Spike in energy prices raises doubts about energy transition

Energy Crunch Graph

Recent months have seen a surge in coal and natural gas prices, both key components of the global energy system, tipping parts of the energy sector into crisis mode. Several energy suppliers in the UK have collapsed.

The cost squeeze has rippled through the supply chain, impacting supplies of raw materials such as ammonia for fertilisers, CO2 for food production and glass. 

In particular, gas suppliers and consumers are understandably nervous about the challenges approaching the winter heating season in the northern hemisphere. Inventories are already low, and unpredictable weather patterns mean that both supply and demand could spring a surprise. 

Europe currently has its lowest level of gas reserves in at least ten years.

The medium-term backdrop for power generation is also a challenge. According to the International Energy Agency, global electricity demand fell by around 1% last year but is set to grow by 5% this year and another 4% next year. 

With many countries pushing forward with their green energy plans, governments and companies are exposed to new risks. Miners and smelters rely on coal and gas for their fuel and power generation requirements, and a range of other industrial consumers need to meet new requirements imposed by ESG policies. 

Many people see gas as a transition fuel as we move towards a greener energy future. It is cleaner than coal, but prices are notoriously volatile due to the market’s vulnerability to supply and demand shocks. 

Electricity Sources

This vulnerability comes partly due to the challenge of storage, but there is also no equivalent of OPEC to act as a safety valve in times of crisis. Furthermore, gas is often produced as a by-product of oil, making supply inherently inelastic. Also, renewable energy from solar and wind is reliant on the weather, meaning that demand for gas to plug any gaps for power generation is also very uncertain.    

The worst of the recent gas crisis has occurred in Europe, with Dutch TTF natural gas prices up by 450% in the past year, reflecting low inventory and anxiety about potential future shortages. Economic activity in the region has bounced back this year from the Covid crisis – lifting demand for electricity – but more important are the broader global dynamics, which are limiting shipments to the region. 

There are four key elements boosting gas prices

  • US natural gas production has been dented by prolonged shutdowns caused by Hurricane Ida. This has limited LNG shipments to Europe.
  • Asia has been boosting its LNG imports, driving up the LNG price in the region by around 60% in the past month. 
  • Russian pipeline shipments to Europe have remained subdued. While the crucial Nordstream 2 pipeline (connecting Russia with Germany) is now complete, regulatory approval is expected to take several months, potentially keeping it shut through the worst of the winter. Additional flows could, in theory, be directed through the existing Nordstream 1 system, which runs through Ukraine, but the concern is that Russia is deliberately holding back supply for political purposes. 
  • The weather has been unkind. In the UK, for example, wind power is important, with the country having some of the largest offshore wind farms in Europe. According to figures from Argus Media, wind farm output in September 2021 (based on the first 21 days of the month) is down about 56% y/y and is heading for a five-year low.

The UK is particularly vulnerable to a gas crisis as it closed its giant Rough storage facility back in 2017 to save money, leaving it with just 1% of European storage. 

In terms of coal, the pressure to address environmental issues creates new challenges for consumers and producers, with China looking to forge a new greener path. Thermal coal prices in South Africa are up by 171% from a year ago. While coal consumption in China has been broadly stable, supply has been scaled back, and inventory levels are also low. 

Given this background, the obvious implication is that relying on natural gas creates its unique challenges.

Countries in Asia and Europe without adequate supply or storage are particularly vulnerable. Nuclear power is more reliable for the power grid, but plant construction costs are very high.  The nuclear industry is viewed with suspicion due to the challenges around waste disposal and after the Fukushima disaster in Japan. 

Renewables are seen as the holy grail by some, but they can’t provide a steady supply of power to the grid due to the variability of the wind and the sun. Over the medium-term, energy importers look set to rely on the kindness of mother nature or the kindness of strangers. 

Welcome to the new world of green energy and tough choices.