Prices are important economic signals. High prices—whether for energy foodstuffs, etc., are signals to the world to (a) supply more; (b) substitute; or (c) conserve.
And so, high energy and food markets today should eventually result in lower prices.
This article will first examine how this principle may apply to energy, then to foodstuffs, and then discuss impact on inflation.
Energy
A dramatic increase in gas prices, especially in Europe, has resulted in a glut —and temporarily negative wholesale gas prices. There are more Liquified Natural Gas (LNG) ships waiting to unload in Europe than available terminals. Storage tanks are pretty well full. All this is testimony to the enormous ability of economies to adapt, when markets forces are allowed to work.
And yet, worldwide, in the short- to medium-term, I am not optimistic about the world’s ability to solve the energy crisis, nor about the prospect of lower energy prices—due to interference with markets. Some examples of market interference are discussed below:
Bringing on board new energy sources is capital intensive—whether hydrocarbon drilling, nuclear or alternative energy (building solar parks, establishing new mines, etc.) Recent increases in interest rates and cost of capital must be passed through to incentivize promoters to bring new capacity on stream. As energy prices are always determined at the margin, this will serve to increase the cost of all energy.
My prognosis is that energy prices will remain high for at least 4-5 years, even if there is a recession, because hydrocarbon-based energy still accounts for 84% of global energy supply; alternatives appear incapable of taking up the slack sufficiently quickly and are constrained by supply of key minerals (copper, aluminum, battery metals, etc.) Bringing new gas, oil or nuclear projects on stream is capital intensive and takes at least 4-5 years.
Food
One of the largest input costs to food is energy. Higher energy prices predestine the world to higher food prices. There are also other factors. For example, fertilizer supply has been disrupted in the world:
Impact on Inflation
As of the date of this article in mid-November 2022, financial markets are breathing a collective sigh of relief at a recently announced lower-than-forecast inflation rate. This trend may be short-lived. Energy and food are two of the largest components of inflation.
There are also lag effects—neither energy nor food price increases have been fully passed through to consumers. A few examples: Many European countries are only now passing through higher gas prices to consumers. Farmers have been using up fertilizer inventories—it will be in spring 2023 that they must decide whether to pay higher fertilizer prices (which must inevitably be passed through to consumers) or to reduce fertilizer usage — resulting in poorer yields—ultimately equally inflationary.
Other persistent sources of inflation:
I would argue there is no way we are likely to approach 2% inflation in the coming years, unless Central Banks hike interest rates enough to induce not just a recession, but a full depression. Assuming they will not be prepared to pay this high political price: brace for high (>5%) inflation.
And so, high energy and food markets today should eventually result in lower prices.
This article will first examine how this principle may apply to energy, then to foodstuffs, and then discuss impact on inflation.
Energy
A dramatic increase in gas prices, especially in Europe, has resulted in a glut —and temporarily negative wholesale gas prices. There are more Liquified Natural Gas (LNG) ships waiting to unload in Europe than available terminals. Storage tanks are pretty well full. All this is testimony to the enormous ability of economies to adapt, when markets forces are allowed to work.
And yet, worldwide, in the short- to medium-term, I am not optimistic about the world’s ability to solve the energy crisis, nor about the prospect of lower energy prices—due to interference with markets. Some examples of market interference are discussed below:
- We are –-in parallel to an energy crisis– witnessing the unfolding of a climate crisis. While the transition away from carbon-bearing fuels is a laudable objective, the execution of the transition has been catastrophically managed—as will be described more fully below.
- Despite high prices, oil and gas companies have curtailed capital expenditures and drilling, choosing to distribute cash to shareholders. Why invest when there is so much interference from environmentalists, politicians, even activist-appointed board members? Case in point: President Biden excoriates oil companies for not producing more, and almost on the same day calls for “no drilling!” Oil and gas companies are legitimately concerned that they may end up with stranded assets—oil and gas that will not be sold, just stuck in the ground.
- The US is drawing down its strategic oil reserves. While the politically desirable objective of dampening prices is achieved—this also diminishes the price signal to conserve and increase supply. Various price caps and subsidies on oil and gas in the EU and elsewhere similarly muddle market signals.
- Governments have taken a large number of nuclear reactors off stream —in Japan due to Fukushima, in Germany due to green pressure, in France due to maintenance neglect, which once again puts pressure on energy markets.
Bringing on board new energy sources is capital intensive—whether hydrocarbon drilling, nuclear or alternative energy (building solar parks, establishing new mines, etc.) Recent increases in interest rates and cost of capital must be passed through to incentivize promoters to bring new capacity on stream. As energy prices are always determined at the margin, this will serve to increase the cost of all energy.
My prognosis is that energy prices will remain high for at least 4-5 years, even if there is a recession, because hydrocarbon-based energy still accounts for 84% of global energy supply; alternatives appear incapable of taking up the slack sufficiently quickly and are constrained by supply of key minerals (copper, aluminum, battery metals, etc.) Bringing new gas, oil or nuclear projects on stream is capital intensive and takes at least 4-5 years.
Food
One of the largest input costs to food is energy. Higher energy prices predestine the world to higher food prices. There are also other factors. For example, fertilizer supply has been disrupted in the world:
- Russia and Ukraine, two of the largest fertilizer exporters, have curtailed exports.
- Ammonium-based nitrogen, made with natural gas, has been curtailed by shutdowns due to volatility and uncertainty of gas supply.
Impact on Inflation
As of the date of this article in mid-November 2022, financial markets are breathing a collective sigh of relief at a recently announced lower-than-forecast inflation rate. This trend may be short-lived. Energy and food are two of the largest components of inflation.
There are also lag effects—neither energy nor food price increases have been fully passed through to consumers. A few examples: Many European countries are only now passing through higher gas prices to consumers. Farmers have been using up fertilizer inventories—it will be in spring 2023 that they must decide whether to pay higher fertilizer prices (which must inevitably be passed through to consumers) or to reduce fertilizer usage — resulting in poorer yields—ultimately equally inflationary.
Other persistent sources of inflation:
- Prices in the service sector and labor markets remain stubbornly high, the ratio of job openings to people seeking work remains very high.
- Rents remain high.
- Globalization (deflationary) swinging to de-globalization (inflationary).
- Demographic trends leading to shortage of labor (inflationary).
- Inflationary expectations often take on a life of their own.
I would argue there is no way we are likely to approach 2% inflation in the coming years, unless Central Banks hike interest rates enough to induce not just a recession, but a full depression. Assuming they will not be prepared to pay this high political price: brace for high (>5%) inflation.