Weighing done smartly thanks to Tal-Tec
It has been said that data is the new oil. That’s certainly true of the agricultural environment where farmers are increasingly using the power of data and data analytics to make better decisions and improve their operations.Continue reading View more
The question of oil: where will it go by 2030?
Fred Razak, Chief Trading Strategist at CMTrading, weighs in on the state of the international oil market, currently under severe pressure and scrutiny due to the Russia-Ukraine crisis, rising prices and 2030’s looming climate deadlines in Europe and the USA.
“As ordinary working people on the street, we will never know precisely what is happening behind closed doors at the White House, the Kremlin or even Luthuli House. But there are always agendas at play that we may not be aware of. Many conspiracy theorists would have much to say about what those agendas might be. All we can do is speculate based on what we see in our world.
“The subject of oil is hotly contested in our current climate. Most of us are familiar with the story surrounding the discussion about oil. Russia – an oil-producing country – is at war with Ukraine. Europe and the United States have voiced their support for Ukraine, and President Joe Biden recently announced a $3 billion military aid package to Russia’s beleaguered neighbour.
“Additionally, the European Union and the United States aim to implement significant steps to move away from fossil fuels by 2030. So, where does this leave oil? This all brings us back to those agendas no one knows about. But while we may not know, we can, of course, speculate.
“Throughout history, wars have been primarily economically motivated. As tragic and senseless as any war is, this conflict is no different. Vladimir Putin recently demanded that ‘hostile countries’ pay for all their natural gas imports in rubles rather than in Euros or US dollars. As the ruble fell rapidly amid the war, Russia blamed the West for its decline. And to strengthen the currency, he issued this ‘ruble clause.’
“This policy on Russian energy exports means that ‘hostile’ importers in Europe and the US need to buy rubles to buy Russian oil – primarily from the Russian Central Bank. In a roundabout fashion, the importers will still be buying in dollars and Euros, but through the Central Bank, rather than directly from Russian exporters.
“If the Russian Central Bank restricted the movement of the ruble, or if the ruble exchange rate became more favourable towards the dollar because of limited access to Russian commodities like oil and wheat, in theory, buyers would want to accumulate rubles, rather than dollars and Euros.
“In this sense, Ukraine is a pawn in one of Putin’s (and there are many) economic plays for power. In the interim, the oil price has soared. But this is less due to a shortage in supply than it is due to the toxic speculative climate. It’s a gamble and a waiting game on Putin’s part, which could have severe humanitarian consequences for the Russian people who make a living via the supply chain. But Putin is sticking to his guns.
2030 and big oil
“In the story of climate change, fossil fuels and pollution are the villains. Under President Bill Clinton in the late 90s, the ‘bad guy’ was tobacco. Of course, both ‘villainous’ commodities are understandably perceived as destructive. In the case of fossil fuels, because of the damaging effect they have on our environment, and in the case of tobacco, because of the immense health risks associated with tobacco products.
“Shares in major cigarette manufacturers Philip Morris, RJ Reynolds and British American Tobacco fell in response to Clinton’s threat of a multi-billion-dollar lawsuit against the tobacco industry, which was based on Clinton claiming that taxpayers should not have to pay the medical costs associated with lung cancer.
“In the end, however, Clinton’s proposed healthcare reform bill was defeated. And speculators who have not been privy to those ‘secret’ agendas behind closed doors attribute the defeat to big tobacco companies funding opposition to the bill. Tobacco shares bounced back, and anyone who invested in tobacco during the crash capitalised on that.
“Tobacco, though globally regulated and off limits to marketing and advertising companies in most countries, lived to fight another day. Big oil will too. China controls most of the minerals needed to build electric vehicles. And while the West is scrambling to find alternative sources of supply, the oil industry remains in charge.
“Even when electric vehicles become more commonplace in developed markets than fossil fuel-powered vehicles, big oil will still – at least for the foreseeable future – be needed elsewhere. Oil is also used to make many other items we use every day. Some of these are surprising. Even wind turbines – touted as one of the solutions for clean energy – use some oil-based plastic products.
