Fuel
Gimme fuel, gimme fire, gimme that which I desire is the first line of Metallica’s song fuel from ReLoad, published in 1997. Now, 25 years later, one could answer to that line that it is a bit difficult these days.
It is valid on many levels. Firstly, one observes the situation in global energy markets where especially Europe, is affected hard due to the diminishing deliveries of Russian gas. Secondly, it is the market for the fuel of human (nutrition), as gas plays a role in the production of fertilizer, and thirdly, as central banks are forced to fight the high inflation rates, it means that there is also a problem with the fuel of our financial system, liquidity. I want to discuss all these topics in this week’s piece of The Weekly Wintersberger.
First, I want to write about the fuel for the financial industry. These weeks Germany and the United States published their inflation data for July. While German inflation numbers came in as expected, though still high, US inflation numbers surprised to the upside.
Year-over-year, German consumer price inflation was 7.6 %, which was .3 % lower than in May, when prices rose 7.9 % compared to the previous year, while on a month-to-month basis, prices fell .1%.
The fall in the inflation rate can be explained due to a mix of policies the German government implemented to dampen the effects of inflation on the public. For example, it lowered the tax on gasoline and diesel. However, one should not assume that inflation will come down substantially now. The ECB, besides the Bank of Japan, the one with the loosest monetary policy, assumingly will still not follow its Anglo-Saxonian counterparts and speed up their tightening path.
Economists expected a US inflation of 8.8% year-over-year, and that inflation dynamics have cooled off slightly. But far from it, year-over-year inflation rose to 9.1 % compared to the previous month, and they rose by 1.3 %, .3 % faster than from April to May.
Stronger than expected inflation in the US puts more pressure on the Federal Reserve. Rates rose sharply on the short end of the curve, 2y yields rose around 16 basis points to 3.20 %, and the 3m rose nine basis points after the numbers came out.
The yield curve flattened further, suggesting that market participants think the future rate hikes will produce a hard landing for the US economy. While analysts already speculate about a 100 basis point rate hike at the next FOMC meeting, market participants already expect the Fed to cut rates by 75 basis points until mid-2024.
The 2s10s spread went negative last week, a leading indicator that the US economy might get into trouble. However, according to Jay Powell, the Fed prefers to look at the 3ms10s spread, which is a lagging indicator and captures the policy rate outlook. Although it is still positive, it collapsed on Wednesday.
President Biden’s reaction to the inflation numbers was that he added that he will give the Federal Reserve the room it needs to help it to combat inflation. Although that statement might seem strange if one considered that the Fed is (at least on paper) independent from the US government, I would interpret it in a way that Biden will blame the Fed when things get bad.
The more aggressive the Fed is in raising interest rates, the more interesting it will be what the ECB does. Recently the Euro fell to parity with the dollar, and if the ECB continues to be hesitant, the lows are not in yet.
Now, let us move on to the food markets, the human fuel. Food prices started to rise in the fall last year because natural gas is an essential component of fertilizer production. Lately, the UN Food Price Index shows signs of some relief, as prices fell moderately in the previous quarter.
Nevertheless, one should not assume that prices will fall back to pre-crisis levels, on the one hand, because fertilizer prices will remain elevated due to the tensions in the gas market. On the other hand, one could assume that the European food supply might fall in the coming years because of environmental laws.
In the Netherlands, farmers are protesting against a legal proposal from the government to reduce greenhouse gases, as formulated in the latest directive of the EU Commission to fight climate change. According to the proposal, the Netherlands wants to reduce the emissions of pollutants like nitrogen oxide by 50 % by 2030. Community governments should make recommendations within a year of how the goal could be reached. It is expected that communities will propose to buy livestock farms, which produce vast amounts of ammonia, to shut them down. Calculations from the dutch government expect that 30 % of all livestock farms in the Netherlands might be closed during the process.
Because of that, many farmers fear their existence if the Rutte government sticks to the proposal. Despite the ongoing protests of 40 thousand farmers all over the country, Rutte refuses to talk with them. His arguments remind one of the ones that Justin Trudeau made during the Canadian trucker protests last winter. Rutte said that it is not acceptable to create dangerous situations and that it is not acceptable to intimidate officials.
It is probably correct to assume that the EU-Commissions plan to reduce greenhouse gases will also lead to the closings of farms in other European countries. Additionally, restrictions on fertilizer usage will lead to a fall in European food production. As demand will remain stable, one could assume that prices will have to go up in Europe, and apart from that, food imports might also pick up.
Sri Lanka is an excellent example that too rigid environmental law could lead to disastrous consequences. In 2018, Sri Lanka’s prime minister published a piece on the World Economic Forum’s website titled ‘This Is How I Will Make Sri Lanka Rich By 2025’, arguing that environmental reforms would guarantee future economic success for the country. Reality should prove him wrong.
For months, the protests of the Sri Lankan people have grown due to a massive spike in fuel prices and other goods of daily need (for example, an 80 % rise in food prices) and regional blackouts.
Apart from unsustainable dollar-denominated debt, which led to the country’s bankruptcy due to the dollar's appreciation, the island also suffers from a sharp decline in food production. After the government imposed a ban on synthetical fertilizers in 2021, rice production collapsed by 20 %. Sri Lanka, formerly self-sufficient in rice production, now had to import rice worth 450 billion dollars while rice prices rose by 50 %.
The tragedy of Sri Lanka shows that blindly enforced environmental policies where no one thinks about potential side effects can produce horrendous results. These days, Sri Lanka learns that the road to hell is paved with good intentions.
And there is also the weather. Europe suffers from a severe drought, leading to a fall in food production and several implications for energy markets. Therefore, let us discuss energy markets now.
