This week, we welcome Adam Bornstein into the SmarterMarkets™ studio as we continue our Financing the Energy Transition series. Adam is the Lead of Innovative Finance & System Change at the Danish Red Cross. SmarterMarkets™ host David Greely sits down with Adam to discuss how ESG, impact investing, and carbon finance can be put to work to fund humanitarian relief and resilience to a changing climate.
We continue our Financing the Energy Transition series by welcoming John Goldstein back into the SmarterMarkets™ studio. John is Head of the Sustainable Finance Group at Goldman Sachs. SmarterMarkets™ host David Greely sits down with John to discuss how ESG and impact investing has evolved over the past two years and where we need to be doing the hard work right now to finance the energy transition.
This week, we welcome Don Casturo and Matt Schwab of Quantix Commodities into the SmarterMarkets™ studio. Don is Founding Partner & CIO and Matt is Head of Investor Solutions at Quantix. Don and Matt sit down with SmarterMarkets™ host David Greely to discuss the role of commodity futures indices in financing the energy transition.
We continue our Financing the Energy Transition series with Nikita Singhal, Managing Director and Co-Head of Sustainable Investment & ESG at Lazard Asset Management. SmarterMarkets™ host David Greely sits down with Nikita to discuss her approach to ESG investing and building investment strategies in public equities.
We kick off our new series, Financing the Energy Transition, with Nat Bullard, Senior Contributor at BloombergNEF and a Venture Partner at Voyager Ventures. Nat writes weekly for Bloomberg Green on energy, transport, technology, climate, and finance. We start our new series by exploring with Nat the size of the investment that’s happening in the energy transition, where it’s coming from, and where it’s going to.
This week, we welcome Greg Sharenow into the SmarterMarkets™ studio. Greg is the Managing Director and Portfolio Manager for Commodities and Real Assets at PIMCO. SmarterMarkets™ host David Greely sits down with Greg to discuss the European energy crisis, commodity markets, inflation, and what it all means for investors.
GS: I think it’s the FED versus OPEC that has been a very challenging dynamic when you’re formulating a view because it is hard to look at the actions of the FED and not notice that this will lead to a slowdown of economic activity. You’re already seeing it in some of the data that’s regarding housing, and you would expect to see the actions of higher Central Bank rates, not just in the US but globally, having a negative impact on real spending capability ultimately over time. Ironically, higher rates also increase the cost of capital to the energy space, reducing potential investment.
GS: So there is a bullish aspect to the FED policy that will be more impactful over a longer term horizon than a short term because investors now have more places to put their money. To places where they’re earning some risk-adjusted return. After many years of interest rates being so close to zero, which was made to facilitate more money going to more places and is now working in the other direction. I think that points to one of the challenges we’re facing right now, that this cycle that we’ve been in higher commodity prices hasn’t been a demand-side cycle. If you look at the last super cycle, the emerging market growth rate, particularly centered in China, really strained global supplies; demand for many of these commodities isn’t much different than where they were in 2019, and if anything, they’re not on the trend where they would’ve been, but we’re seeing extreme tightness and very strong markets in part because of the constraints on the supply side.
GS: If the FED were to move rates much higher, reducing capital availability further to upstream investment and investment in the power sector, it could have a positive long-term impact. Regarding OPEC’s action, they had some concerns about short-term demand, and there is an interest in supporting prices long term. And if you’re OPEC and you’re producing at near max capacity, if you look at Saudi, they were producing 11 million barrels per day recently. From a consumer standpoint, if you believe we need to get that CapEx invested, that we have been shy to do up to now, but I don’t think that’s the only reason. Another part of their view was that if you think about driving your car and you have your pedal down to the metal, you will start getting vibrations.
GS: They’ve never sustained that for two consecutive months. Sure, their surge capacity is still higher, but we haven’t proven that they’ve had meaningfully higher sustainable capacity. So seeing a reduction in output from OPEC also probably has a lot to do with creating flexibility in the system and reducing that vibration. Now the one other piece that has happened since then is also some guidepost from SPR, which has the same sort of guidelines as what you were saying that OPEC Plus was trying to do, which is creating price stability, which over the long term is arguably going to facilitate more investment if the SPR now can commit to forward buying oil around $70. OPEC is willing to adjust its output, at least for right now. Policies have changed a lot in OPEC over the last 20 years.
GS: Their response function today is not necessarily what the response function will be tomorrow, but as of right now, SPR, as well as OPEC, are working to put a floor under our backend oil prices. That leads us to have a constructive view on oil over the next 6 or 12 months or certainly that the market is discounting a lot of demand weakness that could come potentially from the FED tightening, particularly if the FED tightening leads to lower CapEx. Now about China, what’s remarkable about these commodity markets, and in the last cycle up in commodities was very much led by China, and it used to be that if the US sneezes – the world caught a cold. The response function of global growth that changes in China’s growth is becoming like a three-month lag, and it is not just the US now; it is also China’s impulse function.
GS: And that’s even more true for commodities, given their large share of not only growth but also their large share of absolute demand, given how much they’ve grown over the last 15-20 years. Almost all commodities are in a state of backwardation, consistent with low inventories and tight fundamentals where people are willing to pay a premium for prompt delivery. So we’ve had incredibly tight commodity markets across the whole chain. You’ve managed to have this, with China being a negative impulse. Next year, I would love to know what exactly China will grow; they will still grow at a slower rate than they have been and probably decelerating, but if they’re growing. They started changing their COVID policies, which could be a positive catalyst. But up until they make that decision, there are headwinds to commodities, and that’s the challenge for prices, and if not, I don’t know where prices would’ve been. It would’ve been a lot higher and a lot more painful.
GS: For sure. We had the Twitter wars also for four years before, and we’ve had COVID, so there have been many policy shifts and challenges. When you and I were working together, we were trying to get supply and demand down to a couple hundred thousand barrels daily. Now all the inputs could be half a million to a million barrels a day – easily! With China’s demand, if they reaccelerate, that could be $more demand for 500,000 barrels per day next year. The uncertainty bands are wide, and I think that’s part of what is also contributing to a lot of the constructive nature of the market because it challenges CapEx if you’re sitting there looking at this environment. You’re looking at policy uncertainty, demand uncertainty, and the policy being China’s COVID as well as fiscal policy, which is a huge deal in Europe right now. And it has had a big outsize impact on the market, the political future of some European leaders, and the rising concerns leading to protests in the street.
GS: Like there’s a lot of uncertainty. It makes one have to be more nimble, but it also makes the CapEx decisions to solve some of the supply-side challenges even more difficult because of all these uncertainties.
GS: Well, I can also widen that and say the ripple effects across the economies in the politics because Europe is the epicenter, but the echo has been global. And in the real wage contraction, you’re seeing that is very sharp in Europe, in particular, but elsewhere, the European energy crisis has many impacts on other commodities; for example, high natural gas prices are leading to higher coal prices, higher power prices, which has the implications for creating higher coal prices elsewhere as well, which has the feed through to higher power prices. It has a substitution effect on oil. Now I’m a little less alarmist than others on the outlook for winter in Europe. There’s been a bit of migration to that view recently because cash prices in Europe are trading down from €350 per megawatt hour.
GS: This weekend, it traded for $50 or $60. That’s a pretty big change now. The forward curves are still pricing a big premium. We all have the challenge of figuring out the demand response functions when we’ve never seen prices in this neighborhood. And if you look in the past, you’ve seen price spikes, and you kind of get a sense of how the demand responded on a short-term basis, but in almost all those cases, the forward curve was largely unmoved. It was viewed as a transient effect, and today it is the full forward curve at a huge premium to what anything would’ve been expected historically. So I’ve been a little less alarmist because we have so much excess consumption in our energy systems, and there are a lot of actions people can do to save.
GS: One of the ironic things we’ve seen this year is how weak gasoline demand may have been in the United States. It’s been much better in Europe, but it’s been weakish in the United States. Part of that concerns when your real wages are contracting; you start looking at ways of saving energy. Now, if you’re a European energy consumer, you cannot heat your whole home, but you can move back in with your parents, work from the office more, and let your firms pay your heating bills. Like there are a lot of actions, the awareness can lead to a material change. For instance, changing your thermostats by one or two degrees has a huge implication for energy consumption as well as, and curtailing peak power demand has a material impact on thermal generation because thermal is your marginal generation.
GS: What’s going to happen in Europe, it’ll have meaningful implications on the fiscal stress in Europe and their ability to manage through the needed subsidies that they’re planning or the planned subsidies. Whether or not that’s a good idea and if it’s needed, as Europe consumers go, a lot will go in the global market. Suppose we end up getting the 15% consumption out of the consumers. In that case, that’ll be a meaningfully lowered tax on industrial output and lower energy prices that you could expect in Europe, Asia, and elsewhere, big energy importers competing with Europe. Oil could have independent issues because of Russian sanctions and OPEC’s decisions. There’s a variety of things that can make that market different, but certainly, when it comes to gas and coal, it’s Europe that controls and holds a lot of the outcomes cause we’ve seen weaknesses in other places from the high prices that are causing real strains for Asian importers in some of the lower income countries. If Europe can figure out how to contain its demand, that will be very helpful in relieving some of the pressure elsewhere.
GS: We spend a lot of time with the corporates trying to understand their decision functions, trying to get a handle on what dollars are going back in, and at one point, they were spending 120% of free cash flow and now spending 40% or 50%. You look at the changes in oil production relative to what you would’ve expected at similar prices, and you look at changes in investment in terms of rigs; it’s meaningfully lower, and if you look at the international energy agencies’ investment outlook that was published a few months ago, they were also commenting that 50% of your increase in global energy expenditures this year is all cost. So when you look at an inflation-related company, they are more concerned about their cost and cost management because of how investors view and treat their equities when they increase CapEx and have higher costs associated with it. It’s very negative.
GS: When you look at the oil and gas side, we’re investing about 15% below where we were in 2018 and 2019, despite prices about 30% higher. On a real basis, it’s like 25% below. Meaning companies are just being more disciplined now. I think it’s a function of a few things. One, investors demand it after a very long period of subpar returns, and they want to be paid for the risk they’re taking. The second part, think about anything long-term CapEx-related. You don’t just have the demand uncertainty associated with the energy transition; you have liabilities that the environmental policies will change. What is your carbon exposure? What is your remediation exposure? Have you started expanding your time? The uncertainty bounds around these policies, and the demand outlook gets wider.
GS: And that’s very challenging for companies to justify and operate in that environment, and that’s why you see a lot of investments more likely to be green-lighted in renewable diesel, which with LCFS markets down here, it has to be challenged, but at least they can make a justification that in the long term it’s aligned where the puck may be going. The problem’s a long skate between now and then in the energy markets, and that’s not just true in oil and gas exchange but also in power. And while in the long term, more growth in renewables and more growth in storage for renewable, associated renewables are the grid that will lead to lower prices. The problem is we’ve done such damage to the base load generation that we’ve added intermittent sources that aren’t able to meet the full spectrum of our needs.
GS: I think we’re going to end up in a situation where the next three to five years, there will be higher and more volatile energy prices because of the CapEx decisions and the challenges of making incremental CapEx improvements on base load capacity whether it’s thermal related or even nuclear in many places. Even though nuclear is having a bit of a renaissance, it’s still a two-track system where some are going in the opposite direction. It will be very challenging to meet the energy needs when the economy begins to grow again meaningfully.
GS: I think the policy uncertainty is what you’re referencing there. If you look at clean diesel, for example, it relies on policy incentives, and if you look at some of the other investments, it’s all about policy, and if the policy is going to change with different political wins, it does make the challenges harder. Certainly, consumers and governments are willing to look at the next 3-5 years and make that decision, but it’s harder to make that decision over a 20-30 year period. Now we’re moving into a peer with higher LNG FIDs going to be made. Even if it’s the lesser of all the evils, it’s one that markets are paying for. So I think you’ll see more LNG projects, but when you start looking at other projects that would otherwise go, you can easily say that some of the challenges are real.
GS: My concern about LNG is that everyone might want to build an LNG import terminal, and many US builders want to be LNG export terminals. We have to accompany that with upstream. Now, if you’re in East Africa, they are paired, and there are some other areas of the world where they’re going to be paired, like in Qatar, but in places like the US, we have to be able to invest to keep up with the LNG export capacity that could come down the line and permit is a big portion of the challenges in doing so.
GS: I would expect that you’ll see compression in the ERBS because the incentives are there, just like dollars will flow through the highest margin over time. It’s not a grand philosophical statement of insight. Investors go for returns, LNG arbitrages are high, and we should invest in rectifying that.
GS: Yes, but it’s fairly nuanced. Suppose you look at the 60/40 portfolio. In that case, there’s a time with a large historical sample where the correlations between fixed income and equities aren’t negative. Usually, that environment tends to be associated with inflationary environments. You’ve seen that in the past year, inflation has picked up, growth rates are coming down, and nominal rates are going up, creating a problematic time for investors. So owning inflation assets are more important than maybe other periods where growth is a dominant factor when inflation’s dominant, inflation-related assets are in higher demand for portfolio diversification. So there are a lot of clients who are interested in hedging their inflation risk in their portfolios. The thing is that there are a lot of scars, particularly in the United States, from long periods of poor commodity returns and low inflation where it wasn’t the best use of the dollar.
GS: Now the problem is when we have the regime shifts, and you have had the investment, and while
there’s some regret from a lot of the US investor base who weren’t actively engaged like they may have been 10 or 15 years ago. The challenge many are debating now is whether you can buy commodities today if the forward economic ALEC is lower? So there’s a tug of war between those who can get over that hump and view it from a portfolio diversification standpoint versus those who think with a bad economic outlook. Do you want to own commodities in a dire situation? They’re at a higher nominal price than they’ve been, so they think they shouldn’t be interested. It’s a two-way conversation; the other part is for those who were invested because your 60-40 went down so much, and commodities are up; if you had a 3% allocation now, you might be at 4.5% or 5% today.
GS: Portfolio rebalancing, take the cash from here to finance other ills in your portfolio, but the interesting part is that the global investor, particularly in Asia, and Latin America, these are places that historically have had high leverage to EM growth and, as a result, would’ve felt more insulated in an inflationary cycle, a commodity cycle than they have been this time. All of a sudden, they’re finding themselves very subject to changes in inflation globally and changes in the US FED policy. They have found themself on the tail end of the inflation cycle and have become increasingly interested in hedging their inflation. I never had that EM virtual demand growth and never had the EM growth story, I mentioned before about China. You never had the growth, but you still got the commodity, inflation, because of the supply exchange.
GS: So while the US, what our perception is, the US investors are very much split, and some are reducing for various reasons or some have just missed it, and they’re now concerned because of demand. The global investor has been much more interested than they have been in past cycles in part because of the nature of this, rise in prices has been much more on the supply rather than the virtuous economic boom EM-led cycle that we had before. So everyone has a different experience regarding how, or rather everyone has a shared understanding and has different wrong conclusions on how to manage it. There’s no rock you can hide under that’s big enough.
GS: The part of the commodity complex with the best medium-term outlook is the oil space, partly because of the real limitations on the growth and production sides. When I look at other commodities such as agriculture, while the environment is very tight at the moment and we’ve had two years of some fairly unfavorable weather conditions, ultimately, every year, this volatility on the supply side is meaningfully higher than the volatility on the demand side. So if you have good growing conditions, you can start seeing a rebuilding of stock. So it’s hard to strongly believe these prices are sustainable in agriculture without knowing the weather. There have been higher inflationary pressures that will likely limit the ability to bring in additional marginal acreage.
GS: We’ve seen some plateauing or definite slowing of the ability of places like Brazil to bring in additional acreage. There is inflationary potential in the AG space, but I would describe it more as we have much like power and gas and a much more brittle system. If you believe the climate is becoming less stable and more volatile, AG will have a higher likelihood of seeing price spikes than you would’ve seen maybe 10 or 15 years ago if you think this is a fundamental structural change. We had a speaker from Nassau who talked to us about this, and what I concluded from that is you would expect higher average prices but higher volume than you would’ve expected before.
GS: The starting point on the AG market, in the near term, is on the constructive side because of where inventories are and where the harvest has been, but at least the worst has been avoided in the US for corn and soya, but still it wasn’t a great year. When I look at metals, a lot of it has to do with as China goes – the metals markets will go; we see some reductions in CapEx on the metal side as prices have come down, and they’re doing it at higher price levels than you would have expected in the past, but again, related to inflationary pressures. However, still, China is the biggest mover. The energy transition has positives for the metal space, but it’s hard to offset the size and scale of China’s growth to their implications for the metals markets.