“Oil and natural gas are also used to create the asphalt we use on our roads. It is an ingredient in cosmetics, creams, deodorants, and medical equipment like MRI machines. It is still widely used in construction, in many lubricants, waxes, paints, and a variety of other things we see daily that may come as a surprise.
“Many developing markets are also not equipped to become climate neutral yet. Fossil fuel-powered vehicles are likely to be around far longer in those markets than in Europe and the United States. So, for now, the likes of Exxon Mobil, Saudi Arabian Oil and BP are here to stay, despite oil being one of the world’s most significant matters of contention.
“Oil companies have the scope and the time to reinvent themselves in changing markets. And they are likely to stick to their guns, just like the cigarette companies did against the Clinton Administration. Is this another case of the villain emerging victorious? Perhaps oil is the villain now, but we may see it reinvent itself in the years leading up to 2050. The story is far from over.”View more
Russo-Ukranian war and its impact on Godongwana’s plans
An Overshadowed Budget Speech
The 2022 Budget Speech was completely overshadowed by the tragic events in Ukraine. However, it also reflects the fact that there was little drama in the Budget this year, and frankly, that is how it should be. The Budget should be boring and predictable, and devoid of existential angst. Progress in that direction is therefore welcome.
There has been extensive commentary on the Budget already, so it is worth focusing on some of the points that received less coverage and ask how the Russian invasion thousands of miles away might impact some of the issues Finance Minister Godongwana spoke about.
The first point to make is that the government’s finances are in better shape largely thanks to a supportive global environment, particularly in the form of elevated commodity prices. Tax revenues in the fiscal year that will end soon will now likely exceed the updated October projections by R62 billion, with company tax a big (but not the only) reason.
Commodity prices have increased further over a broad front in recent days due to fears that the increased economic isolation of Russia could lead to shortages of the raw materials it exports. Russia is of course a major exporter of oil and gas, but also of wheat coal, palladium, nickel and aluminium. Ukraine is also a major exporter of agricultural commodities, and one will have to assume supply disruptions if the conflict escalates.
Higher oil prices will feed into existing global inflationary pressures and could lead to central banks raising interest rates at a faster pace. However, while the current uncertainty lasts, central banks could err on the side of caution.
Importantly, the price increases signal supply shortages while demand is expected to remain robust. This is indicative of still-solid global growth. We are not at the point where higher commodity prices and rising interest rates trigger a global recession yet.
While South African consumers are likely to pay more for food and petrol (and therefore the government did not raise the fuel levy for the first time since 1990), our own exporters should benefit from these higher prices.
Chart 1: Global commodity price indices
Source: Refinitiv Datastream
That said, the government is wisely not banking on commodity prices remaining high. It has used the current windfall to reduce debt levels and extend the R350 per month Covid-grant for another year. But any increases in the social safety net beyond next year will have to be funded by a permanent increase in tax revenues, not borrowing or hoping for high commodity prices. No significant tax increases are pencilled in for the next three years.
Chart 2: Debt-to-GDP projections
Source: National Treasury
Thanks to the revenue overshoot and reasonable discipline on the spending side, the debt-to-gross domestic product (GDP) ratio is now expected to peak earlier and at a slightly lower level than projected in the October mini-budget, namely 75.1% in 2024/25 (chart 2). By that point, the government expects to run a primary surplus, meaning that revenue will slightly exceed non-interest spending. The budget deficit will then entirely consist of interest payments in excess of R300 billion per year (chart 3).
This remains the key reason for staying on the fiscal consolidation path: interest payments are already the fastest growing item in the Budget and are crowding out other worthy areas of spending. Since South African government borrows at a high interest rate (6.2% on a weighted basis), debt service costs compound quickly.
Chart 3: Main budget balance projections
Source: National Treasury
It is not all bad news: most of this money flows back into the local economy since two-thirds of government bonds are in local hands, held by insurers, unit trusts, banks and pension funds.
