The world is close to counting two years of a pandemic, which have been accompanied by economic pandemonium. The fragility of the globally interconnected economies has been exposed in so many different ways, it is hard to list them exhaustively. Supply chain bottlenecks, micro-chip shortages, lumber shortage, labour shortage. And then came the sledgehammer: energy. The 2020 crash in energy demand, and oil in particular, saw a strong rebound in 2021, despite continued restrictions on movements and activity. Oil prices rose back up, from having been negative for the first time in 2020. However, it was not the oil price as such that caused havoc. Intermittent renewable energy suddenly failed in September in Europe. Prices roofed accordingly. Gas prices followed as back-up systems needed to be put into service. Then the cascade effects started. Industrial producers using natural gas as a primary input saw their costs rise above sales prices. They reduced activity. Electricity suppliers who play the game of selling long and buying short found themselves illiquid and then insolvent. Bankruptcies ensued and government stepped in, trying to salvage the situation. The European countries import significant quantities of natural gas, especially from Russia. Long term purchase contracts have gradually been replaced by short-term purchases. A belief that the market will always be ready to supply, at low prices that is, turned out to be an ill-founded fairy tale. Industrial markets do not work that way. More and more, the term underinvestment has come to the foreground. Energy companies, and advisory agencies, are pointing out that years of low(er) investment have eaten away the capacity of the industry to deliver the physical goods required by the economies. That is a very inconvenient truth. Investment in energy infrastructure takes years to put in place and then requires consistent upkeep. This is the more so in depleting resources, such as oil and gas.
The recent data out of the OPEC+ countries show that several of the member countries are unable to supply their quotas. That is not for want of will, but for lack of capacity to produce. And it is a sure sign that the supply side of the market is struggling and will require substantial amounts of money to invest and reverse the current trend. Another sign of things to come is Mexico’s intent to reduce and even stop exporting crude oil. Domestic use is preferred.
Energy is back on the agenda, so much is clear. The stakeholder and societal pressure in the Western countries to rapidly move away from fossil fuels are starting to back-fire. Companies are being confronted by legal pressure to decarbonise, regulatory obligations and shareholder activism. The consequences are that the cost of energy will go up, and its supply may rise slower than demand.
The German minister for climate announced in mid-January that the country will need to reduce its energy consumption by 25-30% by 2030 to meet its climate goals. This is not a marginal adjustment to the economy. The country has invested considerably in renewables and requires gas and imports of nuclear to offset the shortfalls.
Shortfalls, as experienced over the past months and now announced effectively for years to come, are accompanied by high and rising prices. Energy prices feed through into food as well, given the role of energy in producing food. Natural gas that goes into fertiliser, diesel to run the engines of the machinery.
Energy is the base component of the economy. Threshold levels of what the economy can bear to spend on energy are estimated at around 10% of GDP before the economy moves into recession. If the dark supply-demand balance materialises, the current level of around 9% of global GDP can rise much higher. That will be required to achieve demand destruction, clearing out the least productive use of energy and stimulating investment in new supply.
The analytics behind the dynamics of the energy market are found in cross-over domains of economics and natural sciences. Fossil fuels are finite, even though elastic. That is reality. The 2021 discovery data for oil show that only 1 in 5 barrels of oil consumed were replaced by new discoveries. This is the worst result since before 1950. The process of consuming more than the world discovers has been ongoing since 1991 and accelerated from 2010 onwards. 80% of what has been discovered since 1950 has been consumed. Resource depletion is real. And the price of the resource is reflecting the increasing difficulties of providing what is required. And what is required in the end is a function of price. People will change their preferences as their budgets get squeezed. Companies will adapt their production processes as their margins become compressed or turn negative. Governments will have to follow in multiple ways. Windfall tax revenues from fossil fuels fill state coffers, which then needs to be used to subsidise consumers who struggle to pay for their daily needs. That too is already happening, also in Europe. Subsidies to renewables may need to be increased to expand the installed capacity and decisions need to be made with what constitutes green power, as the baseload needs to be secured. Nuclear is back on the agenda. And with that development, governments face another issue. Greening the energy complex lowers the tax take from vices, as the CO2 emissions fall. That will need a clever solution to replace the revenues that will be missed.
In the meantime, the economy is under pressure and the dynamics may lead to markets and individuals reacting faster to prices than the government can conceive and put in place long term plans.
The world we live in is suddenly speeding up, where factors that were deemed resolved by careful planning are taking their own path into partly unknown directions. Most of the developments have been clear to see for those who wanted to look without a bias. The creative destruction that appears underway will lead to a new configuration of the economy which nobody can describe in detail. There are too many moving parts and actors with different motives, as there have always been. But the medium-term process can be sketched. The timing of the changes might be harder.