GS: Yes, that will ultimately drive much of what happens in other commodities. For example, suppose the oil has the investment. In that case, the cost of investing in other upstream production, whether in metals or agriculture, becomes less challenging, and high fertilizer and ammonia prices result from what’s happening in Europe. If that reverses, that certainly reduces some of the pressures in the system. But I do think oil is the one that has the greatest constraints. Certainly, natural gas has been very tight, but Russia’s ability to shock Europe has now gone; there were 400 million cubic meters a day, and now 40% into Northwest Europe. There’s always zero, and that wouldn’t be an easy adjustment, but in the oil market, their potential drop in exports alone can dramatically keep this market tight for a very long time. So we think oil health’s a better outlook right now.
GS: We’re not going to see a phase-out or retirement of trading and investing opportunities in traditional energy because we have yet to prove that the world can move off of any. We’ve seen lower shares over time for different commodities, but we’re always adding our wood, coal consumption, and so on because of the high demand in the global energy market. So I think we expect that in five years, the investment in space will still be very similar to today with additional opportunities. Carbon, for example, is an area of growing interest. Let’s talk about a market that has big policy-driven views. Europe going for a 50-55% reduction had a meaningful impact on the forward supply of European emissions allowances. US California policy is another market that is potentially going to change, given the new carbon neutrality goal by 2045.
GS: That was just brought into law, but these markets are going to be very interesting because one of how the globe is going to try to make that transition is through bringing in carbon prices, and carbon is almost like a way for the market try to solve the way hopefully forward, but some places will be more command and control, and some other places will be carbon taxed and assume that they know the right place to get the outcome they want, but it’s going to be an area where you’ll have greater opportunities for investing. Now, suppose I think more broadly across asset classes. In that case, it argues for a very flexible approach because you are going to have periods where different areas are going to have higher rates of return, and just being in the energy transition sector and not investing in the old-line energy markets could leave pretty big gaps in one’s portfolio.
GS: Particularly if you’re considering this area as part of your inflation hedging basket. It’s not just a return center, but a return and inflation that needs to have what drives inflation. Core inflation has had its year and a half right now, where volatility is certainly picked up, but if you want to hedge and have your view about that as inflation related, you can’t ignore old-line commodities. Oil and food in emerging markets and elsewhere are still the biggest contributors to the volatility of inflation. In terms of being investible, the capital markets are ignoring some of the challenges with the higher rates, reduced ability for the market IPO, and new technology sector’s kind of the epicenter of some of those challenges; it’s going to continue to grow, and there are opportunities in companies that will take advantage of some of the growth industries.
GS: The challenge I have is if I want to invest in a company that’s going to build batteries; for example, for the grid, they’re all going to target the same hour or two or three a day. So you always have to be very careful with how much you expect current margins to sustain. So I think knowing the history of the challenges and investing in solar globally, investing in wind, investing in some of these technologies is going to be important for investors to take those lessons and learn them because you don’t want to put money behind an investment theme and you’re relying on something very challenging.
GS: I commented before about renewable diesel; look at the LCFS market, we looked at a bunch of projects two years ago, and we got called to sell puts to hedgers because they all needed to have $125 or $120 to generate a good return for their investment and we’re trading $65 or $70 now. It’s challenging because of the growth in projects that we’re looking at over $200; commodity markets are very volatile. I suggest having a very broad approach and a very flexible approach because you have to appreciate just how volatile they are.
GS: Policy, certainty, and clarity would all be very helpful, but I am optimistic we’ll get there. If you look at Europe and United States, the western world is struggling with that. China probably has slightly greater ease in imposing policy certainty, but even there, we’ve seen changes in how they approach their heavy-emitting industries. The big challenge is to deal with that. I think the other challenge is to deal with a lot of the efforts in deglobalization and some of the challenges that a lot of countries don’t want to rely on energy or mineral suppliers from other countries and view it as a zero-sum game. I think that also threatens to reduce the amount of money that will float to the upstream or energy supply. When I say upstream, I do not just mean oil and gas from that standpoint.
GS: The energy transition will require a massive amount of capital, and some of these hurdles are just a real challenge at the very least; one would say we can control policy a little bit better than we have and put some good policy in place. If you look at the political outcomes in Europe with people in the streets and the pressure of rising populism, you can see the imperative of doing so. I’m afraid these events cause bad outcomes as a short-term and political imperative, which reduces the incentive and ability to invest. The other thing is hedging is hard as you go into less liquid commodities, and many banks face different tiering on their capital. So if you trade something that’s highly ill liquid or something long-dated, they have to have higher capital charges and greater reserves against it, which is probably good for the overall financial stability of the system, but also makes hedging very challenging. So there’s a bit of a dearth of capital dedicated to helping facilitate that. I think that’s an opportunity for investors, but it’s an obstacle to the growth of that CapEx.
We welcome back into the SmarterMarkets™ studio Oystein Kalleklev, CEO at Flex LNG and Executive Chairman at Avance Gas. Oystein sits down with SmarterMarkets™ host David Greely to share his unique perspective on the European energy crisis and what it means for the LNG industry.
OK: We started discussing the European energy crisis a year ago. So that was a long way ahead of the invasion of Ukraine in late February. So the energy crisis started building in the late summer of 2021 in Europe. We saw that the inventories hadn’t been built up, and at that time, the Asians were also busy buying LNG and resulting in the LNG prices spiking up, and the Russians hadn’t built up those storage levels in Europe, and now we understand the reason why they didn’t do it. In November, the gas market ended up in a crisis a couple of months before the invasion.
OK: Once you had the invasion, things went ballistic. Despite all these problems, Europe’s been very fortunate because we have had a lack of gas in Europe or globally, but with the shutdowns in China, they have been pulling back. Imports are down more than 20%. So if somebody told you that Europe would gobble up all the LNG cargo and China would slow down 20%, you would think that the shipping market would be terrible, and we saw something very similar in 2019. In 2019, we had a very healthy volume in the LNG market. It grew 35 million tons, and Europe bought 33 of that 35 million tons, and that dragged down the shipping market in 2019 because you had shorter selling distances, and China’s economy cooled down in 2019, given the trade war with Trump.
OK: This year, we have seen something similar, volume growth has been a lot less, and the Chinese demand has forted much more than we have ever seen, resulting in the LNG shipping market being tangible in Q1. The first time we’ve seen the indexes, the freight indexes being negative. So people didn’t pay you. The rates were less than zero or adjusted for fuel consumption, but the risk premium in the market increased once the Ukraine war happened. People didn’t want to be short-chips. So freight ways started to go up after February 24, and they went up a lot until another event happened, which was the Freeport explosion. At that time, gas prices in the US were becoming very expensive, $10 a million MMBtu – sounds cheap in Europe, but in the US, it’s quite expensive.
OK: People were asking about export limitations, and once that explosion happened in Freeport, US gas prices fell 20% overnight. This also made the shipping market weak because Freeport is a big export terminal – 15 million tons, that’s 15 to 18 cargos a month. So suddenly, you have a lot of ships coming open in the market and dragged down the shipping market, and then with Freeport seeming to be starting to ship some cargos again, at least partially, that’s blown up the spot market again. You mentioned $200,000 per day, but it’s more like $400,000. It’s the strongest freight market ever, but when you look at the product side, the prices have decreased significantly. For JKM, for example, their focus now is on the TTF.
OK: So TTF, it’s so volatile, so it’s hard to peg the number, but let’s call it $45. So that’s down from a hundred at the peak. However, with this cargo flow into Europe, you have congestion issues. There’s not enough re-gas capacity in Europe. So having a slot at the re-gas terminal today is valued as much as the terminal. The cargo is $45 per million BTU, but you have to discount the LNG at around $20 – $25 to get capacity at the re-gas terminal. That’s crazy! In addition, we have an intramonth contango of $2 to $3. So if I can sell my cargo next month, I will make more money. Today we have around 35 ships idling and floating storage, which is also tying up a lot of shipping capacity, and that’s why the shipping market’s been just like the LNG market incredibly volatile.
OK: Our principal shareholder, John Fredriksen, who’s probably the most successful shipping investor ever. Shipping is incredibly difficult to invest in because of the volatility. So if you do something wrong, it’s easy to get bankrupt, but he’s been doing this for more than 60 years now, and he founded Golar LNG in 2000. He sold Golar in 2014 and then bought into Flex and all kinds of investment pieces to buy many new ships because there’s been a big revolution on the shipping side. Until 15 years ago, all the new buildings were steam turbines. So, anybody who has some history knows that a steam turbine is not very efficient, but the ships were built with steam turbine engines, and there are still 200 of them in the market.
OK: And then we eventually ended up with these legends, first medium speed, and no slow speed. So Otis, when we made the investments mostly in 2017/18, there’s on new ships, they are 60% more efficient than the steam turbine ships, and that’s a lot of money, you’re saving 60%. So we bought the ships when prices were low, basically $180 – $185 million per ship. The price of a ship today is $250 million. So there’s undoubtedly been inflation also on the shipping side because shipping is tight. Then when we took delivery of the ships starting in 2018, 2019, and 2021, we took our last ships for delivery. We thought that we would play the spot market here until we find a good shipping market, and then we will start fixing the ships on attractive long-term charters. So until 14th April last year, we had 13 ships and turfed in spot ships.
OK: So everything was the spot, and that meant that you have to be on top of the market because of the volatility and because you could quickly lose a lot of money. Even though COVID in 2020, we managed to navigate and make money, and starting April 14, we started fixing our ships on long-term charters. We did the first five with Cheniere, a big US export, and then in June this year, we fixed our last three ships, one ship for ten years and two for each for seven years with our super major. So it’s a lot less volatile than it used to be. We have one ship on index linked to the spot market, but the remaining twelve ships are typically fixed on 3 to 10-year charters with the big players. So volatility in all income has gone down quite a lot right now, maybe sadly, because it would be fantastic to have more spot exposure in this market.
OK: Five years ago, a lot of people were very bullish on energy because you basically should substitute coal with natural gas, and you can reduce your CO2 emissions by 50% -60 %. But a hundred years ago, the US started replacing coal with natural gas because of the pollution, not the CO2 emissions. When you burn coal, you have all the smog, ash, and soot, which is destroying cities. And then, later on, we had the same development in Europe, not driven by CO2 but by cleaning up the local air pollution, which was a huge problem. Every year 10 million people die prematurely because of bad air pollution. Coal is a big problem today as well because most people dying today from air pollution are people living in China and India, and they are the big coal consumers.
OK: We have had a policy in Europe that has been populistic, short-term, and narrow tinkling. The policy was about the action that we are going from coal to wind and solar. But wind and solar are intermittent, and we will not have nuclear-based energy either. So then, what kind of energy system will you create then? You can’t build a lot of batteries for big energy systems. They just sidestepped natural gas and went directly for intermittent renewables, creating many problems. Dunkelflaute is a word that has become common now, it is a German world where it’s not that much wind, and there’s not that much sun, and we had problems last year when the wind conditions in the UK were very low as well.
OK: People realize now with the war in Ukraine, you need gas. The lack of gas is creating a lot of problems. So now Europe is rushing to LNG as the substitute. Even Germany, the biggest gas consumer in Europe, is currently building out 5-6 floating terminals to import LNG; people are building import terminals in Italy, France, and the Netherlands. But the problem is that even though we are building all these import terminals in Europe, we are not buying more LNG. The strategy is to make import terminals and buy LNG in the spot market, driving up prices and resulting in countries like India, Pakistan, and Bangladesh not being able to source it anymore.
OK: When you are sourcing from the spot market, you’re not underpinning new suppliers of LNG because nobody is building LNG export terminals on speculation. These are multi-billion dollars investments. The only way to build them is to have long-term contracts, 10, 15, maybe 20 years. But Europe is reluctant to do that because of the incoherent energy policies. If we try to solve this problem right now, buying in a spot market, but I’m not going to sign up for a 20-year LNG off-day contract because, in 2042, I need to be 100% renewable. So that is creating problems, and so we haven’t solved anything. We will solve some bottlenecks on the re-gas capacity side, but we are not solving the problem, which is the gas supply.
OK: No. Europe has now been able to know fill-up storage at 90%. That has happened because Russia has been flowing gas until recently, and Europe has been buying up all the LNG; more than 70% of the US cargo went to Europe. In comparison, last year, it was like 20-25%. Usually, 70-80% of US cargo are going to Asia, and now 70-80% is going to Europe. China has stopped importing because of they’re the COVID lockdowns. Those COVID lockdowns are not going to last forever. Once they’re opening up, and they’re opening up gradually, China is going to import more of the cargo. In Europe, we are 90% storage capacity; we are going to draw down this very quickly, and once you’re getting close to 30%, people will start panicking, and we’ve been lucky with the weather in October.
OK: The prognosis is that we will not be as lucky in November and December. We have managed to get to 90% by also destroying a lot of demand in the industrial base because prices have been too high; next year will be more challenging because you cannot rely on as much flow from Russia and also sourcing as much LNG as Europe has been doing this year, next year might be more challenging because the Chinese might be back buying more volumes as well. There’s not a lot of new LNG coming to the market next year. So the supply of new LNG to the market will be permuted both 2023/24/25 onwards; you will see more pick up, especially from Qatar and other players, but that LNG has been contracted to other people and not to Europe because Europe is not signing up and not taking agreements. Germany has signed up one LNG contract this year, which was also pretty small.
OK: Yes, we do see that. We see a lot more cargo flowing into Europe, which has benefited crew rotation. Many Asian countries still have limitations on getting people off and off on the ship’s specs. China has been impossible for more than two years now. So, at least, the ships sailing to Europe make a crew rotation much easier. We also see a lot more ships idling, either idling in floating storage or the ships are just idling in, which you would think is incredible when freight rates are $400,000; why aren’t people renting out the ship? Collecting a lot of freight instead of idling the ship, but the reason is the value of the cargo is so substantial that even if you could make a lot of money, what if you don’t get your ship back in time?
OK: You are losing out on the cargo economics, which is much more. So yes, we see it is affecting the routes, and the ton-mile has dragged on a lot this year. So if you looked at the ton mileage sailing distances, you would think that the freight market would be terrible this year. But the thing that has adjusted for it is the ton time, so the time’s gone up, speed’s gone down, and that means that it takes more time to load and discharge a cargo than usual because of the congestion issues and the floating storage.
OK: That’s right, you need to keep it at -162 Centigrade, which is -260 Fahrenheit, and then to keep it at atmospheric pressure, you need to vent out the boil of gas, and the boil depends on the ship. Newer ships are a lot better insulation. So if you have an old steam turbine, the boil rate is typically 0.2%. So every day, 0.2% of the cargo is lost in evaporation. So you need to take that pressure out of the tank; otherwise, it builds up. But you’re not venting it; you’re burning it, so you are using it as fuel. So it’s very handy to have fuel on the cargo tanks. Newer ships today will have a boil-off rate of around 0.05 to 0.85%.
OK: So the boil has been reduced 50% to 80%, and some of them also have a relic system, so you can take the boil off that’s coming off the tank and re-liquefy it and put it back to the tank. Of course, it consumes some power, but that’s feasible. We have a partial leak system on four ships and a full relic on three of them, making it a bit handier to store them. But as you said, it’s not like crude oil, where you can sit for a long time. So floating storage tends to be shorter, typically one or two months. It’s very rarely you see ships idling with cargo for more than two months. You need to flare the boil off in the funnel because you don’t want to vent it, so you then are just flaring it, which is wasteful, or you need to use power to reliquify it. So that is an economic hurdle of having longer storage time.
OK: That’s a good question. Talking about the LNG spot market that developed in another crisis, which happened 11 years ago, which was Fukushima, there was no spot market for LNG until Fukushima hit Japan. Then certainly, with all the nukes storm, they had a shortage, creating the LNG spot market. It was a bit different today because it was a portfolio player rebalancing the supply and pushing more LNG into Japan. So 11 years later, there is another crisis, the war in Ukraine, that is changing the spot market of LNG where Europe is coming in. The people in Brussels think very short term; that’s the problem. Where I reside is one of the biggest gas exporters in the world. The oil companies had long-term contracts linked to oil at a discount with Europe.
OK: So typically, the Asians are buying today; there’s not an LNG crisis in Japan, China, or South Korea because all the supply is linked to oil with a discount of 20-25%. In Europe today, we pay close to $200 per barrel of oil equivalent; in Asia, they are paying $70. So we had these contracts in Europe as well, and then the European Commission said this is on the competition, and they forced a breakup of existing contracts because they wanted to have a spot price on all the contracts. Europe saved a lot of money for ten years on this because the spot price was much lower than what the oil price index would have made, especially during COVID in 2020, the price of LNG in Europe or TTF gas was breaking below $1 per million BTU, which is equivalent to $6 per barrel of oil. This year has gone up to more than $100.