The debt and deficit projections are considerably better than two years ago in the depths of the Covid-induced recession as the economy has recovered much quicker than expected. But there are risks to this outlook: the government faces considerable pressure to increase spending on all fronts from frontline service delivery to expanded social grants to public sector wages. Maintaining discipline will be tough but the commitment is currently there. However, there is no guarantee that a future government won’t take a more populist stance. The other risk is an economic slowdown that once again depresses tax revenues, for instance if the Ukraine crisis spirals out of control. Therefore, local bond yields still contain a hefty risk premium.
While South African bonds sold off as Russian troops rolled into Ukraine, the jump in yields was mild compared to other episodes of global risk aversion and emerging market panics. This reflects the better fiscal outlook, as well as expectations that inflation will remain under control even with higher fuel and food prices. The higher yields therefore offer an even better entry point.
Chart 4: Emerging market local currency bond yields
Source: Refinitiv Datastream
The biggest question for any bond investor anywhere is simply whether the borrower will default (fail to repay interest or capital). While many commentators and investors have framed default risk in terms of the rapid increase in the South African government’s debt levels over the past decade, they have missed another key part of the Budget, namely the debt-management guidelines that Treasury uses precisely to lower default risk.
There are limits on the issuance of foreign bonds and short-term debt (less than 15% of each), while there are ranges for inflation-linked bonds (20% – 25%) and a targeted average maturity for total debt (10 to 14 years). Debt crises have historically happened when a government runs out of hard currency to pay foreign lenders (in other words, it is usually as much of a balance of payments crisis as a fiscal crisis) or when large volumes of maturing debt have to be rolled over at a point in time when interest rates are very high, or market access limited (as was the case with the infamous 1998 Russian default). While the South African government’s debt levels are high, the profile of debt therefore reduces the risk of a fiscal crisis.
Moving in the right direction
Beyond the headline debt and deficit numbers presented in the Budget, it is also important to look at the intent and the message. Apart from the emphasis on fiscal consolidation, there is a strong focus on economic reforms to raise the country’s long-term growth potential. Most of these reforms need to be carried out by departments other than Treasury, so it is often a case of two steps forward, one step back – or simply waiting ages for the first step to be taken. Treasury is involved in Operation Vulindlela, a joint initiative with President Ramaphosa’s office, to drive meaningful cross-cutting reforms.
We need real economic growth to increase from the 1% average of the past decade towards the longer-term (since 1960) average of 3% for the fiscal numbers to make sense in future. That is why the reforms underway are so important, and why more is needed to improve the business climate.
One such change is a continued simplification and easing back of capital controls to foster investment inflows. The Budget announced the intention is to raise the limit on offshore investment of funds to 45% plus 10% for African exposure. In other words, in contrast to a widely held view that government will move to restrict offshore investments, they’ve gone in the opposite direction and local investors will have more choice in future.
Another widely held view – and subject of much scaremongering – was the imminent imposition of prescribed assets which would force pension funds to buy government or state-owned enterprises. Instead, pension fund regulations will be amended to allow for – not force – greater investment in infrastructure projects. Infrastructure investing is likely to become a bigger feature of local pension funds, but probably not for retail investments that have daily liquidity requirements. Still, it is an exciting asset class. The problem is not convincing pension funds to do so but the lack of bankable projects.
If we are going to see higher economic growth rates, we will need to invest in infrastructure. There is no way around it. While Treasury has budgeted R812 billion for capital projects over the next three years, that is not enough to meet the country’s needs and almost half is allocated to provincial and local governments where implementation capacity is limited. Therefore, the efforts to crowd in private capital and expertise across a broad range of projects are crucial.
South Africa remains reliant on a healthy global economy – and of course there will be question marks given the Russian invasion – but we are slowly taking steps to get our house in order and raise the long-term growth potential of the economy. This is very important, since the world increasingly seems like a very uncertain place. The Budget and other recent announcements again reflect the fact that for all our challenges – and there are many – South Africa is not a failed state and the extreme pessimism over the prospects of the country and its financial markets is not warranted.
