a drop in temperatures, demand for natural gas and oil will increase. This is why market participants speculate that oil may hit $100 per barrel during the winter (OIL and OIL.WTI), or that natural gas prices - currently around $5 per MMBTU - will reach double-digit figures (NATGAS). Apart from commodities themselves, there are also hundreds of companies operating in oil, natural gas or coal sectors. Majority of them gained 50-150% over the past year. Devon Energy, involved in oil and shale production, is one of examples with the company's stock rallying 150% year-to-date. ExxonMobil gained “only” 50% so far in 2021. Cheniere Energy, operator of LNG terminals, is also a noteworthy stock. Share prices of the companies gained over 75%. Gazprom is one of the European stocks of interest with London-quoted shares of the company gaining around 75% year-to-date as well. Oil companies like Shell, BP or Eni gained slightly over 40% since the beginning of the year. Last but not least, CO2 emissions are available for trading (EMISS) and their prices may continue to rise should demand for highly-emissive energy commodities increase.

Stock screener at xStation platform allows investors to choose companies from sectors of interest and with desired ratios. Source: xStation5