OK: And now they are saying they want to have price caps and renegotiate contracts. This is not a way to have a policy and a kind of predictability for the actors in the industry to invest. If policies are changing, depending on market developments all the time, how are you going to invest if you’re going to invest in an LNG export plan today, you need to have a horizon of 25 years. You probably need to set aside five years to develop, finance, and get the project going, and then you need at least 20 years to sell cargo for this economics to work, but then if you have these policy changes all the time, how are you going cope with it? That’s the problem in Europe; you have to be a bit more longer term, but then if you’re saying that everything’s going to be carbon neutral in 2050. I understand that utilities are not signing up on new contracts, and then there will not be more supply.
OK: So, who is going to sign up on those contracts? Are we leaving it only to Shell, BP, and Exxon? They are taking the risk that Europe will rely on buying the spot’s market cargo, which could very well be, but you are not incentivizing many new projects by doing it this way. Now, given the situation, Europe should be going to the US and signing up 20 million tons, signing up 20 million tons from Qatar, maybe 10 million tons from some of the African exporters, and doing even more because the Russian flows that we are replacing are huge.
OK: Yeah, even with LNG imposed down 20% plus in China this year, last 18 months of the 100 million tons of new SPAs, China has done 50% of it. So they are certainly signing up a lot of new contacts, and they have been doing well on that. They signed up a lot of contracts after the trade war with the US, and they have been reselling those cargoes into Europe because the beauty of the US cargo is there is full destination flexibility. So Chinese who buy those at Henry Hub plus $3, even if Henry Hub is $8, $11 full price, can sell those cargoes into Europe at $30, $40, whatever the price is. So they’re making a fortune on it, but they are thinking 20-25 years; they’re not focused on thinking today all the time.
OK: Yes, Shell, Exxon and Chevron, and some of the trading houses like Trafigura and Ganvor are doing it because they see that the European buyers need gas, but they are not willing to sign up for these long contracts. So they are buying a portfolio of contracts, and then this is a bit more like the oil place; Germany is not signing up 5 million barrels of oil from some countries. It’s market participants doing it. So I’m not saying that the government should intervene to do it, but the problem is their policies and the signals to the market actors are resulting in them not signing up on something because they don’t know whether there will be a mark the 10 years’ time, so kind of the problem for the government or the policymakers in Europe is more lot of ambiguity and uncertainty they are creating.
OK: They are pushing the bill to somebody else. But then, for instance, if you are developing a gas field head in Norway and, usually, almost everything has gone to pipe to Europe because it’s very close to the only LNG export plant in Norway. It’s very far in the north, where the pipeline would be very long. Let’s say you are investing in new projects today. Would you rather build the LNG plant instead of a pipeline? Probably yes, because you don’t know if the price goes up, and Europe wants to cap the price. So it’s going to be good for me because I am in the LNG business. Rather than building pipelines, they build LNG plants; it’s not really the right policy if you have a gas field shore to the market – the pipeline is the most efficient, but European politicians could very well undermine that by talking about these price caps.
OK: This new billing price has gone from $180 to $250, and the order book is more than 40% of the fleet, and then that should worry any shipping investors, including myself. There are a couple of reasons for this. For one thing, there are a lot of new projects Qatar has today our nameplate capacity of export of 77 million tons per year. In the first stage, they’re not going to increase it by 33 million tons and then maybe add 16 tons on top of that. So Qatar is probably going to order a hundred ships altogether. Then you have some new projects in the US especially Venture Global LNG and Genia, which are pushing forward new projects. So there are a lot of new projects. Of course, it’s not enough. Europe can’t replace all Russian gas just with renewables.
OK: They need to replace most of it with gas. But now, in Europe, we replace it with spot LNG and a lot of coal which is the opposite of what we were planning, so we need a lot of new ships for new projects. We have seen a lot of investment on the shipping side, but mostly all of those ships are built towards our new contract, so not on speculation. The problem is that if you’re doing this multibillion-dollar project, you need to have contract coverage for 70 – 90% of the volumes; otherwise, it’s too risky to give it the green light. And when you have the player that should be signing up the most contracts – Europe, and they are not doing it, that makes you reliant on the super majors and the traders signing up. Europe should probably be signing up $50 – $80 million tons of LNG, and so far, they haven’t done that. And that’s what is holding back investment. With this kind of huge challenge, you have to replace pipeline gas from Russia with LNG and get rid of coal in Europe; then, investments should be bigger.
OK: For all businesses to transport LNG to the market, which is willing to pay the highest price. Of course, we are not instructing our ships where to go. Every fixture in LNG is a time charter. So the guy renting the ship will instruct where to load the cargo and where to discharge, and this is up to market forces, which it should be. What we are delivering is the most efficient LNG ships. So ships built between 2008 and 2021 are the most efficient with the most modern diesel engines. That resulted in an efficiency increase of 60% compared to the older ships. So, that is all part of the value change, and we have built all our ships on speculation; we haven’t built them to contracts. In our considerations, we thought, these are good ships, and prices are good, let’s invest $2.5 billion in these ships, and let’s see if we can fix them out.
OK: It usually takes three years to build an LNG ship. Now, the lead time is more like four and a half years. I listened to one of your podcasts recently, which was with Jeff Currie in Goldman Sachs, which I’ve talked to in the past, and he has a very good point because we have this inflation; yesterday, USCPI numbers were still above 8%. So inflation is high, and as today as back in the 70s, it is driven a lot by energy. People thought the energy was irrelevant; it was a small part of GDP. Energy companies in the SNP index went from 15% of the market down to 3%. So a kind of energy was this dinosaur, an old industry that nobody taught much about.
OK: Now, with energy prices coming up, we see how important energy is and having the reliability of supply and affordability. When inflation came down by Paul Walkers, Jeff questioned whether it was Paul Walker who did it or if it was the CapEx boom in the oil industry after oil prices took off after the OPEC crisis in the 70s. We are at exactly the same point today; we have high inflation because of high energy prices, especially in Europe when it comes to gas, and how will we drive down inflation? It’s a CapEx boom in LNG! So that’s what you have to create. I don’t think people in Europe are willing to start doing shale. They are unwilling to take out more gas from the running and gas fields because house owners don’t like it.
OK: If you don’t want to use that gas resource, you need LNG. So you need a CapEx boom in LNG, much bigger than we are seeing today. We are seeing quite rapid growth on the LNG upstream part. I mentioned there are a lot of ships for construction, but it’s not big enough because the challenge we are facing is much bigger than people realize. We’re trying not to patch it up with some gas subsidy caps, but this is a much bigger problem. We have to start thinking 10, 15, or 20 years, and then we need more LNG, but also the LNG industry also needs to begin to decarbonize. CO2 emissions by replacing coal with natural gas by 50-60%, but there’s a big problem, and it’s the methane emissions; they will need to be reduced to close to zero.
OK: People say it’s difficult, but it’s possible; Equino has reduced methane to virtually nothing in their value change. I think you should have a price on methane as well, so getting methane emissions down and then also on the upstream part, how you electrify it to bring down emissions. Every upstream project today has to start thinking about CO2 capture. So you are capturing the CO2 during that process. And then we also need to start thinking about CO2 capture when burning natural gas because if you manage to do that, you have basically made CH4, which is methane, into hydrogen. So you have been able then to create hydrogen much easier than burning hydrogen because that’s a complex and inefficient process. Overall, I think we are happy to invest in that story. But right now, with the LNG new billing prices at $250 and all the ambiguity about policy, we are sitting on the fence like many other people in the industry.
We welcome Susan Sakmar back into the SmarterMarkets™ studio. Susan is Visiting Professor at the University of Houston Law Center and author of Energy for the 21st Century: Opportunities and Challenges for Liquefied Natural Gas (LNG). SmarterMarkets™ host David Greely sits down with Susan to discuss how the European energy crisis is transforming the LNG industry.
This week, we welcome Bill Perkins into the SmarterMarkets™ studio. Bill is the Founder, Managing Partner, and Head Trader for Skylar Capital. SmarterMarkets™ host David Greely sits down with Bill to discuss his trader’s perspective on the natural gas, power, and carbon markets in Europe.
BP: Things are changing every day in Europe right now, but I generally see that we have a situation where the amount of storage is not enough based on the demanding amount of gas they use. So you have a lot of scenarios where you can either get to containment, and prices fall apart, but still not have enough gas to get you through the winter. We used to have that domestically before storage grew maybe 15 or 20 years ago. Then you have all these other factors with the energy transition: Russia cut off the gas because of war, ship LNG, and policymakers getting involved with subsidizing demand via price caps, nuclear issues, and weather issues. There are just a lot of things that digest in the short-term and long-term. Long term, it’s going to take a while for this market to become less volatile. So I see lots of opportunities here just being the insurance agent. That’s what traders are; we ensure against prices going up, and we ensure against prices going down based on how we see the world.
BP: Just like any other winter, they can fill to the brim, and they can still run out of gas – this is what normal situations would look like. But here we have the Russians flowing 1/6 of what they normally flow that’s being met by LNG; high prices cure high prices, but will Russia cut off more gas flowing through Ukraine? Has demand destruction been significant to get us to the winter, or will winter be very warm, and then we’re being flooded with gas? Or will it be cold, and we run out of gas? There are a lot of scenarios that keep playing out. Right now, we’re kind of in a situation where high prices cure high prices, the demand destruction is significant, and the rest of the world is saying we don’t want the LNG at this price, at least a significant portion of it.
BP: So we have to reckon the amount of LNG flowing to Northwest Europe and Western Europe, which looks crazy when you look at it on a map, but winter is coming, and the infrastructure isn’t such that flowing LNG ships can necessarily place flowing gas in a cold weather scenario. So you have a shutoff through Ukraine, and it’s priced high; you are kind of bearish, but maybe the expected value could be fair or high. People are trying to figure this out, and when you start having policymakers get involved, you begin to lose a free market. I’m very good at trading markets, but I am not good at trading Putin; I’m not a good trader trading Putin. These various schemes that they have induce demand, these price caps.
BP: Are you subsidizing demand when you’re running out of gas? This makes no sense. I often say had they made the price a complete pass through, the crisis would be over in a day. And then some retort about what happens to the people who can’t afford it? I say, here’s what you do instead of just blindly paying the bill, give everybody the amount that would be an increase and call it a pass through. Are they going to spend the extra thousand dollars on energy or will they conserve and spend it on the nightclub? I think many people go to the nightclub rather than spending on a high electricity bill. They’re not putting forth schemes to conserve or produce demand destruction; they’re just absolutely subsidizing demand, which is crazy.
BP: No invasions, but you had growing demand and a lack of infrastructure, and no matter what you thought about the energy transition, energy transitions aren’t smooth; they’re lumpy. Infrastructure doesn’t come on perfectly and match demand. You have this storage situation where they’re not building more; no matter how much you fill storage, you always have a risk of running out. In the early days, we were putting down all these gas-fired power plants and growing our demand sided equation and flows but not increasing the storage, which storage is your shock absorber. That’s your shock absorber for volatility, and so I saw a landscape where we’re going to have a lot of volatility depending on what was going on, what was the weather, what happened in global events.
BP: Nobody wants to trade the boring, 3%, 6%, and 10% Vol product. We were trading the 80% vault product, and back then, I thought – 40 Vol is cheap, or 60 Vol is cheap, and now it’s double. We have scenarios where things will be moving around significantly. Since there are not that many insurance agents in Europe, not that many people want to put their risk capital and be risk warehouse shops there, the premium or the edge we get paid is significant. When there are 30 insurance agents, the insurance margins are pretty thin. There are not that many of us that want to put our capital at risk in that market.
BP: The world went crazy with equities. It’s just you went to raise money looking for your discretionary long-short commodity trading, and they were like, do you trade equities? Are you long equities? Are you long equities? Can we buy the equities? That’s all you heard. And you had this massive run-up from the fed printing, and I guess it was the right thing to do because they were printing money all the time, but that’s changed. They could lose 50% of their portfolio and still want to be in equities before they jump into a commodity long short. And people are starting to pay attention to commodities, but we’re always an afterthought.
BP: Yeah, they are too risky. It’s a strange world, but I guess that’s what’s marketed the most to these risk allocators of the world, the pension funds, the family offices, et cetera.
BP: We hired Nathan Lorentz, he is from the LNG days, and he’s opening up the office, and I’ve already been trading small significant as a percentage of our portfolio, but we wanted somebody full-time with the time differential, so I’m not up at 1:30 am trying to figure out what’s going on. We’ll be building out that risk book and the desk as time goes on. When I was in high school playing football, I remember the coach used to say: “Run where they at! Perkins run where they at!” You have to go where they are, and so many people are not in Europe, they’re bailing out, they’re blown up, they’re not allocating risk, and that’s where you want to be. That’s where you want to be in that market. You want to put all your fundamental analysis, your programs, your research, and that data you’re buying over there. I think you’ll have a very positive expected value position in Europe.
BP: We clearly have the run-out of gas scenario. That’s interesting because the EU isn’t the United States because they’re kind of loosely together. What I mean, do you have certain states go that would go about it like we’re not going to ship the gas, no transit fees, or we’re not shipping you power? The European Union has stressed itself, and those are secondary effects of scarcity. There is also a lack of proper planning, years of the policy of we don’t drill, we don’t put in infrastructure, we rely on Russia for our natural gas, and that’s coming home to roots. You have scenarios where there has been demand destruction. They have sent out a signal; the market is set, here take the LNG, China says, we’ll burn all the coal in the world – we don’t care, take back your LNG. You could have a normal to mild winter, and just be flooded with gas in storage at the end of March. So I think both tails are on the table. They’re completely on the table right now, and I would say that the no-shutting-off Ukrainian flows scenario with normal weather is actually bearish.
BP: You have a lot of demand destruction and flows. You’ve sent a price signal, and high prices cure high prices. The problem in Europe is that the person using the gas and paying for the gas is often not the same person. In industry and commercial, you will pay for it if you use it. They’re shutting down aluminum plants and smelters all the way through, and you just have enough demand destruction. There are 92 LNG ships on their way to Europe right now. There are 260 ships on the water. If they’re all going to Western Europe, and it doesn’t look like they want to stop. The storage is 90-91% full in Northwest Europe is what we defined as Northwest Europe. It’s on its way!
BP: Once you get to 92%, you start to have injection issues, you can’t stuff it at the ground at the same rate, and it starts to drop off precipitously, and so you’re seeing that cash was trading €30 back on futures and you could see it in the front spread, which was a premium and now it’s €15 back, call it five bucks back, I mean, it is €30 back printing today, and I see that scenario getting worse as long as the weather is normal. So you have everything on the table here, weather normal down the fairway, slightly bearish, but the volatility is so high, but as time evolves, that will start to get more solidified one way or the other.
BP: That’s an education question. It’s really hard. I guess people respond to visual cues, so maybe show them the distribution of events, like what happens and some prices you estimate going on. That’s how we look at it, so here’s the world as we see it now. This is the S&D; this is the demand destruction, run me the last 30 winners through scenarios and show me in how many outcomes we’re running out of gas, et cetera. I think every trading shop does that this is no fancy witchcraft here, and then you could start saying that what if Russian flows of this run the weather scenario? What if Russian flows of that? What if LNG flows of this, and you run that deck, and then you have the distribution of what we see and what’s possible, but you don’t want to see a 30% chance of running out of gas; you never want to see that. You don’t even want to see 10% or 5%, so that’s what’s pretty scary.
BP: And that’s what you can see in somebody’s cards you pull up or these scenarios. In my view, policymakers want to get elected, and look good, so they say they’re the bears of good and sometimes false news or, often false news.
BP: Right now, we’re much smaller than we normally would be, and that’s just a function of all margins. I guess everybody’s smaller, but the other thing is that we’re waiting for very extreme, high favorite scenarios and tighter spreads. One of the things that recently we were looking at is that the winter might be crazy, and there’s always going to be this like kind of war premium and Putin premium, but there’s a significant chance that they can run out of storage. They can’t inject as much gas as they’d like to carry to prepare for the winter, although they’re going to send that price signal out. A month ago, I knew we should be short the front and long the back, even though the market is backward dated, this market should be contango because there’s this x probability of getting to a hundred percent full.
BP: Things happen, and it changes to even 95%. So we started running numbers and saying, what’s the odds that we get to 90% full by today? Right, what are the odds we get to 95% full? What are the odds we get to a 100%, October the 15th – 95% is a really dire situation with the amount of flows you’re flowing right now. In a normal weather scenario, is there enough space, is there enough demand plus injection demand to handle that, and there were just too many scenarios that were like there’s going to have to be some discount. Then there were all kinds of discussions about what could they do floating storage and then there was a debate on how do you store if all the slots are already taken to re-gas in the winter?