In fact, the strength of our democratic institutions contrasts very starkly against the one-man decision-making of Russia’s autocratic president Vladimir Putin that will directly influence the lives of millions of people. Russia is oil-rich, but its people aren’t wealthy. Russia’s real per capita income of $11,000 is a quarter of the UK’s, for instance. Putin is diverting valuable resources that could’ve improved the lives of Russians to destroy the lives of Ukrainians. His actions could also reshape the global economic and geopolitical order in profound but unpredictable ways.
Clearly the events in Ukraine are unsettling especially since the world is still dealing with the lingering uncertainty of the Covid pandemic. Markets have been extremely volatile, and this is likely to persist until there is more clarity. History suggests that such geopolitical events have historically had a minimal long-term impact on investment returns unless you are directly involved, and particularly if you are on the losing side. On the contrary, they have often presented investment opportunities. Investors are understandably anxious, but more damage to portfolios is often done panicking in response to big events than by the events themselves. The best course of action remains ensuring your portfolio is appropriate for your long-term investment goals – be it growth, income, or capital preservation – and then sticking to your strategy.View more
Ukraine-Russia crisis and the oil price pain
· Oil and other fossil fuel prices have increased sharply over the past year.
· Fears over a Russia-Ukraine war have stoked further recent increases.
· While oil raises the cost of living for consumers and reduces business margins, we’re not yet facing a repeat of 1970s stagflation.
By Old Mutual Wealth Investment Strategists Izak Odendaal.
Global oil prices have increased rapidly in recent weeks, some would say alarmingly so. This is part of a broader rise in energy prices that is creating winners and losers, threats and opportunities.
Over the past year, the Brent crude price has risen 60% in dollars to hitting $90 per barrel for the first time since 2014. While oil price volatility is normal, the usually sleepy coal market saw prices triple, fall, and rise again to 156% above year-ago levels. Even more impressive (or depressing, depending on your vantagepoint), European natural gas prices rose in the region of 300%, depending on the specific contract.
Chart 1: Energy futures prices in US$
The most immediate cause is the risk of a war between Russia and Ukraine. Russia is one of the world’s energy superpowers, being a major producer of oil, gas and coal. In particular, Europe is reliant on Russian gas exports, and therefore an easy target if Russia wanted to retaliate against any new sanctions imposed by the West. Adding to the geopolitical risk premium usually built into oil prices is a recent attack on UAE oil installations.
The deeper cause of surging energy prices is simply that demand has recovered faster than supply can keep up. It wasn’t that long ago that the reverse was true. Lockdowns in early 2020 decimated oil demand, and a key American futures contract memorably traded at a negative price in April 2020. Traders were giving the stuff away. Not anymore.
Today global growth is strong, mobility has largely recovered, and demand has improved. Supply is a different matter, for a number of reasons.
The first is that OPEC together with Russia still maintains production quotas. In other words, there is an artificial restriction on supply. For those panicking about prices shooting ever higher, this fact should serve to calm nerves somewhat. Cartels require enormous discipline to keep production down when prices are high and there is the chance to sneakily make more money. This is particularly the case for the OPEC countries that rely on oil to maintain public spending while non-OPEC producers have a free ride and benefit from higher prices without having to show any production restraint. Moreover, given that there is no certainty that the world will still be using oil in two or three-decades’ time, there is a strong incentive to get as much of it out of the ground now. But for the time being, OPEC has only announced a small increase in its production quota.
Secondly, the swing producers that emerged so forcefully in the past decade – the US shale companies – have changed their business model in a small but significant way. Instead of spending to grow production at all costs, there is a much greater focus on returning cash to shareholders. Some of the most productive wells are also rapidly depleting, meaning output cannot be ramped up even if producers wanted to.
