Energy and food prices are front and center of people’s awareness as the war in Ukraine worsens underlying structural problems, amid a cost-of-living crisis in many countries.
In addition to making it tougher to pay your bills, inflation also drives bond markets, as well as specific sectors within stock markets.
Central banks are under pressure to act, even if the medicine that’s needed could risk extinguishing the fragile post-Covid economic recovery. Just how did we get here? It’s a complex issue that we’ve tried to unravel into basic themes:
Stubborn energy demand
Oil demand grows 1.0 to 1.5% per year due to population growth and increases in standard of living increases. The only exceptions have been severe slowdowns in the economy.
So far, the investment in renewables has only slowed the growth of demand in isolated areas. Even in Norway, where electric vehicles (EVs) made up 72% of auto sales last year, oil demand has only been flat for the last 10 years. This greatly outpaces oil demand forecasts from the International Energy Association which predicted 30% decline in oil demand under those circumstances.1 However, ethane (for plastics) demand was up 31% and diesel (for deliveries) demand was up 15%, offsetting any decline from auto fuel demand.
Chart 1: Cumulative weekly price decomposition. January 7, 2022 - May 20, 2022
Source: US Federal Reserve, May 2022
Poor policy
Government and investor policy based on dramatically lower crude oil demand served to constrict oil supply well ahead of a demand drop. More than $500 billion must be invested globally per year to maintain last year's production. For most of the last eight years, the actual investment was half of that, causing a shrinkage in supply capacity. This would have been fine if the policies of constricting oil demand were as effective as those constricting supply, but they weren't.
Given the structural shortage of supply, the prospect of meaningfully keeping Russian supplies off market is exceptionally difficult as the precious crude finds a home in China and India.
"Zero-Covid" China
Offsetting this bullish outlook for oil is weak demand from China. China has stuck to its zero-Covid policy, which has held back Chinese economic activity (and demand for things such as industrial metals and oil). We had started to see quite a big surge in investment capex from China in renewable infrastructure, particular in wind power. However, the pandemic has put a halt to many of those projects for the time being, meaning demand for traditional energy supplies are likely to rise as activity increases.
Chart 2: China electricity construction investment by power source
Source: Haver, CEC, abrd Research Institute, December 2021.
Current lower Chinese demand in some ways helps to offset the inflationary pressures seen elsewhere, but supply-chain disruptions are adding to them.
Port congestion in China (and elsewhere) is a serious problem and as a result of this, we’re expecting price pressures, as well as disruptions across the supply chain.
In light of the China Party Congress later this year, the Chinese government is highly motivated to improve things. They also control their own destiny more than most governments, which makes it difficult to bet against an improving China later this year. A strengthening Chinese economy only raises the prospect of higher energy and industrial metal prices.
Don’t mention the war…
At best, the Russia-Ukraine war and the resultant sanctions are keeping 500,000 to 1 million barrels of crude oil off the market. This is a small percent of the more than seven million barrels exported. If the global oil shortage were not as dire, we may not have even noticed.
But inventory levels have drawn down to the average levels seen in 2010-2014 as prices have risen to the high levels seen during that time.
Spare supply capacity is 2 million barrels per day. This is roughly 2% — a very thin margin for error.
Since February 2020, there hasn't been a time when the entire globe has been open and out of regional lockdowns of some sort, giving cause for worry about future demand surprising to the upside.
Labor, costs, policy
Another problem is a lack of labor — there just aren't enough experienced workers to run all of the oil rigs to help meet demand. The materials costs have increased — in some cases by some 15% - 20% — because of inflation. Service costs have also increased dramatically over this inflationary period.
US energy policy and its attitude towards fossil fuels is confusing to oil companies. The Biden administration has sent conflicting messages to oil and gas companies sometimes in the same day. In sending these mixed messages, the administration has frozen producer decisions to expand, even amid dramatically higher oil prices. Companies are naturally reluctant to make the long-terms investments needed amid this uncertainty. Said simply, the policy of reducing supply was not married up to effective policies to reduce demand via renewables growth.
...the policy of reducing supply was not married up to effective policies to reduce demand via renewables growth.
Demand has exceeded supply with the result being higher prices. It will likely get worse.
Supersized food inflation
Bad weather has negatively impacted agricultural prices. For example, droughts across the US have impacted wheat production. La Niña, or drought conditions, has hit South American supplies and this has affected soybeans and coffee prices in particular.
We're all aware of the importance of grain supplies from Ukraine and Russia. But finding alternative supplies raises protectionism issues linked to national food security, as well increased logistical difficulties and costs associated with longer supply chains.
Fertilizer supply has also been hit because of the war. The shortage today could lead to lower crop yields this year. The estimates here are quite varied. But even before the war, higher energy costs were pushing up the price of fertilizers.
What are the investment implications?
- Politics - While people in richer countries may have greater flexibility to adjust their spending habits to account for higher prices, people who live in the developing world will find it hard to find alternative food and energy sources. This is important because when governments fail to provide these essentials at affordable prices, discontent can spill out onto the streets — consider that the "Arab Spring" protests more than a decade ago were partially caused by rising food prices and scarcity. Of course, political instability usually leads to market volatility.
- Physical markets - We've seen a tremendous uptick in financing costs for physical commodity markets. Price volatility and rising interest rates are both factors. Higher financing costs tend to reduce physical supply and diminish the ability of commodity trading houses to meet demand for physical commodities. Visible inventories of most industrial metals — such as aluminium, nickel and zinc — are very low. The physical demand is actually pulling inventory off of exchanges. Many metals are energy intensive to produce (one reason why supply isn’t keeping up, even though they’re often critical components in the energy transition).
You can listen to Sree and Bob discuss these issues with Richard Dunbar in the latest edition of the Investment IQ podcast series here.
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