BP: You don’t have firm re-gas rights in the winter. So you can’t just sit there with a $100 million cargo hoping to get a $20 spread. I don’t know the exact answer, but I felt that enough of the distribution was that this thing backwardated or flat or even down a dollar is too tight, so we stay kind of tight within season. It’s one of the ways you could kind of trade, trade around containment and running out. On a longer-term basis, that’s tougher; the further you go out, your accuracy decreases with time. When you go from, let’s say to the summer, we call that three trade lifetimes away because each season is a trader lifetime. After all, you can die in any season.
BP: We look in the range of the extremes what’s going to happen, what’s going to happen with demand destruction, are these distributions reasonable? Can we put on a trade that expresses that we can survive being very wrong because the name of the game is to stay in the game. The market will provide you with outsized returns. You just need to stay alive. Even if you get cut in half, you’ll have a chance to really come back and thrive as long as you stay in the game.
BP: Just don’t get knocked out. You could get knocked down bloody, you can do a nine count, they can cut your eye, but make sure you’re able to go back in a ring, and you’ll eventually win.
BP: I generally view them to be who they are, and their primary concern is not solving the problem; it’s solving the problem of how I stay in office? How do I look good? How do I get reelected? It’s simple; energy is a pass-through. It is over. You will get 30% conservation out of the RC sector you’re worried about. They’re just not paying that much, and then, their concern is about people’s high bills, that they’re angry, and that they will not get reelected.
BP: So that’s how they’re always going to behave. So whether it’s like we’re going to move the index over here, it’s never solving the demand problem. It’s not solving the LNG problem, it is just hiding it. It may push it further down the road and make it worse further down the road, but it’s never really actually solving the problem. Here’s something where you can solve the problem and get reelected. Just say, let’s say your bill was $100, and now it’s going to be $1,000 and you don’t want them to see the increase, so usually what they do is they just cap it, and they pay the bill for them, so you have no demand destruction.
BP: Give them $900, but just tell them the price is the price. So the consumer, they’re not paying anything extra, but they have $900 to make a choice, spend it on energy or conserve energy and go out and party. The price is a pass-through so there’s no harm to the consumer, but then what’s going to really happen is that these guys are not going to like take the $900 and ship it back to Juniper, which is now a government-controlled entity. They’re going to take that, turn down their thermostats, winterize their houses, and you’re going to see conservation that on a scale you’ve never seen before in the RC amount, and you’re going to solve the problem crisis over immediately.
BP: It’d be empowering the consumer so that would be a policy shift where they are doing the socialist thing, but we’re doing it the smart way. We’re distributing it to the end user and letting them decide whether you’re not; you’re not subsidizing demand in that way. You’re actually destroying demand in that way, but I haven’t heard that once out of anybody, out of any policymaker. They’re politicians; they’re not economists, they’re not commodity traders. They don’t necessarily do that, and their focus is on getting reelected and staying in power.
BP: I’m just proposing a way that they can actually be superheroes. It’s just like I got $900 and I got to keep $200 more to spend. it’s also an economic boost. It’s a direct ejection.
BP: Definitely a trader first. I wouldn’t call myself highly successful. I’ve been successful in tournaments, but cash games, I’ve gotten beaten up early enough and I’ve gone through the school of hard arts learning poker, but when I was like a clerk, I got introduced to playing no limit at holding them and all the traders, they have this natural inclination to risk, they like to gamble as entertainment. When you’re always a house, sometimes you just want to get lucky, and socialize, and that’s kind of the mentality of the floor, at least when I was coming up.
BP: There’s certain people focus on the downside. They’re just risk averse, and there are people who are always at missing the opportunity costs, and I think that’s more traders. They’re always like, what could have been, what could I make, they’re not thinking about the downside. I think that’s the bent of traders and so they like action.
BP: I think what they both do in different ways is trading and poker let you know about yourself. You go in the market, it doesn’t care, it doesn’t have a vendetta against you. You play poker and they don’t have any vendetta, they’re going to come away. It’s really how you react to every scenario. For instance, there’s winning traders and and losing traders. it’s really how much did study, how did they react to each scenario. So you really learn about yourself when trading . Yound the same is true with poker. When you find your leaks in your poker game, for example, you over bluff or you under bluff or you call too much or those things you find like there’s something personal to you and your personality, the way you are maybe, in your childhood that wired you to be this way. You need to unwire and fix this thing in order to get better at poker.
BP: And I think the same is with trading. Like if you’re the type of guy that gets upset when you lose and get irrational or you hold onto a trade too long, when you should be getting out because whatever you become attached or whatever; there’s all kinds of trading leaks that are out there. I’m not a trading psychologist, but I am very well aware of when things go right or I’ve done things wrong, it’s me; it’s not the market. Bad things happen in the market. That’s a guarantee. Like the trading guarantee something is going to go wrong. You’re going to have this perfect thesis and boom, polar vortex in your face. It’s bullish as all get out, and the market goes into infinity, and Freeport LNG blows up, and there’s a ton of gas on the market, and boom, we vaporized 2-3$. These things are just going to happen. You don’t know when they’re gonna happen. That’s the bargain of life. That’s the bargain of trading and what really matters is how do you react to it.
BP: I guess one of the things I would say is that even when bad things that are happened when you’re making your thesis that volatility that got you is also what’s going to pay you. This is part of the game. Do not get too upset. If you’re in that game that is what’s going to pay you this volatility, this structure has set up. We’re all complaining about margins are crazy, and I can’t trade that much. This is because it is, don’t worry. There is lot of juice and you’re needed. Many people, look at the trading as useless. And I say, we’re needed, we’re risk warehousers. So you’re needed, hang in there, keep your wits about you, and be rational. They should use the word – risk warehousers. We take the risk that you don’t want.
BP: We’re really glorified insurance agents. If you’re a fundamental trader, we’re glorified insurance agents, producers come out and they’re say, we want to sell a gajillion contract so we can make the widget and where do we buy this thing you; it looks bullish here. I’m going to buy it, and then it’s like we’re worried about running out of gas. We go to buy it, and we’re like you actually could run out of gas. Where would I sell this thing? That’s what we do. We’ve just glorified insurance agents.
We welcome Tracy Shuchart, Partner at Intelligence Quarterly and @chigrl on Twitter, into the SmarterMarkets™ studio. Host David Greely sits down with Tracy to discuss the broader impact of the European energy crisis across the commodities and financial markets.
TS: We were singing secondary and tertiary effects across the entire commodity sector. Last year before the Ukraine invasion even, we saw energy prices already spiking in Europe, and people kind of forget that this started well before the Ukraine invasion. Last September, we saw spiking energy prices in the UK first, which threatened small meat firms. By October, natural gas prices got so high that started affecting fertilizer companies that were intern forced to curb production, which then caused problems in the meat packing industry because they rely on the CO2 from the fertilizer companies. And then, if we move to last fall in the EU, we saw the fertilizer industry being hit there too. We also saw iron, copper, nickel, aluminum, zinc smelters, and stainless steel mills forced to either shutter entirely or curb production because those metals are very energy intensive.
TS: We saw aluminum probably the hardest hit throughout the year, and Europe produces about 11% of global production. So since the fourth quarter of 2021, eight European countries have seen aluminum closures. We’ve had five aluminum plants in France, Romania, Slovakia, Slovenia, and Germany leading to reduced production. While we’ve had three in Spain, Netherlands, and Montenegro shut entirely, 50% of European aluminum smelting capacity is currently offline. So obviously, that’s going to lead ultimately to higher aluminum prices, higher metal prices all around because we’re facing kind of these structural supply deficits, and moving forward, we know that these countries are going to pull back on their green plants. So if we look at things like EVs that require massive amounts of aluminum, 250 kilograms per vehicle on average, solar panels, the new generation solar panels require twice the amount of aluminum that the older generation did, and obviously, turbines also require a ton of metal, ton of aluminum, a ton of steel and so this is going just to make all of these products more expensive and if metals are more expensive, manufacturing is more expensive, products more expensive. We’re going to see ripple effects across all of these sectors.
TS: It always takes a lot longer for things to play out than you initially think they do. Especially when you’re looking at big macro ideas, they take a long time, and our three major themes have been energy, metals, and agriculture. If you start with the energy sector, you know that the energy is pretty much at the heart of everything. Obviously, that started with the energy sector after the bottom fell out of the market in 2020, oil went negative, and the whole world shut down, but even before that happened, we were already seeing some supply problems in the energy sector that just derailed it for six months or so.
TS: Energy makes everything run. I knew that this would eventually affect things that were very energy intensive, like metals and particularly in the agriculture industry, which also is very energy intensive. Not only do they require fertilizer, which requires a lot of gas, but getting their farms running requires a lot of diesel, kerosene, and different fuels of that nature. Energy is at the heart of everything; then it’s kind of seeing how long it is going to take to hit these other markets, so that’s kind of the timing issue. It’s not always easy to get right, but I think that’s what we’re seeing right now.
TS: We saw a fertilizer kind of spike this summer, and I have pulled back since then, but those markets are starting to jump again because of all the production that’s being taken offline in the EU. We’re already experiencing some shortages in the US, and we’re not even at planting season yet. So looking at those markets, I think that’s going to play an even larger role in H1 of 2023 as we go into planting season. Energy input costs are going to be higher. Obviously, we’ve seen energy pull way back, but still $80, $85 that’s very high for the norm.
TS: I think we’ll see higher energy prices for longer. We’re going to see input costs for agriculture starting to storm. That will also affect supply problems, because countries like Canada and the Netherlands want to cut back on fertilizer usage, whether or not that puts some farmers out of business, which then takes more food supply off the market. The Netherlands is the number two global exporter in the world of food, and they’re looking at many farmers that could be hurt by this and go out of business. I think we barely scratch the surface. Food prices have escalated up 13% this year. Probably even higher. So, I think that’s going to be higher for longer, and I think we probably haven’t even started to scratch the surface of that yet.
TS: There’s often a prevailing notion that commodity prices are directly inversely correlated to the dollar, so people are looking for icommodity prices to go down f the dollar goes up. Certainly, there are cases that happen, and there are points in time that happen, but if you look over a long enough period, this is not the case for the most part, especially when looking at supply-side problems. Over the last two years, energy, grain prices, and industrial metals have been rising alongside the USD. So when we have these structural supply deficits in all of these markets with inelastic demand, other than shutting down the entire global economy as we did. We will continue to see rising commodity prices in the face of a rising dollar.
TS: It’s going to be a problem for the US, but it will be an even bigger problem for emerging markets. I think we’re going to see a lot more food protectionism and energy protectionism start coming into play, just as recently as India put a 25% export tax on their rice. Earlier this year, they even stopped exports altogether for the time being. I think we will see these kinds of actions coming up more and more globally.
TS: I think I have to go back to the point that pretty much everything revolves around energy. It literally runs the global economy. I think it’s particularly important for anybody to watch this sector as it affects the cost of everything else. For most businesses, energy is one of the highest input costs from small to large businesses. This factors into their bottom line and affects how they conduct business. Earlier, we talked about the ripple effects of high natural gas prices affecting smelters that in turn affects manufacturing, which in turn affects global supply chains, which in turn affects all aspects of business, from transportation to food processing to utilities to consumer discretionary to healthcare, even to the tech industry. Expanding on this supply chain problem was right after the pandemic, we saw how supply chains could be interrupted and how they could affect businesses.
TS: And even many businesses and industries continue to operate with these disruptions today. If we take, for example, the oil industry, we’re still having problems sourcing steel pipe and things of that nature. And that’s not the only business that’s still having problem kind of sourcing materials. So if we look at that and take that as a whole and know that all of these things affect whatever business you’re looking at and investing in, then you have to consider how the commodity sector factors into how they do business. I think the energy sector might be biased, but I think the energy sector should be of particular interest to anyone investing globally in any equity market.
TS: We have to realize that the source of the problem, and the energy crisis spike over the last year or so, is poor policy decisions that started a decade ago and, in some cases, two decades ago, and this has all just finally come to fruition because we had the right elements in place to spark it off. It was going to happen regardless of COVID and the Ukraine invasion – all these happening is just further exacerbated problems, but as far as policymakers need to look up, they need to understand that energy transition just doesn’t happen overnight and the technology is just not there yet.
TS: You can’t base energy policy on hope. You’re talking about the livelihood of billions of people, and I think their big mistake was wanting to switch off fossil fuels right away and switch to wind and solar power. But wind and solar are intermittent power sources, and the battery tech is just not there yet. We still need fossil fuels as our base load power, and if you don’t want, this is where natural gas is perfect for the transition fuel because it’s much cleaner than oil or coal. I’ve been talking about this for years, but they continue demonizing the industry. On the flip side, we have the option of nuclear power, which is super clean, and the most energy dense, right?
TS: You need a tiny amount of uranium to create enough energy, but the west has largely shied away from that. We haven’t done anything in the last two decades. There haven’t been a lot of upgrades; there haven’t been a lot of builds in the west. We have seen some in Africa and Asia, but we haven’t in the west because we had Chernobyl and Fukushima. The west got freaked out and marked it as dangerous. And then we had the environmental groups talking about the radioactive waste, and we’re all going to die. I think there was just not a lot of education out there. Ever since those accidents happened, there have been fantastic strides in nuclear energy.
TS: It’s very different now; it’s not the same plant that it was 20, 30 years ago. I think that’s sort of the media’s and the government’s fault for how they portrayed this without educating people. And now they’re forced to go back to the drawing table on nuclear. We’ve seen the UK wants to start eight new nuclear reactors; we see Germany deciding on and off whether to keep these last three nuclear plants. There is more interest. In the US, we just had California, for example, which wanted to shut its last nuclear plant, but now they want to keep it open for another 10 years. So we’re seeing some warming up to it.
TS: So I think that’s good as far as policymakers are looking; let’s give them a little pat on the back. It is good that we see policymakers change their view on this kind of energy, and that’s the developed market side. If we look at the emerging market side, I think the west needs to stop interfering. For example, last week, we had Simon Zarchary in Africa speaking about not investing in natural gas long-term. For developing markets, this is just really unrealistic. Cheap, abundant natural gas is a great transition fuel; although it’s not so cheap at the moment, if they were to drill locally, it would be cheap. We have to realize that over 600 million people, 43% of Africa’s population lack access to electricity.
TS: Most of them are in Sub-Saharan Africa, which has a lot of resources they could tap into. Many African countries have in trying to argue against the west and say this is unfair that you’re trying to put us in a position, and we’re just not at the same level as a DM market. I think policymakers should continue to try to get investments for their oil and gas industry to bring them out of poverty. And the west, if they want to help them, should stay out of their way a little bit and not get so involved in energy policy.
TS: Every four to eight years, you change administrations in the US. I think you should hire people with more experience than we currently have because all these energy decisions that people are making are really from people not that qualified to make those sorts of policy decisions. They are all politically motivated policies because a bunch of bureaucrats got together and decided we’re going to have this climate Paris accord, but nobody is well versed enough to say how we will get here? Everybody wants clean energy and clean air, but how are we going to get there? Governments need to have a bigger conversation with those who have more experience, not just bureaucratic think tanks.
TS: And the scary thing is it’s being so demonized, they are having a hard time finding labor in those markets; those fields are dying. If you go to college these days, nobody wants to major in the oil or mining industry because it’s dirty. It’s got bad connotations, so the labor pool is also dying. We need more engineers in those fields and get them together; this is not going to fix itself by itself. As you can see, it’s self-destructing before our eyes. So we need a whole redress of the situation, hopefully, sooner than later.
TS: Well, I had just moved to Chicago. I didn’t know anybody, and I had just started in the industry at CBOT, had a grunt job, and thought it would be a good way because I had a friend that was like, you should go one. There’s a lot of financial people on there, and I was like, okay, and so I kind of just went on to shy, Chigrl cause I wanted to be anonymous. I didn’t have my name on there for years, and so that’s how I just really started. I started talking to financial people, and my circle grew. I remember when I got like a hundred people following me, I couldn’t believe a hundred people wanted to hear what I had to say.
TS: And it grew organically. Social media can be beneficial for beneficial for everybody. But at the same time it can be very toxic. Financial Twitter, it’s a really good place where you can meet people, there’s a lot of good to be found there. There’s a lot of good advice. There’s a lot of ton of good information. There are a lot of people that you can learn from. For instance, I specialize in commodity markets. I don’t know that much about a bond market, so I can follow a bunch of bond people and learn all about bonds. I can follow a bunch of people who specializing in healthcare. I can find out about all the healthcare companies, anybody can do that. So that’s where I think that it’s beneficial because you can learn a lot from everybody else. You just have to sidestep the toxic people. There are always wil be those who would want to start fights and the best engagement with those people is no engagement.
TS: You get views from all different companies, all different kinds of traders, there’s a ton of information out there just if you’re new to Twitter, just wade through it, it’s worth it in the end.