US oil production has therefore increased after collapsing in 2020 but is still below pre-pandemic levels.
Chart 2: US oil production and capex
The third reason is less clear cut but the fact that the extraction and burning of fossil fuels has fallen out of favour among many investors means capital to fund such activities is becoming scarce. Listed oil producers are investing less in new capacity. This is a good thing, but the problem is that the world is not quite ready to function without fossil fuels.
Electric vehicle sales have shot up in many countries, but still constitute only a fraction of total vehicles on the road. In China, the world’s largest car market, EV sales increased to around 20% of the total last year, but that means 80% of new cars and an even higher percentage of older cars still have internal combustion engines. This trend towards EVs is likely to accelerate and eventually a key tipping point – peak oil demand – will be reached where oil demand falls sharply when a substantial portion of vehicles on global roads no longer run on petrol or diesel. The influential International Energy Agency believes it can be in as soon as 2025 if policy adjustments encourage further electrification of transport.
This is in contrast to the last big oil price spike, in 2008, when the prevailing narrative was one of “Peak Oil” referring to peak oil supply. This was the idea that the world faced an imminent decline in the supply of oil with devasting consequences for economies and society. It proved to be very wrong for the simple reason that there are abundant sources of oil worldwide – South Africa might even have a meaningful endowment – provided there is the technology, capital and political willingness to extract it from hard-to-reach places.
Where the peak demand tipping point is exactly is hard to know, and until then oil prices can remain quite volatile, with small changes in demand relative to supply causing big price swings, including upward spikes as we are experiencing now.
That is hardly comforting, but the brutal reality is that high, not low oil prices, will spur the adoption of battery electric and hybrid vehicles. The transition to clean energy is not necessarily a smooth or pain-free one, but it still needs to happen.
Needless to say, energy shares have surged over the past few months or so. Until recently, investment strategies with an environmental, social and governance (ESG) overlay could claim to outperform with help from being overweight technology shares, and it was an easy sell: do good and earn superior returns. But not this year. In 2022 money has been made by owning the dirtiest of industries and shunning technology.
This does not mean that investors should abandon ESG principles. Rather, as in most things in life, you only realise how committed you are to your principles when sticking to them causes discomfort. If saving the environment matters, as it should, investors should surely be prepared to sacrifice something to achieve that.
Chart 3: Select global equity sectors (MSCI All Countries World Index)
Oil embargoes and association price spikes caused a major global recession in the 1970s. Many fear a return to that dreaded period of soggy growth and high inflation. But the world economy is a lot more energy efficient these days. Each unit of GDP uses a lot less oil and gas, and therefore every dollar the oil price rises, takes a relatively smaller chunk out of business and consumer pockets.
However, the recent spike in energy does not leave those pockets whole by any means. The first impact of higher energy prices is simply that there is less money to spend on everything else. Therefore, while energy prices will push up headline inflation rates, central banks don’t respond immediately. They will only respond when there is evidence of “second round” effects, where firms such as retailers push up selling prices in response to higher input costs. This can only happen in reasonably healthy economy. Raising your prices when consumers are under severe pressure means they walk out the door.
The same is true of global food prices, which are hovering around all-time highs according to the UN Food and Agriculture Organisation. Its food price index gained 28% in the past year, driven by increases in a broad range of soft commodity prices as supply chain problems, shipping costs and extreme weather collide with rising demand. Higher oil prices compound food price spikes, as more maize is diverted to produce ethanol. As it happens, Russia and Ukraine are two of the biggest maize and wheat producers, with the famed chernozem (black soil) of the steppe forming Europe’s breadbasket. Conflict between them is likely to put further upward pressure on global grain prices.
Nonetheless, it does muddy the water for central banks. With inflation rates already at multi-decade highs in the US, Europe and elsewhere, surging food and fuel prices can cause a panicked reaction and the urge to do something. We could see faster-than-expected interest rate increases at the same time as consumers are squeezed by commodity prices. This increases the risk of a major slowdown, but for now does not seem likely in the big and developed economies.