The drought is playing into Russia’s hands, on the one hand, because lower water levels lead to lower electricity production levels of hydropower. On the other hand, Europe’s rivers are also crucial for other sources of electricity.
For example, German coal plants rely on rivers to receive coal deliveries, while French nuclear power plants use the water for cooling. The level of the Rhine is the lowest it has been in 15 years, and hence lower than it was during the last drought. The only sources of electricity production left for Europe are wind and solar, highly dependent on the weather, and gas.
Additionally, Russia has stopped delivering gas to Europe, although not totally. Deliveries via Nordstream I stopped due to maintenance work. However, there is fear that the pipeline will be closed afterward in response to the European sanctions against Russia. Governments at least should prepare for such a scenario as German and Austrian (both countries are highly dependent on Russia) gas storage is hardly filled. According to OMV, Russia delivered about 70 % less gas than ordered.
At this point, one usually criticizes how blind Germany and Austria must have been to become so dependent on Russian gas. While that is principally correct, if one looks at the data, one will find out that this is not the only reason gas storage is so low. If one looks at Poland, its’ gas storage is at 97 %, which is the highest level in Europe. So, why Poland?
Poland decided to stop buying Russian gas back in September of 2021 and to buy gas from Norway instead. The plan has been that Norway delivers the gas through the Baltic Pipe pipeline currently built and should start operating in the fall. However, until then, Polen decided to buy gas at the German spot market. Since December 2021, Poland has been buying gas there, thus contributing to the German gas prices rising.
This week, german gas prices rose by 19 %, and prices will continue to increase during the coming fall and winter. That will push the German economy into a sharp recession as cheap Russian gas is no longer, or less, available.
On the other hand, some people still claim that an import ban on Russian energy is doable, in my opinion, without thinking that through. The former CEO of Eon, Johannes Teyssen, was interviewed in the German Mission Money podcast and warned against such considerations.
When he was asked how dangerous a gas embargo would be, Teyssen answered (my translation):
Extremely dangerous... it is really about a widespread breakdown of the basic industrial structure that is dependent on natural gas and the entire value chain behind it. If one ever understood how endless the number of products that contain chemistry is, knows when the big production locations...no longer produce anything, how quickly this will lead to supply bottlenecks in other industries.
The whole interview is a must-watch because Teyssen is making a lot of interesting points about German energy policy and how to deal with the crisis. However, I want to highlight one more quote it. When the interviewer asks him why so many economists say that an embargo on Russian gas is manageable, he replies:
Economists have no deep understanding of supply chains and business economic connections. They all have a macro-view, overall economic models, where they just take out a certain percentage factor and assumes that this is representing it appropriatly.
I think that the devil is in the details. One has to understand that natural gas not only is fuel, it also a commodity for a variety of products and not replacable… now one finds out that the US or the Middle East cannot just compensate the quantities because they simply do not exist. Those models are way too abstract, too theoretical and do not take into account quantity flows and relationships between companies.
Even though Teyssen says that the German government should prepare for the worst case, he argues that it should not initiate the worst case. Another important thing that he criticizes is that one should not decide to exit a form of energy without thinking about how to make up for it.
It is a bad idea if Europe cuts energy supplies from Russia completely. Facing the possibility that Russia might do that, UBS economists have calculated that this would lead to a fall in company revenues by 20 % and a EUR/USD exchange rate of 0.90, and the economists say that this is not the worst case.
Europe desperately looks for alternative energy sources that can substitute Russian gas. Many are turning to the US and Qatar for LNG, while Italy also talks to Algeria about additional gas supply. However, substitution takes time, and it is probably too late to secure gas availability for this winter.
Germany has decided to exempt the use of coal plants, but as the EU agreed to ban Russian coal from the market from August this year, other suppliers experienced a rise in demand, and prices sharply rose.
Additionally, oil is considered an alternative energy source, but this would potentially mean more trouble at the gas station as fuel producers are now competing with additional demanders for the supplied quantities of oil.
It is not true that petroleum companies are artificially elevating prices. The main reason behind the rise in margins is the lack of capacity due to the continuous fall of investments in these sectors. Totally understandable in an environment where politics plans to abolish the use of fossil fuels in the future, again without thinking about the potential side-effects of such policies.
The question of whether Europe can cope without Russian Energy is definitely not in the short term, while it is probably doable mid-term, but only under high sacrifices of wealth. Europe is in a much different position than its US ally because Europe is a net importer of Energy while the US is an exporter.
The US is not dependent on Russian energy, and Europe is. Additionally, mistakes were made. Nuclear power has a bad image in Europe, while the continent's natural gas resources have been idle. As a result, Europe became totally dependent on Russian gas while the disagreements increased, and Europe implemented sanctions. Everyone should have expected Russia to join the economic war at some point.
With open eyes to catastrophe, one might say. High debt levels and high inflation make it harder for governments to support struggling citizens and those who fear losing their jobs. The ECB cannot help either because it cannot print energy, so one has to hope that the coming winter will be mild.
All the above points suggest that staying the course could jeopardize Europe’s social order. The number of Protests all around Europe is already increasing, and if one looks at Sri Lanka, it is observable that after the tipping point is reached, it can go fast. Mass protests and social unrest in Europe were unthinkable two years ago. Now they are very probable. That would deteriorate the economic outlook further, and more capital will move out of Europe.
Now, it is time for a short summer break. The next Weekly Wintersberger will be published on September 2. Have a glorious summer!
Fabian Wintersberger
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity.)
Have a great time off. One can only imagine how things will have progressed by the time you return