Oil prices rose another 22% over the quarter. The market is now up 70% in the last five months alone. A host of factors may be relevant here, including the threat of inflation and rising global commodity prices generally as investors seek haven in hard assets, Pushing up prices of raw materials and encouraging major energy users to lock into forward prices now, buying in higher volumes than they would otherwise.
As cited in this blog previously, research by Purvin & Gertz has identified a strong serial correlation between the price of oil and the supply cost of replacement reserves: of new exploration, production and export infrastructure capital costs combined. Their research, published back in 1957, has stood the test of time ever since and it may be especially relevant if the inflationary climate changes and we see higher labour and commodity-intensive capital costs driving supply costs higher. In the background still are the geo-political and infrastructure problems affecting several African and Middle Eastern producers reported on previously, which have not shown signs of improvement.
One reason the commodities and bond markets are on ‘inflation watch’ may be the perceived or ‘unsustainable’ purchases of government bonds by central banks worldwide: Quantitative Easing (QE) to use the official term. In essence this is the printing of money by central banks in order to buy bonds issued by governments who have no realistic prospect of buying the debt back. Additionally the interest coupons normally payable to the bank as the holder of the bond are not claimed. Instead this interest is handed back to the treasury concerned, which simply includes it with the newly-minted reserve of cash, increasing its new and potentially non-refundable supply of money further.
QE was conceived just as an initial measure to ease credit in the aftermath of the 2008 Financial Crisis. However the practice never ceased and when the 2020 pandemic struck, it went into overdrive. QE today remains endemic across many western banking systems, with central banks purchasing a seemingly never-ending stream of new-issued government bonds; Treasury Bills in the US or ‘gilts’ as termed in the UK. Inflation never took off significantly in the wake of the initial rounds of QE although these were modest by comparison to today. However, the gilts market may be viewing things differently next time around. Expecting any new inflation to be more difficult to control now given how fragile the world economy is to, also to its dependence on zero nominal interest rates which are already negative in real terms. This might now rule out the use of the interest rate rises to levels needed to bring future inflation under control if it materialises. The same is true of other economies not least the USA.
To put this into perspective, the dollar is almost 250 years old although 75% all the dollars ever created have been printed by the Federal Reserve since 2008, most of these in the past 15 months alone. Other central banks, including the Bank of England, have followed suit. But because the dollar is a reserve currency the Fed can – up to a limit – print dollars ad infinitum, safe in the knowledge that economies must hold dollars in order to trade internationally and must buy US Treasury Bills. However other central banks, notably the BoE which now owns well over half the gilts issued by the Treasury, have no such insurance cover. Such economies will be vulnerable if national levels of QE indebtedness look unsustainable to international investors or buyers of gild-edged stock.
It looks increasingly likely some western governments will not find (may not be seeking even) the means to buy-back their issued bonds. In reality, the debt will be cancelled by the central bank, exposing QE as the money printing exercise it was all along perhaps. But there is no precedent in economic history where inflating the money supply by cancelling a central government or treasury balancing sheet has not led to higher inflation eventually.
Looking at today’s yield curve and UK government borrowing graphs, Treasury spending and BoE bond purchases have moved more or less in lockstep over the past year, despite the independent status of the Bank of England officially. If international lenders (investors in gilts) see significant inflation ahead which will reduce the real returns on their government bonds purchased they will quickly command commensurately higher rates of return. The upwards sloping yield curve now may be construed as a sign of future inflation in the wings, or certainly gilt market expectations of such. To put this into perspective too, a cursory look at the Treasury yield curve already shows UK government borrowing costs on quite a sharp rise. On 4th January this year, the 5 Year Treasury Note stood at 0.10%. This nominal rate of return on gilts has since risen four-fold to 0.39% in the past three months alone. The yield curve moves of course but the concern is that the UK like Eurozone countries may be close to entering a ‘liquidity trap’. Unable to unwind QE lest that trigger a recession while governments borrowing costs rise as investors command every higher rate of return on government bonds; and central banks owning an ever-higher percentage of the government debt as QE continues and as existing bonds (held by private investors) gradually mature. There is a finite (if unknown) percentage of government debt which a solvent central bank can own before the situation becomes unsustainable, even if we are possibly not at that point yet. But there is no do doubt that inflation does reduce the real value of government debts and higher inflation will be deemed preferable (or “nice problem to have” to quote one senior official).
Of course, it could equally be argued higher government borrowing costs, inflation or depressed economic activity could suppress energy prices with them. For the meantime however, no such scenario is immediately evident. If anything, stock markets are factoring in a ‘post Covid bounce’ so the recent rise in commodity prices and potential rise in supply-costs (as discussed above) could become the more deciding factor.
Forward gas prices nudged up 2% amid strengthening prices of spot traded Liquefied Natural Gas and petroleum products generally. LNG is likely to influence gas prices to an increasing extent as locally-sourced gas production declines, especially were the UK to join Denmark in ceasing to grant further North Sea exploration licences, as was discussed in the press recently. There is no early sign this will actually happen however. Other factors to consider in future will be the strength of Sterling versus the US dollar with global LNG prices traded in $/MMBTU. Also Sterling versus the Euro with gas supplies increasingly imported via inter-connector pipeline and traded in €/MWh at the Dutch Title Transfer facility (TTF). Meanwhile future imports from Norway, North Africa and Russia will stay indexed to petroleum products and general price indices to a significant degree. So there is no escaping the fact that wholesale gas prices will be exposed to a sustained increase in inflation, if it materialises.
A retrospective look at the forward gas curve reveals an unusual pattern with October Year prices spiking at almost exactly 55 pence per therm on three separate occasions, each of them one month apart. It is tempting to attribute such patterns to AI, ‘machine trading’ or some market resistance level. But there is a host of fundamental factors to explain this including the recent inter-play with the oil and commodities markets as discussed above. The October Year contract retreated by 12% off its peak towards the end of March but it could still test 55 p/th again soon or surpass it if demand is seen to fully recover soon.
The base-load power market exhibited a similar trident fork shape if less flat with a rising price on each occasion. The October Year Contract ended just 4 per cent higher. However, industrial and commercial power prices will be especially vulnerable to inflation due to rising non-commodity charges including network costs, green tariffs and surcharges. Notably contracts-for-difference (CFD) price subsidies for new-build nuclear power stations and major low-carbon projects; all of these indexed to inflation at some level. Non-commodity charges now make up circa 65% of the average commercial electricity bills and the quotient will rise further with impending legislation. So the twin-tasks of verifying and minimising such costs however possible will be an important key to reducing energy costs in future.
It was recently announced that EDF’s 1.6 GW Olkiluoto 3 nuclear power project in Finland, sharing the EPR1 reactor design of Hinkley Point C, will begin ‘cold functional’ testing in June. Successful trials here could be a sign we will see new volumes from the Hinkley and Flamaville power stations come 2025. Exports from the Flamaville nuclear power station in Normandy will be enabled by the 1.4GW FAB (France-Alderney-Britain) cable under construction now; the combined volume to add an important 4.6 GW or 10% addition to current UK generation availability.
The UK and Continental systems share many issues concerning aging coal, gas fired and nuclear power stations in particular. Looking at the future, electricity grids will be increasing finely-balanced as ever more intermittent wind, solar and bio-mass generation is included in the generation mix. Notably in the case of the UK due to an additional reliance on sub-sea interconnectors which entail technical reliability and security of supply issues of their own. So plenty to keep tabs from this point on.