It is a different story in some emerging markets where interest rates have risen to nose-bleed levels. Brazil now has the dubious distinction of double-digit consumer inflation and short-term interest rates.
South Africa is an oil importer but a coal exporter. Since the coal price has increased more than the oil price over the past year or so, the impact on the trade balance is limited (other key export commodity prices, iron ore and palladium, have also gained in recent weeks). The biggest impact is therefore on consumers’ pockets and companies’ margins.
Last week’s price hike took South Africa’s petrol price back to above R20 per litre, but the fuel inflation rate has already peaked. It was 40% year-on-year in December, declining to 28% in February. Today’s elevated price creates a high base from which future inflation rates will be calculated. The petrol price can still rise if global oil prices increase further or the rand weakens and come April, fuel levies are likely to be adjusted higher. However, it is unlikely that the fuel inflation rate hits 40% again.
Therefore, our Reserve Bank can also afford to largely look through these price increases until it sees evidence of firms passing on these increases. Together with elevated food prices, fuel prices undoubtedly put pressure on consumers’ purchasing power. Core inflation is still below 4%, indicating limited passthrough from surging commodity prices to prices of other goods and services.
Chart 4: SA inflation components
A taxing matter
As the petrol price has increased, so have calls to reduce the portion made up by taxes as the various levies make up a third of the total price. Regulated margins make up another 16%, with the basic fuel price (global petroleum prices at the prevailing rand-dollar exchange rate) the biggest component at around half.
It is true that the share of total pump price made up of taxes has increased over time, but it is still not high by global standards. Taxes constitute more than half of the pump price in most European countries, not only because it is a relatively easy tax to collect, but also because it serves to disincentivise unnecessary driving that causes pollution and congestion. In other words, they serve a non-fiscal purpose too.
Some developing countries subsidise fuel prices, which is a great way to keep voters happy but comes at a great cost to the fiscus – especially when global prices spike – as well as encouraging wasteful use. In fact, in some places like Nigeria, subsidised fuel was simply smuggled out of the country and sold in neighbouring states for a tidy profit. Therefore, fuel subsidies are unsustainable in most cases.
If the South African government did not tax fuel, it would have to raise taxes elsewhere. It’s six of the one or half a dozen of the other.
Deregulating dealer margins could result in somewhat lower prices in South Africa but will also likely lead to a big variation in prices between urban and rural areas, with small towns having to pay much more for fuel than cities. In other words, it is not straightforward.
We should all hope that war doesn’t break out between Russia and Ukraine, but it is unpredictable. Outsiders cannot read Vladimir Putin’s mind. For the time being, the world still runs on oil and other fossil fuels. The sharp increase in prices (from historically low levels in 2020) will hurt global economic activity, but they are not at a point yet where we have to start worrying about a global recession or a repeat of the 1970s stagflation. Therefore, while it makes sense to drive less in response, making large portfolio changes is unnecessary.View more
Fossil fuels on fire
By Old Mutual Wealth Investment Strategists Izak Odendaal and Dave Mohr
These strange times have become even more unusual. Despite the enormous efforts to reduce the demand for carbon-emitting fossil fuels, their prices have shot up in recent weeks.
The upcoming COP26 Glasgow Climate Summit could ironically take place against the backdrop of coal and natural gas prices at record levels and oil at multi-year highs even though the share of renewables in the global energy mix has thankfully risen steadily.
Chart 1: Futures prices for coal, gas and oil, US$
A perfect storm
It is a perfect storm of events that got us here. On a positive note, demand for energy has increased from the lockdown-induced lows. For instance, IATA estimates a 26% growth in airline passenger numbers between 2020 and 2021, though they are still more than 40% below 2019 levels. However, this improvement in demand has not been met by rising supply. On the contrary, several factors have constrained supply.