TS: I think it was more gradual over time. It took a long time to get to like 50,000 or something, and then it kind of just grew from there. I’ve been on Twitter since like 2009. I started in the industry a little bit before then that’s a lot of dedication on.
TS: I think the sector is just starting to see the explosion of problems. The problems that have been created are not going to be fixe any time soon. I think this is going to be a strong sector for the rest of decade. It took us long to get into this mess and it’s going to take us twice as long to get out of the mess. On a shorter term, I’m kind of looking at agriculture in 2023, and I think metals will hit probably half of 2023 into 2024. As soon as some of this energy sector calms down a little bit, metals will be the next freak out. I think this sector’s strong and there are plenty of opportunities to be had out the current situation even though the situation is not great.
TS: It’s going to take at least a year for Europe to figure out its energy flow. After they do that, that’s going to exacerbate the metal problem even more. Because right now their focus is on how do we get close here. How do we get LNG here. How do we get oil and gas if we embargo Russia in December. They say they need two to three years to build LNG space, but that’s going to take a lot longer than they think. Anyway, their primary focus right now is on how to get energy flows to them to replace the flows that are not Russia related or that are Russia related.
TS: I think the metals are going to take a little bit more for that when they shift their policy back around to focusing on EVs and getting their manufacturing back up. Because right now their manufacturing shutting down. They are getting their energy house in order flow-wise. The metals going to be the next problem because they’re going to have, because of the green policy goals. So that’s why I think that’s going to take a little bit longer. I think you’re going to find huge opportunities in agriculture. I think the next surge you’re going to see is in 2023 where we’ll have spring and summer planting and there is not going to have enough fertilizer. All three sectors are going to play a huge role over this next decade.
TS: I’m focusing on energy flows right now because I think that’s the most important thing that we need to look at. Germany just came out and announce they have enough gas, at 90%, but that’ll last us through winter, which I’ve been saying all summer it’s all about flows. So right now, we should be focusing on global energy flows no matter what. I think Russian barrels are going to stay on the market more so than anybody thinks. That’s just what is going to happen because other countries are going to take advantage of that discount regardless. I would be focusing on how that energy flow space is revolving if you to use as a gauge on how quickly we can get out of this mess.
This week, we welcome Mark Lewis back into the SmarterMarkets™ studio. Host David Greely sits down with Mark to discuss the energy crisis in Europe and what it means for the European carbon market.
ML: It has been a rollercoaster ride for the last 12 months. If we go back to August 2021, we were all talking about what would happen with the Nordstream 2 pipeline. It began to look as if there were going to be problems with the approval of Nordstream 2 by the new German government in September. Sure enough, in October, because of the escalation in the rhetoric between Russia and the West, the German government declined to approve the Nordstream 2 pipeline, which led to a step change in gas prices going into the winter.
ML: Last year, we were in the disadvantageous position of having very low gas stocks going into winter. So that’s where we were this year ago, prices much lower. To give you an order of magnitude this time, last year, we would’ve had the gas contract for the one year ahead priced at €50 to €60, which already was a very high price by historical standards. If you go back two years, European prices were €15 per megawatt hour which would be around $4, $5 per BTU. We’ve gone from €15 per megawatt-hour to absolutely astronomical prices this August with the new year ahead contract for €250 to €260; it went down now at €180, but still, this is too high price for the power.
ML: It’s been the same story. We’ve gone from €60 megawatt-hour for the year ahead contract to an incredible €1,000 per megawatt hour. Last month we came back down to €500, but again, that is still spectacularly high. On average, two years ago, €50 a megawatt hour was a standard number, and carbon had been going up for structural reasons of its own because of the climate policy and the tightening of the cap. So there was a more normal narrative around the carbon price, but of course, it’s been exacerbated, and it’s been having to deal with the backwash from these very high power prices and gas market. So it’s been a more volatile ride for carbon. So that’s the background.
ML: If you think about why this has happened and what’s happened, then clearly, Russia’s invasion of Ukraine, the war of aggression on Ukraine, has led to the weaponization of gas by Putin and the Russian government. That has been driving power prices and, to some extent, carbon prices. Carbon has its logic and its narrative. There is a link between gas prices and power prices. For the last 12 months, gas prices have been at the margin in Europe. In other words, they’ve been the fuel setting the marginal price for electricity.
ML: As the cost of gas has gone up, the price of gas has gone up too. The price of electricity has gone up as well, and of course, when Putin invaded Ukraine in February, we were still coming out of winter with low stocks because we’d gone into winter with low stocks. We were fortunate that we had a mild winter because if it had been a hard winter, we might well have run to zero storage gas levels, but we came out with at least some gas in the tank. Then following the invasion of Ukraine and the need very quickly to adjust Europe’s energy policy, to find a way to get off all energy imports from Russia. For the last seven months, the European Union has been gradually refining and accelerating its plans for the energy transition. The main priority over the summer was to stock up on storage levels ahead of the winter because that is crucial.
ML: You’ve also had this saga of Russia, sequentially cutting more and more of the flows into Europe, for example, through the Yamal-Europe pipeline, which runs through Poland. It’s already cut some of the supplies coming through Ukraine. And most recently, with this rather absurd saga over the turbines for Nordstream 1, flows coming directly to Germany are now at zero. I don’t think anybody expects them to restart whatever the Kremlin says. In European circles, the calculation for the winter ahead the remaining flows that are currently coming through Ukraine, which are about 36 million cubic meters per day, will also fall to zero, and that’s why it’s been imperative to bring storage levels back up.
ML: With the news that we are already ahead of target in Germany and Europe for the storage levels ahead of winter, that’s received positively. So that’s why gas prices over the last two or three weeks have started to come back down a bit, but be under no illusion this winter is going to be very tough. Although that’s the immediate priority getting through this winter the next winter is already in many people’s thoughts. We benefited from the flows from Russia over the whole of the first half of the year that filling up our storage tanks for this coming winter, but that will not apply next year. We will not have Russian flows to help us through the first six months of next year and the summer of next year. So filling up storage levels for next winter, i.e., winter 2023/24 is already starting to worry people.
ML: What we’re looking at here in Europe now is a protracted period of very high gas prices, probably through to 2025, by which time, number one, there will have been demand substitution in Europe and more energy efficiency measures taken and more deployment of renewable energy technologies. Then on the supply side, Europe will have ramped up its import capacity for LNG, and the United States, and other jurisdictions with LNG to export will have ramped up their exports. But over the next 18 months, as those import and export capacity constraints are still in place, we will have to live with very high gas prices for the foreseeable future. And that means high electricity prices as well.
ML: Crucial question and energy professionals, those of us who follow energy markets very closely, we have been seeing these very high prices on screens for many months now, but consumers and end users haven’t even seen the full brunt of them yet. I think in the UK and Germany, it’s in October when you will see a sharp rise in prices for residential households. This is a major political crisis on top of major energy, economic, and financial crisis. Residential tariffs are more tightly controlled than business tariffs, which are free market and so on. So free market for residential customers for the most part across Europe.
ML: But government likes to control the sequencing of those price increases. Now, one example of an order of magnitude is the new UK government, which just came into office last week with the new Prime Minister Liz Truss; within two days of coming into office, Liz Truss said we will freeze energy bills for residential consumers at a price of £2,500. And to put that into context, up until January of this year, UK residential consumers were only paying £900 for their gas and power bills, and to put it into further context, if the government had not stepped to freeze that tariffs, the price would’ve gone up to £3,600 and in January would go up further to £5,000. So the government had to step in because it faced wholesale social disintegration and disturbances.
ML: The cost of this is that taxpayers will ultimately have to pay for this is £130 billion. That’s more than the UK government stepped in for to deal with the impact of the pandemic. It’s certainly the largest-ever intervention by a British government in the energy market, and it’s an indication of the real panic amongst governments across Europe about the scale of social disintegration that this could cause if they hadn’t stepped in. So, one of the levers they can pull is direct intervention, freezing prices, and finding a way of paying for it. This is where it gets interesting because the UK government has decided to put it on the taxpayer. Ultimately there will not be windfall taxes in the UK on energy producers.
ML: Whereas in Europe, and we will get more details on this tomorrow when the president of the European Commission, Ursula von der Leyen, sets out the plans. We know there will be a so-called solidarity tax on fossil fuel producers and upstream fossil fuel producers. So oil, gas, and coal companies will have to contribute to help pay for the price freezes that will almost certainly come across the whole of the EU. Different countries will do it at different levels. And for different periods of time, the UK has frozen UK energy bills for residential consumers for two years. That’s why the bill is so high, £130 billion, so there will be taxes on at least some of the industries and companies in Europe to help pay for this. Still, the reality is the economic and financial cost of this is necessary because if the governments were not willing to step in, I think you’d be looking at a very disturbing political context across Europe here.
ML: So I think there’s a recognition we have a war on our doorstep. This is the biggest military conflict on European soil since the Second World War; it’s an exceptional situation. We need to support Ukraine, and as a result, we need to maintain the sanctions in place. We need to take some pain because, ultimately, that’s a price worth paying for a freer Europe and resisting the threat of aggression on our doorstep. So that’s the political logic, and one can totally understand that it has to be the right call. But overall it’s going to lead to a mixture of higher taxes ultimately and whether it be the companies that are making windfall profits at the moment, or ultimately on general taxpayers as income tax rates. One way or another, this debt will have to be paid off at some point.
ML: So that’s how European governments are looking at the financing. In terms of some of the other policy levers, what’s crucial, of course, is reducing demand. We talked earlier about the need to bring in more LNG on the supply side, but a very important policy response is also required on the demand side. Just to put something into context, that £130 billion that the British government is going to spend to freeze bills at £2,500 for two years. Imagine what you could have done over the last 10 years if you’d invested £130 billion in energy efficiency measures. This is when you have a crisis like this, bringing home how shortsighted energy policy is in most countries. We are not investing the way we need to either for climate change or the energy security of supply.
ML: One silver lining from this whole desperate situation in Ukraine is that the dawning realization on many policymakers in Europe that investing to align our economies with the imperative of reducing emissions and net zero by the middle of this century goes hand in hand with providing security of energy supply over the long term. I don’t think that’s been obvious to many people; a lot of people have made the argument that we’re not investing enough on the supply side. Well, it may be true, but we should be investing in renewable energy resources, which benefit from being environmentally friendly, providing local jobs, and providing an energy security supply. Energy efficiency is going to be the unsung hero in all of this.
ML: That would be for an annual bill. So those numbers that I gave, it’s always the annualized number for a given quarter, which is why it was £970 at the beginning of the year. That was the annualized rate for that quarter. But because, normally, energy prices are not moving the way they’ve been moving over the last year, and that’s why people were getting terrified, as we were going from £900 to £1,970 at the beginning of April, and then should have been £3,600 from the 1st October, but the government said we cap it at £2,500, and then it would’ve been £5,500 by January and no government can live with the social consequences of staggering of that.
ML: Absolutely; there are a number of actions being considered. To quickly recap, the European Union’s policy-making trifecta, that is the European Commission, the European Council, which are the member state governments, and the European Parliament are now entering the final crucial period to finalize the revision to the European carbon market. That will take it to 2030, which means aligning it with the ultimate net zero targets by 2030. Now the commission laid out its plans, its original proposal in July of last year, the parliament and council arrived at their respective negotiating positions for this forthcoming trial between the three parties in June, and then, and the council is slightly tougher in what they want to see in the final shape that the EUETS reform takes vis-à-vis the original proposal from the commission.
ML: But then, with these sky-high prices that we’ve seen in the intervening convening period in July and particularly in August, policymakers have come back from their summer break thinking what we are going to do about the whole energy crisis now. This is interesting because, as we emphasize at the beginning, the rise in energy prices in Europe is overwhelmingly a gas story. Gas prices have gone up for people who use gas, but electricity prices have gone up because of the gas that we use in the market. In fact, if you look at the constituent elements in the increase in the wholesale power price across Europe, over the last 12 months, 90% of that increase is because of the increase in gas prices. Carbon is only 5% to 10% of the increase in power prices.
ML: But the big difference between carbon and gas, of course, is that carbon is a variable that is within the control of policymakers, whereas gas prices, unfortunately, are not, or at least not in the short term. Even though the carbon prices only respond to the increase in carbon over the last 12 months is responsible for between 5% and 10% of the rise in wholesale power prices. That’s for good reasons because we have seen a number of energy-intensive industries in Europe, shuttering facilities over the summer; I’m thinking of the aluminum industry, the zinc melting industry, the fertilizer industry, even the steel industry, these very energy-intensive industries, more than anything else they’ve been hit by high gas and power prices. There is a lot of focus now from European policymakers on what they can do to keep prices in the European carbon market more under control, at least as we get through this winter.
ML: The carbon element is in there, and the industry also lobbies Brussels, knowing that they can make more headway complaining about carbon prices than they can about power or gas prices. The long and the short of it, good news first, there will not be any change to the fundamental points proposed by the European Commission. The cap will fall to the level, at least to the level that the commission proposed last year; we will see a 61% cut in the cap by 2030 compared with the level of emissions in 2005. That’s a dramatic tightening of the cap, compared with the 43% reduction versus 2005 levels that the previous legislation had. So there’s a very significant tightening of emissions. To put it into better context for your listeners, tightening the cap means that over the 10-year period from 2021 to 2030, industrial companies in the European Union will have to make further carbon savings of about 1.5 billion tons of CO2.
ML: That’s equivalent to about one and a half years, almost one year’s emissions. Effectively that’s a very significant tightening of the cap, and that’s why we’ve had carbon prices going to record levels over the last 12 months. That’s the good news. They weren’t tampering with that fundamental point because if they did that, they would be undermining the sanctity of the legally binding target of net zero by 2050. So they don’t want to do that. However, what they can do and what I am convinced they will do is confront load some of the supply that would ordinarily come to market in the second half of the current trading period; that is to say, between 2026 and 2030, they confront load some of that supply bring it to the market. Now, sell more, and inject more volume into the market today to bring prices down so political heat is taken out of the discussion in the short term.
ML: And there is political heat. There is always political heat, particularly from the countries, the member states of the European Union that have a lot of coal fire generation in their power mix because they’re the ones that are disproportionately impacted by high carbon prices, obviously because the carbon intensity of the coal in their power generation mix. So Poland has been saying for the last two months we should just have a flat price for the foreseeable future of €30 a ton. Now that has been rejected out of hand by the European Commission. I don’t think there would be many if any, other member states that would be in favor of that. Still, it’s nonetheless an indication of the political heat that is out there on this issue, and as a result, you’ve had a couple of very senior experienced policymakers.
ML: You’ve had Peter Liese in the European Parliament, a member of parliament charged with leading the reform of the EUETS through the parliament. He’s a very significant figure. He’s going to be negotiating on behalf of the parliament in these discussions with the commission and the Council, who has said, we need to bring more supply to the market sooner rather than later and then in the second half of the current period from 2026 to 2030 supply will be tighter. So all you are doing in front loading, the supply like that is making it tighter at the back, but again, it’s an indication of how urgent the problem is today that they will say, we’re worried about that later, for now, the absolute priority is to bring prices down in the near term.
ML: Peter Liese is retired from the Brussels bureaucracy, but another well-known figure in European carbon circles is Jos Delbeke. He was the Senior Civil Servant at the European Commission in charge of Climate Change, and he is the architect of the EUETS. And now, he is a professor at a university, and he is retired from the commission, but he made a public statement two weeks ago that any, anywhere above €70 a ton in the current climate is politically dangerous, and it would be expedient to see prices below €70. Right now, we’re trading €69-€70 today. So, I think prices probably have further to fall through the winter, both because you will have pressure to front-load some of the volumes and the impact on industrial demand. Unfortunately, I think we’re likely to see further temporary shutdowns of some parts of European industry in response to these very high energy prices.
ML: These are crucial questions. If you look at the power sector, we have had, for a long time, for at least 9 – 12 months, carbon prices that are too low to encourage gas fire generation to run ahead of coal fire generation. On a short-run perspective, in the power sector, the carbon price is doing nothing to reduce emissions, which is another reason there is political pressure. I mentioned Jos Delbeke a few moments ago; Jos has made the point publicly. Even though carbon prices have been highest levels in August, we got up to €99 a ton, but even at €99 a ton, gas is so much more expensive than coal that you would’ve needed a carbon price.
ML: In August, in particular, when gas prices were at their peak, you would’ve needed a carbon price of €900 a ton on the front month and front year contracts to incentivize gas-fired power plants to run ahead of coal. Now, of course, in those circumstances, very difficult to persuade anybody that the carbon price is serving any purpose when coal is running flat out and is much more profitable than gas. For the past 12 months, the carbon price has been doing nothing, and for the foreseeable future, if you looked at the gas, the forward curve for gas, and the forward curve for coal, it won’t have changed that much.
