Disclaimer: After this article was already written, the Wall Street Journal published a piece on the fall of oil prices due to the Omicron variant, the set-back on Biden’s plan, and the interruption in supply chains given the higher inflation. Still, the analysis stands as energy stocks have felt the hit with the decline in oil prices. Furthermore, the long-term analysis regarding structural changes in the energy industry will most likely prevail, and the impact on the global energy prices may still hurt consumers’ pockets. A more detailed analysis on the US energy market will follow in the next few weeks.
As the economy starts to recover from the pandemic, utility companies’ demand for natural gas is on the rise. Producers may not be able to keep up if inventory and production levels continue to dwindle. Family households and large companies alike are struggling to deal with prices as a relentless winter marches on... The scenario is dark: As the northern hemisphere becomes barren and cold, many now fear that losing heating may be a possibility in the coming weeks. Governments have a renewed sense of urgency, which translates into higher prices in the spot market. As one can see in the chart below, spot prices have been rising in the US market to unprecedented highs, above and beyond previous highs which occurred in the 2020/2021 winter.
The US economic recovery and the NATO/Europe relationship with Russia may be partially to blame. In 2020, both business activity and production declined, causing demand for natural gas to fall by 1.9%. As the current recovery is on the rise again, the International Energy Agency (IEA) estimated a 3.6% demand rebound in 2021. This should continue, as the IEA expects that by 2024, gas consumption will rise 7% above pre-pandemic levels. On the supply side, Europe is still very reliant on Russian gas, which is responsible for 46.8% of all non-EU imports. Yet, to make matters worse, Russia is currently facing domestic shortages, which reduces supply even further and puts more pressure on Europe.
As one can see from the graph above, electricity prices have soared across Europe in the second half of 2021. While there was a slight pandemic-related decline in April and May of 2020, it grew exponentially afterwards. The average price for a megawatt hour went from 50 Euros back in January of 2020 to more than 200 Euros by October of 2021.
Consumer energy prices impact stock price movements. While some industries are struggling with the rise in energy prices and production costs, others are thriving. Businesses that are able to exploit higher margins are happily welcoming even higher demand. Exxon Mobil, for instance, just posted its third straight quarterly profit, at US$ 700 million. On the other hand, heavily energy-dependent industries (e.g., materials) have borne a significant rise in costs. This led to slimmer margins across the board and lower demand for discretionary products, especially when demand is elastic.
As one can see from the graph below, energy stocks went up in September, as they were expected to capture higher margins according to energy contract futures. Materials, on the other hand, plummeted at the same rate with the rise in production costs. See below:
This crisis will not stop on the other side of the pond. As of November, natural gas prices had nearly doubled over the past year. With winter just around the corner, US consumers will likely feel the cold, as rising prices will not be limited to Europe. Since March of 2021, US oil inventories have been below their 5-year average. August inventories reached historic lows. The same drivers seen in Europe can explain the situation here: the economy bounced back after the pandemic but supply lines are plagued with disruption across regions.
In conclusion, what started out as the European energy crisis can now be considered a global one. The European energy price spike crossed the pond to American shores. As soon as the economy starts heating up again, some people may be left with little to no heating due to rising costs. There is still no clear-cut solution for the problem. Even if production, supply, and logistic lines can be organized and functioning again in the near future, rising demand might continue to fuel prices (as expected by the forecast shown in graph 1). While the surge in prices can be profitable for some sectors, the overall economic activity will be impacted with higher inflation and interest rates.
Bernardo Weaver is the CEO of Weaver Advisory, producing Macro Research, Financial Modelling, and transaction advice to global financial institutions. Mr. Weaver has over 17 years of experience advising the World Bank on international deals. He is a financial modeling instructor to top investment banks and hedge funds in Wall Street and London. He also teaches M&A as an adjunct professor at Georgetown University's McDonough School of Business. Mr. Weaver holds a Wharton MBA degree and has been based in Washington DC for the past 20 years, living in Georgetown with his wife and two children.
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