One is simply the weather. Northern Europe relies heavily on electricity from wind, but it has been less windy than usual. Droughts in Brazil, China and the US mean hydro-electrical production has also been lower than normal. This has led to increased demand for natural gas and coal. However, natural gas inventory levels have been lower than usual at storage depots across Europe. This has created an opportunity for Russia, Europe’s main gas provider, to flex its geopolitical muscles and go slow on deliveries, although it has indicated a willingness to stabilise the market recently. With winter looming, natural gas prices in Europe have gone stratospheric, pulling up prices in other parts of the world.
In China, flooding has disrupted domestic coal production. China is already the biggest consumer of coal in the world, but demand has increased recently, and with it, its price. Geopolitics play a role here too. China blocked Australian coal imports, about a tenth of its total last year, after Australia questioned the origins of the coronavirus. Imports from Mongolia have also been disrupted by Covid.
Chinese electricity prices are heavily regulated, and utilities cannot freely pass on the cost of higher coal prices to customers. Many have opted to cut back on production, rather than sell at a loss. Beijing has now announced that selling prices will be allowed to rise somewhat. All this has happened at a time when local governments were already reducing electricity production from coal to curb air pollution and carbon emissions. The net result is something South Africans know well: widespread load-shedding.
Finally, in terms of oil, OPEC (along with Russia) has largely maintained the production cuts it put in place last year to prop up the oil price. In other words, there is no fundamental shortage of oil. Supply is being deliberately held back. OPEC can increase supply if it worries that high prices will choke off demand, but for now, its members seem comfortable with the revenues flowing in. Importantly, the price increase has not yet led to the associated increases in American shale oil production as has been the case over the past decade. Shale producers have largely abandoned the old production-at-all-costs mindset in favour of maintaining profitability and shareholder returns.
Chart 2: US oil prices and production
An associated factor is that these companies and their peers face increased difficulty in accessing the funding needed to increase short-term (in the case of shale) and long-term production (in the case of the oil majors). Banks and asset managers across the world are phasing out exposure to fossil fuels and some have already cut all ties. This has contributed to steep declines in capital expenditure by fossil fuel producers.
In other words, the big move among global investors towards embracing environmental, social and governance (ESG) principles might have the unintended consequences of higher fossil fuel prices until such time as renewable sources reach critical mass.
Chart 3: Capital expenditure by listed oil, gas and coal companies
The good news is that elevated fossil fuel prices do create a strong incentive to increase investment in alternatives. This is where ESG can play a big role to make sure the alternatives are green, not brown. Economists have long argued that the best way to tackle climate change is to put a tax on carbon emissions. This is because the price we pay for a tank of petrol, for instance, covers the cost of production and distribution but not the cost of the associated air pollution. Since the cost of this externality is not included, petrol is too cheap. This leads to excessive demand. A carbon tax raises the price to its “correct” level and lower demand. The recent price increases could therefore achieve a similar effect.
A tax on your houses
Increased energy prices act as a tax for most consumers. Most of us have no choice but to fill up our car. If you live in the snowy Northern Hemisphere, you have little choice but to heat your home with gas.
In other words, this will be a drag on global consumer spending, the question is just for how long will prices remain elevated. It is somewhat compensated for by the excess savings that households in the rich world have built up, but it also appears that most of the excess savings are concentrated in the hands of more affluent households. Meanwhile, it is lower-income households that are most exposed to increases in energy prices and associated rises in food prices. Nonetheless, it is worth pointing out that at around $80/barrel, the oil price is nowhere near the $150/barrel record set in 2008 on the eve of the global financial crisis, or the $100+ levels that prevailed between 2011 and 2014, especially adjusted for inflation or growth in incomes.
The other complication is that these price increases come at a time when inflation rates are already elevated. The global production and delivery of goods are already severely constrained by Covid-related disruptions, shortages of inputs and labour, and logistical bottlenecks. But now production in China, the world’s factory, has to contend with electricity blackouts. This is likely to worsen the supply chain problems already besetting the world economy.