ML: It’s not until you get to the middle of 2025, so three years from now on the forward curves, that gas is in the money compared with coal because it takes that long for the gas price on the forward curve to come down to a level where today’s carbon price or the forward carbon price in 2025 is consistent with fuel switching in the power sector. So to all in terms and purposes, the carbon price, the carbon market is broken at the moment in terms of encouraging fuel switching from coal to gas on the industrial side. And this is where it gets interesting. I made the argument last time I was on the show with you that we’d reached a point where the carbon price was in the 90s, and there seemed to be momentum in February before Russia’s invasion of Ukraine for carbon prices to go through a €100 and reach a level €121 – €130 that would’ve been a level consistent with green hydrogen being more competitive than gray hydrogen.
ML: So there’s a very strong long-term argument there. The structural decarbonization angle, as I used to call it, whereby the carbon price was reaching a level that would lead to structural decarbonization of European industry. Now what’s happened again, a silver lining in terms of high gas prices, is that green hydrogen becomes competitive with gray hydrogen without the need for any carbon price at all. Just to put some numbers on this, the cost of production of green hydrogen, using wind or solar and electrolysis to generate hydrogen, so there are no emissions associated with the hydrogen. The cost of production of that in Europe today is around €6, so $6 we’re parity between the Euro and the Dollar; €6, $6 per kilogram, and for gray hydrogen now the cost of production, which would ordinarily be when you have normal gas prices, it would be around €1.5 per kilogram.
ML: Today, it’s more like €7, €8, €9 per kilogram. So green hydrogen is cheaper to produce today than gray hydrogen, given where natural gas prices are. If you look at the forward curve, you’d be looking at 2526 before you need a carbon price to incentivize green hydrogen versus gray hydrogen. But by 2526, the cost of producing green hydrogen will have fallen. The problem today in Europe is that we don’t have green production capacity at scale; if we did, you’d be running and producing all your hydrogen from electrolysis. Unfortunately, we haven’t built out the infrastructure yet, but the incentive is very clearly there now. So I think that’s, to my point about the silver lining, the one silver lining from this dreadful situation, this dreadful war of aggression in Ukraine being waged by Russia, is that it forces everybody to focus on the need to accelerate the energy transition. And that means more renewable energy. It means more imports of LNG from sources other than Russia. And it means building out the green hydrogen infrastructure.
ML: In my view, I have touched on the key pricing parameters here. The power sector accounts for about 50% of all emissions in the EUETS. Power emissions will be very high, much higher than last year because of the coal running and flat out. One thing we haven’t mentioned has been the very poor availability of France’s nuclear generation fleet over this year, even predating the summer. So on the power side, it’s hard to see gas prices falling to a level before the end of this winter, at least where almost any carbon price would incentivize gas to run ahead of cost.
ML: There are a couple of issues going on in the French nuclear sector that are worth pausing on a minute because this is very important for the carbon pricing outlook and the power pricing outlook. So France’s nuclear fleet has 56 reactors in total, 31 of which are currently offline, partly because some of them found earlier this year to have corrosion problems and so are having to be fixed for that problem. That’s a very serious problem, and it needs fixing. Then you’ve had the catch-up effect from COVID. A number of nuclear power plants that should have had their outages for maintenance did not have those maintenance outages during the COVID period for obvious reasons. So they’ve been having delayed maintenance outages. Finally, because of the very hot summer we’ve had in Europe, high temperatures, a number of plants have not been able to operate and certainly not operate at the usual level of availability because there are problems with the water availability, particularly nuclear power plants that are on rivers have not been able to use river water if it’s above a certain temperature. Often that has been the case.
ML: River levels have been low, and that’s been a problem as well, even for the coal generators, getting the coal in Germany, down the river Rhine because the river level has not been high enough for some of these very big, heavy barges to get down the river Rhine. So there have been all kinds of factors over the summer, which led to this super spike in power prices in August. Now going into the winter, EDF, the French national nuclear company national electricity generator, has said it will bring back 12 of its nuclear reactors this month, another 7 in October, and another 4 in November. So by the time, we get to the end of this year, hopefully, of those 31 reactors that are currently offline, we should have 2021 of those reactors back online, which will go a long way to helping with the power crisis in France and Europe more generally.
ML: But of course, that will have a depressive impact on emissions because to the extent that France has had so much of its nuclear capacity offline, they’ve relied on imports of electricity from other countries, not least Germany, and Germany, therefore has been running its coal plants. So even higher levels than it would be based on the economics of gas versus coal and the price signal from the carbon price simply to be able to export to France. So that will take at least some of the pressure off. So although you won’t see any relief from the carbon price in emissions, in the power sector between colon and gas, you will see some relief from a large segment of those French nukes coming back offline. But generally speaking, emissions in the power sector will be strong.
ML: On the industry side, unfortunately, a much trickier situation. We’ve got a number of industries already shutting down production, and I think there will be more going into the winter. So we’re going to have lower emissions from the industry right through the winter. I think that you can take that pretty much as a given, unfortunately. And then, on top of that, if you net those two off on fundamentals, I would say emissions probably end up still being slightly higher than last year or flat at best. Whereas six months ago, I would’ve assumed emissions would be much stronger this year than last year. On top of that, you’ve then got the political pressure. I mentioned pushing for front-loading of allowances. So when you put all of that together, there’s already been an extraordinarily sharp or steep declining carbon price over the last month. August is a funny month in the European carbon market because of the European holidays.
ML: They cut the supply of allowances from auctions to 50% of the normal supply level, and so you always see carbon prices have a bit of a rally during August. This August, we got to a new all-time high of €99 a ton which was €20 higher than at the end of July, simply from cutting the auction volumes. And then we’ve come back down to €70 a ton today. When you put all of that together, I think we’re probably going down closer to €60. If you think of what happened in the immediate aftermath of the Russian invasion of Ukraine, we got down to €55 from €92, which happened in the blink of an eye in a week back in February and early March.
ML: And this has been quite sharp, as I say, from €99 to €70 already; I would expect prices to fall further heading into the winter and I think around the €60, maybe even the €55 level that’s where you’ll start seeing fundamental support coming back into this market. If you’re taking a long-term view on this market and the industrial companies will take a long-term view on this market, then you have to start worrying about the fact that in the second half of this decade, supply is going to be lower. So I think there comes a point where you will see fundamental demand reassert itself in this market below that kind of €60, €55 level. One of the things to point out is the German government hasn’t legislated for this yet, but it has indicated it would like to see across the whole of the EU or in Germany, at least, legislate for a minimum carbon price for German emitters in the EUETS of €60 a ton, which again is why psychologically that’s an important level for the market.
ML: So putting it all together, I’m bearish heading into the winter, and I think around the €60 level is where it starts to get interesting again, but that doesn’t mean it can’t go a little lower €55 was the lowest in early March and that’s the level that the market will have in mind.
ML: It won’t be on the scale of previous recessions, but we are probably heading into a recession in Europe. The German economy minister made noises to that effect today, earlier this afternoon. But I remember back in 2008, when the global financial crisis was starting to accelerate in October 2008, we saw a real wave of very significant selling of the free allocations that that industry had received. The three reasons why that’s less likely to happen at the same scale, although there will be selling pressure at the margin. The first one is as compared with 2008; we now have a very clear long-term target here. We know the cap will fall to zero within the EUETS by 2040 to achieve the overall EU target of net zero by 2050.
ML: So that comes back to my point that the industry knows the second half of this decade is going to be a lot tougher, so they won’t want to sell too many. There’s a real trade-off between how much I can raise cash today to see me through the winter versus yes, but it’ll be a false economy if I have to buy those allowances back in three or four years’ time at €120, €130. So, that calculation will be in play. Secondly, because of the rule change within the legal change within the EUETS, the clawback mechanism, if you sell free allowances, is much tougher than it was back in 2008. In 2008, you could sell up to 50% of your allocation of free allowances without suffering any clawback in subsequent years.
ML: Now you can only sell 1-5% to up to 15%. If you sell 20% of your free allocation in a given year, there will certainly be industrial facilities across Europe that will be producing this calendar year and probably next calendar year as well at capacity levels of only 80% or less relative to their free allocation, but if they sell more than 15% of their free allocation, then they will be allocated corresponding the fewer allowances in the following year. So they have to be careful about that as well. So behaviorally, that was a smart change to the law, but a necessary one because taxpayers are helping European companies with the free allocation. It’s a form of subsidy. It’s a necessary form of subsidy so long as other countries outside Europe do not face similarly high carbon prices, but still it’s a subsidy. So I think there will be some industrial selling at the margin, but not significant amounts.
ML: The single most important feature here is going to be the market’s expectation of intervention on the part of the authorities in the form of front loading and the sale of UAS, either from future auction volumes or from a couple of the funds that have been set up. So there are two funds, the innovation so-called innovation fund, and the so-called modernization fund. These are funds that were set up at the beginning of the current trading period in 2021; they have several hundred million allowances in them that were taken out of the overall cap for an entire 10-year period, and normally, they are auctioned off all freely allocated in equal installments over the 10 years, and obviously what they probably will do is take some of that and front load it. The other element they’ve indicated they will look at is taking a limited number of allowances from the stability reserve itself and putting those into the market.
ML: I think that’s what’s going to weigh on a market sentiment most greatly. In May, the European Commission came up with raising €20 billion from the sale of allowances. Some allowances are currently held in the market stability reserve, but that would’ve been done over a four-year period. There are now certain moves to accelerate that to potentially one or two years, and if you front load that kind of volume, it would be to raise €20 billion at current prices, you would need about €300 million tons. If you do all that in one year, that’s a significant increase in the volume of allowances being auctioned. So I think the market will get nervous about that.
ML: Two thoughts on that. The first one, to the Doomberg point and the redefining of the energy space in Europe and indeed globally, because Russia is in a sense excluding itself from the global energy market, or at least from a very large part of the global energy market in terms of Europe, the United States and sort of Western aligned countries. So there are real global ramifications to that, but as far as Europe is concerned, I think the key point that will come out is that we have a winter ahead and it will be very difficult. In fact, two winters ahead. It will be very difficult, but if we can see through that, the prize at the end of it is very great because the prize is an accelerated energy transition away from fossil fuels to a cleaner energy system and a secure energy system in terms of security of supply.
ML: There is going to be a redefining. Obviously, it won’t be as simple as that. There are going to be some, some very sharp corrections that need to happen across some places, and it’s not going to be pleasant. We shouldn’t be under any illusion there, but the ultimate prize is worth the sacrifice in the short term. I think that’s the key point. How do we see the European compliance market playing out with the expansion of voluntary carbon markets, and in particular, what’s the impact of Article 6 on all of this? I’ll begin with the voluntary market and how it might impact compliance markets after that.
ML: Because I think there will be a very strong link between the two. I think within three years; we won’t any longer be talking about a voluntary carbon market as such, or at least not in the terms that we have traditionally talked about voluntary market. I say that for this reason, under the Paris agreement and Article 6, Paragraphs 6.2 and 6.4, you are going to have incentives for private sector players to establish emissions reductions projects in jurisdictions that will then give those private sector companies the right to take emissions reductions credits from those countries, with this all-important stamp of a corresponding adjustment, which means those credits now have been accounted for under a global emissions accounting system that is consistent with achieving the Paris Agreement and so what you’re getting in effect is a scientific seal of approval to the extent that the Paris agreement itself rests on the science as developed by the IPCC.
ML: And that will be worth a lot more, I believe, in the future to any corporate than a voluntary credit that does not have a corresponding adjustment attached to it. I think you can see the reputational advantages of having offsetting your carbon footprint with a credit that has a corresponding adjustment and therefore is effectively helping countries to align with the Paris agreement versus a credit that does not have that. So there’s a reputational argument, but equally important, I believe, and perhaps you have to think a bit more imaginatively about this, but I genuinely think this is likely to happen. Probably takes 5, maybe 10 years, but there’s an option value to any credit, which has a corresponding adjustment going forward as well because of what you have, and this is why I said the terminology is going to have to change. We won’t be discussing the voluntary market in the same way in the future. If you have an emissions reduction credit with a corresponding adjustment attached – what you have effectively is a quasi-compliance credit. Because if you think about the EUETS cap is going to fall to zero already by 2040. What that mean? It means that European industry will not be able to emit a single ton of CO2 beyond 2040. Now, 2040 is still a long way away, and nobody is freaking out about that too much. But I would imagine that by the time we get to 2026/27 and certainly 2030 industry is probably going to be saying, hang on a minute, can we fully decarbonize by 2040, or shouldn’t we be able to use offset credits that come with a seal of approval that ensures that they are consistent with the Paris agreement.
ML: So if the EU were to say, after 2030, a certain number of emissions reductions credits that come with a corresponding adjustment could be used within the EUETS. I think that would be very advantageous for everybody. Number one, there would be no dilution to the purity of the EU own climate targets, because this would be consistent with the whole point of a corresponding adjustment is that you’re not double counting. So if the EU uses it, somebody else, whether it be Brazil, Mexico, whichever country, whichever jurisdiction that credit came from, has to reduce its own emissions on top of the value of that corresponding adjustment to reach its. So it’s entirely consistent with the Paris agreement, which was not the case with Kyoto, that was very different, and that’s why Europe stopped the importing of CDM credits CRs. There wasn’t this equivalence, and there wasn’t this capturing of all emissions under the same accounting system that we will have through Article 6. So I think it opens up enormously productive and suggestive possibilities for the future. That compliance jurisdictions that have very tough emissions targets, may well come to consider using Article 6 credits with a corresponding adjustment for compliance purposes, So I think they’re going to be very valuable in the future.
In this episode, host David Greely welcomes energy and #fintwit icon, Doomberg, for an in-depth discussion on the European energy crisis covering the team’s take on the winter ahead in Europe and policy’s role in the path forward.
Doomberg: As you’ve mentioned, yes, we are anonymous. I’m the head writer for a small team that runs the Doomberg Substack. In our real lives, we are consultants, and former industry executives in the commodity sector. I am a scientist by training and spent a couple of decades leading worldwide teams of researchers working on tough problems in the energy sector. My editor-in-chief, for example, has a very strong finance background, so we were consultants and doing quite well together as a team. After leaving the industry, we have probably 50 years of industry experience combined on the team, and then COVID hit and put a big dent into our business. We lost something like 80% of our business virtually overnight, and you have to decide what you’re going to do.
Doomberg: We got a fantastic piece of advice from a famous hedge fund manager who suggested that we should look into helping people who create content and sell it on Wall Street. Look into helping such people run their businesses better. He recognized our understanding of the finance world from the industry perspective and our abilities as business leaders and strategists, and we embarked upon that journey. And it was a fantastic 12 to 18 months after we decided to open up that vertical in our consulting business, and it was much more fun than our prior work, which had focused on C-suites and family office types, and we had a lot of success. One of our best clients suggested that we just start our own. His advice was you will follow all of your advice, unlike me, and build something from scratch.
Doomberg: I’ll lend you a hand, and it was the beginning of truly the work of our lives. It’s been an unbelievable 18 months, and we’ve grown the brand. We’ve improved the product and made it our full-time job. We’ve put our consulting business on hold. We’ve kept only our favorite clients. We’re turning away business, and doing Doomberg for a living, so why stay anonymous? I could tell you why we started anonymously. Building a brand behind a person from scratch is difficult if you have no social media presence. And one of our rules in marketing is that you can’t be remembered if you don’t stand out, and we sort of designed the green chicken one day. We were playing around with names. We did some preliminary AB testing. It scored amazingly well, and we just went with it.
Doomberg: Now, why stay anonymous? We have observed that when popular Twitter accounts or big anonymous social media accounts reveal themselves, sort of the error is let out of the balloon; the mystique, the intrigue is gone. So Doomberg has grown so big and so fast that we just can’t have a reveal ourselves. It’s not some big secret. There are lots of people on the street who know who we are. Substack knows who we are; Stripe knows who we are. Our painters know who we are and that we’re doing Doomberg ice. It’s just part of the brand now, and the last part I would make is that I’m the head writer and the person who appears on podcasts, but we truly are a very tight-knit team. And it wouldn’t make sense to rebrand around a person at this point. So we’re just going to stay as the green chicken. It’s a fun character, and that’s the background.
Doomberg: I would say the way we analyze the world is we begin with a very basic but critically important question, is the world currently experiencing an abundance of primary energy or a shortage of it? Unless you make an intelligent assessment of the answer to that question, it’s very difficult to analyze the markets for the past two decades. The Western world and the group of leaders within it have been bathing in excess of primary energy driven predominantly by the boom in shale oil and gas production in the US. When you are swimming in excess of primary energy, it is easy to think that the energy commodities are yesterday’s industries that can be considered and treated like any other fungible commodity, and don’t matter all that much.
