In addition to making it tougher to pay your bills, inflation also drives bond markets, as well as specific sectors within the stock markets.
Central banks are under pressure to act even if the medicine that’s needed often risks 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 which had 72% of auto sales in EVs last year, oil demand has only been flat for the last 10 years. This greatly outpaces oil demand forecasts from the IEA which predicted 30% decline in oil demand under those circumstances1. However ethane (for plastics) demand was up 31% and diesel (for deliveries) demand was up 15% offsetting any decline from auto fuel demand.
Source: 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 years production. For most of the last eight years the actual investment was half 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 were not.
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 wind powered. 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.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 we’re expecting price pressures as a result of this, as well as disruptions across the supply chain.
The Chinese government is highly motivated by a China Party Congress later this year 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. An improving Chinese economy only raises the prospect of higher energy and industrial metal prices.
Don’t mention the war…
The Russia Ukraine war and the resultant sanctions are keeping 500,000 to 1 million barrels of crude off the market at best. This is a small percent of the over 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, roughly 2%, a very thin margin for error.
Since February 2020 the entire globe has not been open and out of regional lockdowns of some sort, giving cause for worry about future demand surprising to the upside.
Labour, costs, policy
Another problem is a lack of labour – there just isn’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.
Oil companies are confused by US energy policy and its attitude towards fossil fuels. The Biden administration has sent conflicting messages to oil and gas companies sometimes in the same day. In sending conflicting 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. Demand has exceeded supply with the result being higher prices. It will get worse.
Supersized food inflation
Bad weather has hit agricultural prices. For example, droughts across the US have impacted wheat production; La Niña 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.
Fertiliser 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 fertilisers.
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 – 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).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.