People often confuse higher fuel prices with inflation. Fuel prices are very visible since most motorists have to fill up at least once a month. But inflation refers to sustained price increases in a broad range of consumer goods and services. Energy is a component in consumer price indices and therefore higher energy prices do have a direct short-term impact. But the big question is whether firms can raise their selling prices to compensate for higher input costs. In this way, higher energy costs ripple through the economy. If workers then demand higher wages to compensate, we have the beginnings of a wage-price spiral. This clearly requires pricing power on the part of firms and bargaining power on the part of workers that have been absent for many years. However, in the current Covid-distorted global economy, there have been signs of both.
Winners and losers
There are clear winners from this energy crunch. Net exporters of coal, gas and oil are clearly smiling, particularly countries such as Nigeria that have really struggled until recently.
In contrast, many countries are energy importers and face not only higher inflation rates, but also potentially balance of payments problems as they need to cough up more of their scarce dollars for each barrel of oil. Compounding matters, this comes at a time when the US Federal Reserve is planning to scale back its monetary stimulus, which has put upward pressure on the dollar. Some developing countries, therefore, face a triple whammy of higher energy costs, a weaker currency, and domestic central bank interest rate hikes aimed at stabilising exchange rates and inflation.
South Africa has one leg in this camp as an importer of petroleum products. The rand has been on the back foot in recent weeks, and this means a big petrol price increase is on the cards for next month.
However, we are also the world’s fifth-largest coal exporter (behind Australia, Indonesia, Russia and the US) and the rising export revenues limit downward pressure on the rand. Coal exports would be even higher if not for the capacity constraints on the Transnet rail corridor from the Highveld to the coal terminal at Richards Bay.
It also helps that inflation has been relatively stable in South Africa, with price increases excluding food and energy costs running at only around 3%. The SA Reserve Bank’s latest forecasts suggest that inflation should stay close to the 4.5% midpoint of the target range over the next two years. However, the risks are clearly to the upside. A gradual interest rate hiking cycle is therefore likely to commence in the next few months. How gradual will depend on where energy prices settle and how the rand responds. The Reserve Bank will also keep a close eye on what other central banks are doing, particularly the US Fed.
Oils well that ends well?
In summary, it is a delicate moment for the global economy, and could end up being a long, cold winter for people in the Northern Hemisphere. The big risks are a slowdown in consumer spending, further disruptions to production and persistent inflation that forces central banks to tighten monetary policy sooner than they’d like. None of this is good for markets.
However, it is worth repeating that the underlying cause is the strong recovery in demand as the world gradually puts the pandemic behind it. This is good. Moreover, energy prices are notoriously volatile. In April last year, a key oil futures contract briefly traded at a negative price. Traders were willing to pay to get rid of the oil rather than take delivery. The most recent price moves in gas and coal also have all the hallmarks of panic-driven trading, and therefore are unlikely to be sustained over time. Investors in diversified portfolios should similarly avoid making panicky moves in response to the recent dramatic headlines. The current situation is the result of a nasty confluence of events, and some of the contributing factors on the supply side could ease.
Finally, in the current context, it might be worth remembering that 13 years or so ago, “Peak Oil” was a dominant investment narrative. It was believed that the global supply of oil would peak and this justified prices surging to $150/barrel and beyond. The opposite turned out to be the case. Today, we’ve probably already passed the point of peak oil demand due to the rise of electric vehicles. Demand for coal could prove stickier, while natural gas could increase in importance as a “bridging fuel” while the world transitions to renewable sources. However, short-term price movements are clearly going to remain unpredictable.
This is relevant when thinking about investments more broadly. Dominant narratives can lead you astray. Just because you read about a “megatrend” or “structural change”, whether it is ESG, clean energy, blockchain, biotechnology, or demographic shifts, doesn’t mean that there is easy money to be made. It could be priced on already, or simply overhyped. You could be way too soon or too late already. Maintaining appropriate diversification across different asset classes and within each asset class remains the best way of investing, even if it sounds boring.View more