Doomberg: It’s only when you enter into an unexpected period of a primary energy shortage the laws of physics take over and dictate the policy choices for our leaders, and a confluence of many events occurred in the past couple of years that pivoted the world from an era of excess to an era of chronic shortage. The three main ones are the ESG movement and the desire to defund fossil fuels when we do not have bridging technologies other than nuclear, which environmentalists also oppose. We do not have bridging technologies to get us from where we were to where we want to be with regard to carbon emissions. Yet, we still sort of saw it away at the legs of our stool by chopping away at the acceptability of funding fossil fuel development projects, that’s one. But to be fair to the environmentalists, it’s also true that the shale booming incinerated a lot of investor capital, which was all driven by access to cheap debt and abundant money.
Doomberg: And that investor capital was burned, and then the precipitating event of the shutdown of the economy in response to the pandemic was the catalyst that marked the pivot point from the era of abundance to the era of shortage. So when those three things converged in March of 2020, you saw a wave of bankruptcies, particularly in the shell patch and the companies that emerged from
court-supervised reorganizations have a cash-oriented mindset. They aren’t investing, and now we have what we have, which is chronic shortages of primary energy. And one of the themes that we’ve been pushing in a phrase we’ve become known for is energy is life, and energy commodities in times of shortages are extraordinarily elastic. What is the price elasticity of demand for life, and who can pay it? The clearing price for life is far above what most people can afford. And that’s what we’re experiencing right now. The genesis of the crisis was born in Europe. It has spread globally. The economy cannot survive in a way that we’re accustomed to if Europe collapses. We believe we are at a significant turning point and a historical one that is unfolding in real-time before us.
Doomberg: Well, that’s by choice too, though, in some ways, right? It doesn’t need to be this way, which is why we’ve been so critical.
Doomberg: So Putin certainly has the leverage for the economic part of this hybrid war. We believe and have written, and we’re writing as far back as a year ago, that by handing our energy cards to Putin, we should not be surprised when he decides to play them. We just put out a piece about it. And we had a fake quote that we put in. We usually open our pieces with a good quote, and this piece is called – Europe on tilt. The fake quote we used was in times of war, hand all the leverage to your enemy, then complain loudly when they use it. We handed Putin the keys to Europe’s energy future. We believe that he understood the leverage that he had and is now using against Europe. When Putin decided, which I think was incorrect, to cross the border into Ukraine and initiate a kinetic war in the heart of Eastern Europe.
Doomberg: I think that was a total blunder, to be very clear. Some have accused us on Twitter of being sort of relatively pro-Putin in our analysis. We don’t think it is unpatriotic to point out the reality on the playing field and to suggest alternatives that we believe would help achieve our geopolitical objectives. That’s what we’ve always tried to do. The cards that Putin has – were given to him by the west. He’s playing them now, and some would say, and I would concur, that completely shutting off the gas from Nordstream one is potentially a sign of weakness and desperation on his part, but it will certainly hurt Europe in the near future term. What it does for Putin in the mid to long term is a different question whatsoever. But I do believe he has the leverage. He is using it, and we’re on the cusp of a dire situation in Europe. We’re in the middle of one, given the headlines of the past week, which have been unbelievable.
Doomberg: Drawing on our direct and real-world experience in commodities, it differentiates our analysis on the support and topic we believe. Anybody who has ever operated ran a business in the commodity sector. I don’t mean as they worked at a think tank and study charts or taught at a university and read theory, but you’ve run a business with a P&L. You understand something very quickly; the first thing is you make all your money in very short periods of time. And discount cash flow models make, they’re almost meaningless for large commodity investments because you make all your money in very narrow windows, and then you do your best to tread water in between. And why is that? You make all your money when there’s a shortage.
Doomberg: The analogy we’ve used was predictable. We wrote a piece on June 1 called “Crazy Bills,” where we outlined what was wrong with the sanctions and what should be done to correct them, and here’s all you need to know. Putin exports 10 million barrels of oil a day. If we successfully shut in 5 million of those barrels and cut it in half, the price of oil would be way more than double, and Putin would make more revenue on the 5 million barrels still finding their way to the market. As perverse as it sounds, we should be encouraging Putin to flood the market, and we should be flooding the market because you cannot win a commodity war by trying to stop somebody else’s volume from reaching the market. When your objective is to reduce the value of your opponent’s commodity, you can only win a commodity war by flooding the market with the commodity. Oil went to minus $37 a barrel on relatively minor excess and a lack of storage at the peak of the COVID crisis. It swung violently to $125 a barrel on shortages, as small as half a million barrels a day.
Doomberg: If we were smart about this and we had people in government who took the time to get some experience in the industry preferably, but at a minimum, treat them as your allies and get them in into a room and have an open and honest discussion about what should be happening. We would’ve understood this; the sanctions have hurt the west way more than they’ve hurt Russia, and the pain is still to come. This is knowable, utterly well known. There are very few people with deep industry experience who have the freedom to write a blog like Doomberg. We have no overlords. We can write what we want to write. Our subscribers pay our bills. We have no ads and take no sponsorships so that we can have a hundred percent editorial freedom. This is so widely known in the industry that it is remarkable that this was the policy choice that we have made.
Doomberg: Now, having made that mistake, how do you correct it? Step A, you decide tomorrow to admit this was a mistake. Step B, hold a press conference surrounded by industry executives from the oil and gas. And say we were wrong, we’re going to do everything in our power to pump as much energy into the market to pivot the world back to the point of energy surplus, which will crush prices and defund Russia’s military expenditures. This is the only path forward. All other paths chosen right now do nothing but increase the price of primary energy, which feeds Putin’s greedy war machine.
Doomberg: It’s one thing to sanction, a small country that produces 200,000 barrels of oil per day for export that’s doable, but we’re talking about literally the largest exporter of energy in the world. As we said in the piece, I believe it wasn’t crazy pills. We don’t want to take Russia’s. We shouldn’t want to take Russia’s energy off the global market because it would collapse the entire modern economy,
including ours. There would be riots. There would be social unrest. There would be revolutions. The world cannot live without Putin’s energy at full stop. Axiom number one, in the analysis, if your objective is to minimize Putin’s revenue, the only handle you have is production volume, your production volume, and beg and pray that he doesn’t unilaterally cut the world off of his energy, just to make a point, which is what he is doing to Western Europe today.
Doomberg: We had no cards, and we’re still acting as though we have all the leverage; this is utterly crazy, G7 proposal on capping the price of Russian oil has to be the most insane thing we’ve ever seen – the hubris in their delusion. The G7 leaders think they can dictate to 4 billion people what they will pay for property that does not belong to the G7. It’s quite absurd, pushed forward by Janet Yellen, who is a product of cushy jobs at universities and a small stint at a think tank, but who has only otherwise lived in the halls of the federal reserve, it’s literal insanity, and it baffles the mind. This morning we have the president of the European Union out saying that in two weeks, to flatten the curve, we are going to do mandatory cutbacks of energy to flatten the curve because we just want to shave off the peaks. She has no idea what she’s talking about, and it’s okay to point out that the emperor has no clothes because that train will hit us either way. You may at least try to point out the flaws and the fallacies of the pronunciations of our political leaders. I mean, it’s crazy, but it is what it is. You know, it’s the world we find ourselves in.
Doomberg: Energy. In contrast, the ultimate currency, and the currencies we’re familiar with, the Euro, the Dollar, and the Yen; they are just sort of overlaying our energy transactions in the hopes of making them more efficient. That’s the way you need to think about the world. And this is especially true during a time of energy shortage. Everyone is saying the dollar is getting stronger against certain currencies. What are those currencies, so the way we measure the dollar strength today is through this index called the DXY, but if you look at the DXY, 83% of that index is composed of the Euro, the Yen, and the British Pound, all three of those regions are chronically short energy today.
Doomberg: And that’s why their currencies are de-basing for the exact front running of the phenomenon that we know government leaders will do, which is to try to print Fiat in a desperate effort to secure molecules, but of course, you can’t print molecules, and so the Russian Ruble, of course, has strengthened quite radically because Putin has all the cards. Now, the US dollar is doing quite fine against these currencies because the US is a net energy exporter. And so while energy and your position as an importer or an exporter, don’t explain all of the variances of your currency movement. It certainly explains a fair bit of it, and in times of chronic shortages, I would bet that your energy position might explain 80% of the variance of your currency movements, which is what we’re seeing today.
Doomberg: The Yen is collapsing as we speak, which is a sort of another bomb waiting to go off in Asia. So yes, you cannot print molecules! When you’re at a period of shortage and gone far enough into the season and plus Putin’s recent decision on Nordstream 1, it basically assures that Europe is entering the winter with insufficient molecules. So now the only question becomes what is the most economically efficient/socially acceptable way to ration the insufficient remaining molecules that they have. In our piece on Europe that we called the dead of winter, we rolled Doomberg’s law of antilogic, and in that law, we assume that the current slit of Western leaders will make the very worst possible decision at every opportunity. We advise our clients to assume as much in their modeling.
Doomberg: We have predicted price caps. We predicted stimulus, and we predicted protectionism. Still, a week later, as though things are accelerating at such a pace, not just price caps internally. Still, we had the president of the European Union today saying that she’s considering putting a price cap on global LNG as though she has some magic wand to dictate to the world the price of something everyone knows she desperately needs. It’s like Rome has fallen and the Roman Senate still thinks it’s a global superpower. It’s high time for Europe to get very serious about the important business of rationing in a way that minimizes damage to the most vulnerable in their society. So, for example, take Germany, they’ve rolled out a €65 billion stimulus to be paid for by windfall profits taxes on the very energy producers that they’re reliant upon in order to get the incremental volumes, to get them through the winter.
Doomberg: This will simultaneously increase the price, decrease supply, and backfire in the most spectacular way possible, thereby proving our theory of antilogic. We’re seeing the same thing in the UK. Look, this is not easy, and we take no pleasure in being right. We would much prefer to be on this podcast today, apologizing for being alarmist, but it’s just I don’t see a path out. It’s going to be amazing to watch this play out in the next few weeks and months.
Doomberg: In our writing, we have been especially critical of Justin Trudeau, who we think is perhaps the most dangerous and simultaneously least capable leader on offer in the Western world today. Canada could be an energy superpower right now, and Justin is just another example of somebody who was born on third base and thought he hit a triple and the son of a former prime minister who was sort of ascended to the throne, a charismatic guy, handsome man but intellectually incapable of leading his way out of a paper bag and so Canadian energy is trapped, Alberta’s Oil is finding its way to the US market. But the Keystone pipeline was canceled on the US side by Biden shares as much blame for that as anybody, but Putin’s nonsense about exporting hydrogen to Germany instead of just building the required liquefied natural gas export terminals. Natural gas in Western Canada is probably half the price of what natural gas is in the US, which is 1/10 the of the price that it was in Europe last week, to bank on Justin Trudeau’s regime to make an intelligent decision in the energy sector.
Doomberg: I put it this way. If you ask me to select who to be led by the current slate of European leaders or just Trudeau, I would reluctantly choose Europe. So I think we could just take Canada off the board until we see a regime change in Canada, which doesn’t seem to be on offer anytime soon.
Doomberg: So the best case is, in the next few weeks, the Western world plugs its nose and cuts the best deal it can get for peace with Putin. I know that’s probably a controversial thing to say, but as it pertains to resolving the energy crisis, that is the best case. That piece suddenly breaks out, or maybe Putin gets overthrown or pick your favorite path function, but hostilities end and taps open and molecules flow, and the world narrowly averts, what could have been a generational crisis. We hope for that outcome to be very clear, nothing would please us more than this crisis, passing with minimal hardship, born by those who can least afford to bear it. That’s the best case. The worst case is a rapid and hyperinflationary dissolution of Europe. There are scenarios where the pinball machine goes full tilt, which is why we wrote the last piece, Europe on tilt.
Doomberg: The worst-case scenario is that Putin follows through and keeps Northstream 1 down, but he has another valve he can turn: the pipeline through Ukraine if he completely cuts off Europe. And in fact one of Putin’s spokespeople said that any country proposing a price cap on Russian oil would get no gas, no oil, no finished products, no fertilizer, nothing. And if he follows through on that threat, at a time of maximum weakness for Europe, it could be a catastrophe. We see nothing in the current responses emanating out of European capitals that gives us hope that sensible policies will be chosen and one of the things we have predicted. And we fear a tilt of European politics already in Italy. You’re seeing the leading far-right candidate saying that we’re on our knees and we need to sue for peace.
Doomberg: We’re seeing demonstrations in the Czech Republic, Germany. There is a major risk to the ruling elite in Europe that if they continue to get this as wrong as they have, they will lose the authority to lead. We don’t think they will go down without a fight. There’s lots of scenarios you’re which is incredibly difficult to model. Still, if they enter the winter with us, there is a chronic shortage of molecules, as we anticipate they might. In their efforts to rationalize those molecules efficiently, they bundle it and make things worse, which all evidence would indicate they will. There are scenarios in play that get very ugly, very quickly.
Doomberg: It’s a great question. So I guess the best way to answer it is to tell you what our Bloomberg terminal launch pad fires up with every morning when we make it to the office. We look at the price of natural gas in the US, Europe, and Asia; often unspoken about in this crisis is the impact that elevated natural gas prices in Europe is having on Asia. The LNG contract price, JKM is $55 per million BTU today compared to $60 in Europe. So is Europe still paying more for the incremental carrier of LNG? We look at the coal price. So one of the charts that we make that we’ve not published yet, but we’re going to share it with our pro tier subscribers in a presentation later this month; we have developed a way to correct for the units of trade of all of these different energies/commodities so that you can just read across in a very simple way to see on a sort of dollar per million BTU basis, which helps you understand whether oil more expensive than coal, or is coal more expensive than natural gas.
Doomberg: One of the interesting phenomena that we see right now in the chart is the price of coal which is higher than the price of oil, which is interesting because, in theory, oil has far more utility. You can do many things with a barrel of oil. With coal, you can just burn it to make steam, to make electricity. And now that we see that coal is more expensive than oil is a fascinating little nugget of insight into the global economy. We look at the major currencies the Japanese Yen, the Euro, the Canadian Dollar, the Australian Dollar, and then obviously electricity prices in Europe as well, year forward prices. We look at the shape of curves; for example, the natural gas curve or Dutch TTF is pricing extraordinarily elevated prices out till 2024 that just a year ago would’ve been unthinkable. We are now priced into the curve out two years, $40, $50 per million BTU, natural gas, no economy can survive that.
Doomberg: We would look for increased flows. You can track the flows through Nordstream. We look at the molecules, the price of molecules, the currencies, and of course, you always keep an eye on gold and Bitcoin, sort of as reads for market mania or lack of it.
Doomberg: So there are a lot of thumbs on the scale right now, and a lot of it is sort of whispered about, and you don’t want to sound too conspiratorial because, okay, what other prices on your Bloomberg don’t you believe. We, of course, were accused of putting too much emphasis on the relative strength of the Russian Ruble because the constant refrain on Twitter was what can you do with a Ruble? It’s only because he has capital controls in place, and our counter to that there are 4 billion people still transacting with Russia and the number you see on the screen is real. We just take the mortgage back securities market, of course, the fed interfered in that market, but it doesn’t mean that when I went to the bank and got a mortgage, that I got a different price, because, well, this’s just correct for what the fed is doing. Prices is just a price, the numbers on the screen are real.
Doomberg: If the governments can intervene in the natural gas or oil markets and bring the price down, more power to them. And, of course, this is what OPEC is designed to do in the other way like OPEC exists to manipulate the price of oil. Prices are manipulated, and governments interfere, but the price on the screen is the price somebody’s paying, and it’s a clearing price somewhere. We just tend to believe it’s to give into the temptation of only believing the prices that fit with your narrative means you won’t capture the narrative shifts when they happen.
Doomberg: We have characterized the winter of 2022/23 as the greatest geopolitical event to resolve in the next few months. I would confess that we are surprised by the speed at which resolution is being imposed by the markets here; markets, of course, are forward indicating, so we shouldn’t have been so surprised. We view the resolution of this event in the same way that a physicist might view a singularity. In a singularity, the laws of physics breakdown, which means it is fruitless to try to predict what happens on the other side of that singularity because it’s unknowable. The big bang theory is predicated on such a singularity, and famous physicists like to say it doesn’t matter what happened before the big bang because it was a singularity, and we think there’s an economic singularity on the horizon.
