As the world embarks on its journey towards net zero, a few implications seem straightforward: coal should be oversupplied, natural gas should stay abundant and the marginal cost of electricity should approach zero as renewables take over.
In the fullness of time, these forecasts may well turn out to be correct, but the road between here and net zero seems to have a few unexpected twists and turns. The impact will be felt well beyond the energy and commodities markets, affecting everything from growth to inflation to politics.
Take the current situation: global coal consumption peaked back in 2013, yet the price of thermal coal is close to its all-time high, having more than doubled in the past few months to almost $200 a tonne. The same has happened to liquefied natural gas, which has rallied from $7 to more than $20 per million British thermal units during the past few months, also an all-time high.
European natural gas prices have risen in tandem which, in turn, have driven a sharp increase in electricity prices: day-ahead prices across continental Europe have gone from €50 to €150 per megawatt-hour — you guessed it, an all-time high. As a knock-on effect, aluminium prices have soared, from $2,000 at the start of the year to $2,900 a tonne today.
This was unexpected, especially because the global economy has yet to recover fully from the Covid-19 crisis. So what is going on? As often happens, the story starts in China.
The combination of a post-Covid recovery and unusually hot weather has increased electricity consumption sharply this year. Most of China’s electricity is produced from coal, but domestic coal output is struggling to keep up due to regulatory reforms, under-investment and more stringent health and safety inspections.
Another important source of electricity in China is hydropower, but because of droughts in key parts of the country, it has failed to grow this year too.
Over the summer, this led to power crunches that forced regional governments to curtail consumption — street lights were even switched off at night in a number of regions. Another victim of these measures was aluminium smelting, which is a particularly electricity-intensive process.
Normally, China supplies 60 per cent of the world’s aluminium. With its output curtailed and global demand continuing to grow, aluminium prices soared.
China’s domestic coal shortage compelled it to turn to imports. However, coal production elsewhere has also had its issues: heavy rains and labour shortages in Indonesia, railway disruptions in Russia and unrest in South Africa. As the seaborne coal market tightened, global coal prices rallied.
The same factors drove up China’s demand for LNG, but here China was not alone. A severe drought in Brazil also curtailed its production of hydropower, driving up LNG demand. With a number of production outages at liquefaction terminals, the global LNG market has tightened severely in the past few months.
Europe is usually the end market for a substantial share of the world’s LNG. However, competition for the commodity has meant European LNG imports declined sharply this summer. At the same time, fewer windy days meant power generation from offshore wind disappointed, boosting demand for natural gas.
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Yet, with gas supply from Russia and other regions constrained, Europe was unable to build gas inventories as it normally does in the summer. European gas inventories are now unusually low for this time of the year, with winter yet to start. As natural gas prices largely set electricity prices, they have surged in tandem.
So what does this all mean? We highlight three conclusions:
First, this sequence of events shows how interconnected commodity markets are. One region affects another as do multiple commodities. A drought in China can drive up the price of electricity prices in Spain but also the cost of soft drink cans in the US.
Second, this year has shown how difficult it can be to anticipate such moves. Even a few months ago, the common view was that practically all these commodities were abundant, and would become more so over time.
Finally, it shows how little margin of safety there is in the world’s energy system, and this has important implications for the future.
Over the next few decades, the world will need to fundamentally retool the way it produces and consumes energy. So far, the supply side is adjusting faster than our consumption patterns. The world is still in the early stages of its decarbonisation journey, so this creates the potential for further instability and squeezes in the future.
Martijn Rats is the global oil strategist and head of European energy research at Morgan Stanley
The Commodities Note is an online commentary on the industry from the Financial Times
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