Doomberg: The range of potential outcomes is so chaotic that it is fruitless to try to model it. We spend most of our time reading real-time data to see where things are going in the near term because, like the weather, you can predict 3, 4, or 5 days ahead; a week ahead is a bit sketchy. And after two weeks, just forget about it. We think we’re in the same type of scenario right now with Europe; you could imagine things like an overthrow of the German government, as crazy as that might sound. You could imagine things as crazy as mass starvation in Western countries because of a cold snap, like pray for a warm winter. And if your strategy is to pray, you’ve lost, no offense to the religious amongst your listeners, but it’s truly a singularity.
Doomberg: I don’t know that you can look past this December and speak with any kind of authority about what’s going to happen? What will things look like in the spring or winter or two years after that? Other than to say, perhaps, we will learn our lesson and reacquaint ourselves with physics over platitudes, but it’s not clear to me that whoever replaces this crop of leaders would be any better. I don’t think you could see through a singularity with any intelligence. And so it’s best just to admit that you can’t and observe the short term with keen interest.
In this episode, host David Greely welcomes energy icon and Vice Chairman of S&P Global, Daniel Yergin, to discuss EU energy crisis warnings and calls for immediate solutions spread across global headlines.
Covering everything from his predictions in The New Map: Energy, Climate and the Clash of Nations to S&P’s recent Future of Copper Report — Greely and Yergin pack a half hour with insights on Europe’s energy crisis and its impact on our road to decarbonization, and what’s next now that Winter is Coming.
DY: This energy crisis did not start on February 24 when Russia invaded Ukraine; it really started roughly a year ago, in September of 2021, when the markets began to tighten because of preemptive underinvestment in conventional energy sources. It was an economic development rather than a geopolitical one. Although Russia had begun pulling back on supplies, normally, prices would go up, and we put more gas in, but strangely enough, Russia didn’t do it, and that contributed to higher prices. So maybe this was a warm-up for what was going to come with February 24 to put the Europeans in a more difficult position, which was one of Putin’s miscalculations. He thought that Europe’s heavy dependence on Russian energy would mean that they wouldn’t protest but just wave through Ukraine, just like the annexation of Crimea had been accepted.
DY: Now Putin is doing something that the Soviet Union said they would never do. They would never use energy as a weapon and were a reliable supplier. Putin is now using it as a weapon, and he laid out his strategy in June at the St. Petersburg International Economic Forum. He said explicitly that high prices would bring Europe to economic hardship, which would cause social tension and problems, which might bring populous parties to power and change the elites in Europe, undermining the coalition that supports Ukraine. And that is exactly what he is trying to do. And It looks like he has this one victory under his cap, which is Italy, where Mario Draghi, who went to Kyiv on a train to commit Italy’s support to Ukraine, is being pushed out of power by one of the far-right parties, which withdrew from the coalition. So now you have the situation where Europe is reeling from prices that people never imagined that they would see.
In a way, it reminds me of the energy crisis of the 1970s, when you had the collision between a global energy crisis and the global geopolitical crisis. This isn’t just about markets anymore. It’s about the whole system under stress because Putin is using gas as a weapon. It puts pressure on big companies and on smaller companies, not just in England, but people and families closing down their bakeries and shops because they can’t afford it. Plants and fertilizers shutting down because energy is too expensive. This may not be so well perceived in the United States or other parts of the world, but Europe is in a very difficult situation. It’s highly likely that Europe will be in a recession by the fourth quarter.
I think it will change; the world after the crisis in the 70s was different than the world before. The world after this crisis is going to be different. If we go back 30 years, the collapse of the Soviet Union brought down barriers for the first time after the Bolshevik Revolution. As a result, you had an integrated global market. People didn’t know until February that the US was importing half a million barrels a day of Russian oil for its east coast refineries to help them run more efficiently and produce more products. There always was politics, but it was also about efficiency. You had global markets and energy, oil, gas, and coal flowing from Russia, an investment in technology flowing into Russia, and the development of a global gas market.
And we have the big four LNG exporters: Qatar, Australia, the United States, and Russia. The barriers have gone up again because Europe has said we’re not going to import Russian energy anymore, and I think unless there’s a major change in Russia, there’s no going back from that. But they haven’t really prepared themselves for that, and so it can be very difficult for them to do. It’s just changes and flows; India never imported Russian oil. Now I think it’s either the largest or second-largest importer of Russian oil because they get it at a discount. So what we have is a restructuring of the global markets. It’s only the beginning, and there’s no more single market and investment flows around the world anymore, now it’s going to be a fragmented market. Generally speaking, we’re heading into this kind of new era of fragmented and divisive globalization.
Certainly a new chapter, because obviously the world changes, but the last sentence at the bottom of Page 78 said Ukraine was the issue that was going to blow up between Russia and the West, and it happened. I didn’t necessarily envision that it would happen this way, but you could just see that this was a tinderbox, and it was a focus because it reflected on the fact that Putin did not accept the outcome of the cold war. He did not accept the outcome that Ukraine was a separate country and gas was so intertwined with it. One of the primary reasons why Russia was building Nord Stream 1 and Nord Stream 2 was so they don’t have to send gas through Ukraine, through which most of their gas historically had gone to Europe. I wrote in the book a lot about how this relationship between Putin and Xi has developed between Russia and China.
And at the book, I had a scene describing being at the St. Petersburg conference in 2019 and watching when Putin’s guest was Xi and Putin began the conversation by apologizing, he said, President Xi, we kept you up until 4 o’clock your time, with talking, and Xi said, we never have enough time to talk, and then I thought, what do they talk about? One of the main things they talk about is that they don’t like the international global economic and political order that, in their view, the US dominates. They don’t see it as a multilateral system; we see now that Russia’s basically headed to become economically dependent on China. The other thing that I wrote about, which is unfolding right now, was explaining why we’re seeing this movement from the WTO consensus in which China, and the United States, were all in this together and all benefiting from globalization and that China would be a responsible stakeholder and all those terms, but now we have a great power competition. And in the book, I explain how this came about, why, and where I think the next crisis could be.
Let me divide this into two parts: the Europeans and the US. The European consumers are surely worried about this because they’re living with it, and those consumers are also the voters; there is a big very concern about a social disorder that can ensue. And they’re struggling to figure out how you manage this. And now, the focus has been to get as much gas to the winter’s storage as possible, which has contributed to the higher prices. But now the question is how do we cap the prices, do we subsidize, do we send money to consumers, how do we handle this, and that’s what they’re struggling with. You’re going to hear a lot about price caps of one kind or another, the US proposal for price caps on Russian oil, the European proposals for price caps on natural gas, or windfall profits.
And of course, the other response you’ve had in the US is the so-called Inflation Reduction Act, which doesn’t seem to have much to do with inflation, except maybe it’ll drive up the cost of minerals, but a lot to do with the Industrial Policy Act 2022, which is a pretty massive intervention in the energy markets and in the effort to change will cost a lot, and will probably end up costing a lot more because it always is.
I think it’s a dicey situation because Putin, from his point of view, has to win his war, and breaking the coalition, creating confusion and disarray, is a central objective of it. He’s going to throw everything into it. I think, at the end of the day, the Europeans are going to hang together because they look at the Ukraine war as a war in Europe, and there’s lots of apprehension about what if Putin succeeds here, what’s next? So Russia can’t be allowed to win. And that’s why it’s very hard for people to see what the way out is here, and of course, what’s making it more complicated is that one side has nuclear weapons, and the other side, NATO has nuclear weapons too, and this has caused terror. And then you have this nuclear power plant in Ukraine that was taken over by Russians, which they treat like war booty, and this comes with grave danger and higher responsibility.
If something bad happens at the nuclear power plant, the west really needs to say that basically, Putin uses nuclear weapons, but in a different form. I think getting through the next few months will be critical element, and there is a new player in the global energy market now, and it’s called the US Federal Reserve and the other Central Banks, and you have already seen that the cost of bringing down the prices may result in stagnation or recession. And the prices are very volatile, and things could change tomorrow. Prices would come down further if there’s an Iran nuclear deal, and more Iranian oil prices would go up if China got out of COVID restrictions and went back to old oil consumption levels. And for the federal reserves, a form of price management would be relentlessly raising interest rates.
The Germans have certainly been talking about, and not only the Germans, but the imminence of some kind of rationing, and I think Germany has been preparing for it. Preparing for the decisions about who gets gas, who should be the priority among industries? Because you don’t want to short-change the industry and then have unemployment. I think that would qualify as a war footing. Intervention in the market price caps that’s like a war footing. Some have compared this intervention by the US government to the war footing intervention of World War II. For Europe now, this is the question of economic life and death, and it’s also about political survival for current European leaders. For the European politicians who are currently holding office, they don’t want to have the Mario Drughi scenario.
The best scenario is that Europe gets the gas storage full and will be running ahead of schedule. At the moment, they are around 85% as we’re speaking today, and if it’s a mild winter, that would be the best outcome. The worst outcome is a social breakdown, and governments can’t stand the pressure. A recession turns into something worse than a recession. Putin thought the war would be over in three days and his officers, when invading Ukraine on their way to Kyiv, brought their dress uniforms for the ceremonial parade, didn’t turn out that way. World War 1 was supposed to be a short war but turned into trench warfare. So we don’t know how things will go, and there is the additional danger that Russia is a nuclear power. Putin has already talked four or five times about using nuclear weapons. He seems now to back away from that because he doesn’t know what the repercussions would be. And certainly, there are even worse case scenarios, but I prefer not to go there. I prefer to go with gas storage filled and warm winter.
From the energy point of view, relieving the pressure on Europe, not a recession, but an economic slowdown, and see where it takes and the people’s behavioral responses. We also do see price responses. For example, gasoline demand in the US now is maybe 6% to 8% less than it was this time last year. So we shouldn’t forget that every price is a little piece of information that tells people what to do. Higher gasoline prices hit teachers, nurses, and people driving to work, but now gasoline prices are down, and that is partially because people have found ways to reduce consumption. So I think prices itself is an important factor here, and they always say that the solution for high prices are high prices because they bring low prices.
There is also a larger question about investment. Two questions. One is that preemptive under-investment is a real problem because energy, oil, and gas demand will continue to grow. You can’t tell emerging markets that they can’t have energy and one of the things I wrote about in “The New Map” book, is about the merchants of this new north-south divide are the developing countries saying, hey, you can’t tell us that we can’t use natural gas instead of having people burn wood in indoor cooking, you won’t finance that. And by the way, you do want to finance more natural gas terminals. Another thing I’ve been working on is about a world of big shovel mining.
At S&P Global, we have just concluded this big study on copper, and it’s very interesting. We look closely at the Biden 2050 goals and the EU 2050 goals. What does that mean, technology by technology and sub-technology by sub-technology, and how much copper would you need? We picked on copper because copper is the metal of electrification. We saw that you get this energy transition demand on top of existing demand, and guess what there’s not enough supply. Supply would have to double to meet the demand embodied in these goals by 2035. Look at Chili, they have a new president, and they are aiming to tax copper production and restrict mining, put limitations on it, and make permits harder. So why does Chili matter? Because Chili is the source of 25% of the world’s copper. Chili and Peru together are 38% of the world’s copper, and 42% is smelted in China.
Absolutely! Over the last couple of decades, the amount of copper produced in the United States has declined by half, and now try getting a permit. The IEA says the international energy agency says it’s 16 years on average from discovering a resource to the first production, and what they left out is the other 15 years of litigation as it works its way through the courts in the United States.
Well, people are not anticipating that you’re going to see a lot of inflation in the cost of the materials that are required for the energy transition, and it may get more expensive. Now people may look at solar panels and wind turbines and see the incredibly dramatic drop in cost; solar down 90% and wind costs going even more down. So now people are just extrapolating that those costs will continue to fall. But, in truth, if everybody rushes to the same side of the boat at the same time, it will not be a smooth sailing anymore. And I think that this question of where you’re going to get the materials from, for instance, half the world’s cobalt comes from the Democratic Republic of the Congo. And you can go down the list and this just issues with permits to mine around the world.
Then South Africa, same issues with permits. It’s gets harder to do this, and then still you need so much more. In the copper study we mention a new supply, greater efficiency in mining and recycling are all those necessary elements. But at the same time, if we talk about, recycling, iron steel, for instance, can be recycled, but these other things, you have to gather all the stuff on a scale. It was really interesting looking at copper because, factually, copper is not on the critical minerals list of the US government, which is really odd. You need it for electrification. The assumption that just you can do all this really quickly, that everybody can have an electric car and offshore wind.
I know that electric car takes at least two and a half times more copper than a conventional car, and maybe with innovation, they can reduce it. When California declared that all cars sold in the state have to be electric by 2035. Let’s multiply every one of those, whatever the amount of copper, let’s multiply it by 2.5. Did they figure that in the legislation? Probably not. Copper is a good example because you just see where the supplies come from and then, of course, there’s a famous phrase called the obsolescent bargain. Let’s say David Greely Inc. makes an investment in a developing country. You have a festive dinner and signed all he papers and everybody agrees on it. And so it goes, and he price goes up and down in the market. Then a new government comes in and they have no vested interest in the deal and so they tell you that they made too good of a deal to get you to invest your money here. Let’s change it because you’ve already invested, and so the bargain becomes obsolescent. And suddenly the cost goes up. As sure as the sun rises, that’s exactly what is going to happen with these minerals and resources as they will become more important for the energy transition. Most people are not thinking about it in the context of how economic history unfolds.
That’s a very good point! It would be interesting to see, for instance, take your 2% and then do another scenario in which the prices of those inputs go up to 4% a year. What if your 2% does become 5%? How will this work? It’s a massive achievement that solar costs have come down so much. And thank you, China, because China produces 80% of the solar panels, and they brought those costs down. And you’re also going to run into the globalization issues. One reason costs have come down is because you had globalization, you had the efficiency. You could get the cheapest solar panel from China, and not really worrying about production elsewhere. Now, sorry but no. No, we don’t want to be so dependent on China.
China has its own calculations as well. There’s a price for security, and we don’t know what that price is going to be. It may be higher than people think. So I think one needs a little more modesty about the assuredness about how an energy transition will unfold. One of the things I did in the New Map, is to look back historically at all energy transitions we had. The energy transitions we are going to have now should not be talked about like any energy transition we had before. Because oil overtook coal as the world’s number one resource in the 1960s, now today, the world uses three times as much coal. Let’s say we have plan A and B. We’re going to chuck A and then just have B. That’s never been done in 28 years. In today’s about an 88 trillion world economy, and could be 150 trillion world economy by 2050, is 82% dependent on hydrocarbons. I think you need to be at least a little modest about getting that done. The real world tends to be a little more complicated than scenarios or PowerPoints.
We kick off our new series, Winter is Coming, with Samantha Dart, Head of Natural Gas Research at Goldman Sachs. SmarterMarkets™ host David Greely sits down with Samantha to discuss the outlook for natural gas and LNG this winter in the face of all that has happened – and is happening – in Europe.
To close out our When Markets Break series, SmarterMarkets host David Greely sits down with Arjun Murti, the Former Head of Energy Equity Research at Goldman Sachs and the publisher of Super-Spiked on Substack. David and Arjun discuss the July 2008 spike in WTI crude oil prices to a record high of $147 a barrel and their subsequent collapse.
In this episode, SmarterMarkets™ host David Greely welcomes David Gornall, the former Global Head of Precious Metals Trading at Natixis and Former Chairman of the London Bullion Market Association (LBMA).
Together, they discuss the massive dislocation between the gold markets in New York and London in March 2020 during the early days of the COVID-19 lockdown.
DG: Well, we should say that the new premium over London has always been a few cents and sometimes a few dollars an ounce. So for the market to move up to $67, this was a seismic move that the risk of this differential, or which we call the EFP, was modeled to be around a dollar, or say a dollar and half, and stress tested to around five. The other important aspect of the gold market is that the physical over-the-counter spot market is in London, and the futures market is in New York. What we’ll see as a physical gold that’s held in London, typically hedged with a short futures contract deliverable in New York. There are good reasons why this is the preferred hedge mechanism of a physical trader. First of all, the futures offer a price spread that’s narrow, stable, and often yields a better forward contango than London OTC forwards. The exchange age also removes the OTC bilateral credit risk that an OTC trade carries, as the differential widens, anyone with a short hedge was getting squeezed. So the exchange margin calls would force banks to decide on whether to maintain the short, pay the margin and try and deliver or close out and pay the loss.
To evaluate the vulnerability, we should define this part of the market structure as five risk factors. The location difference, which translates to your logistical risk. The size of the barrage you mentioned in each market – we call that the fungibility risk of metal. The next thing is expert physical trading knowledge. Then there are exchanges, internal position limits, and then you’ve got the bank’s own risk appetite and limit. So there are five things that all play out. At various times during this dislocation, at least one of these factors prevailing to affect the price. And that it’s high, all five of them played a part in the story. One thing about the peculiarity of having a physical spot market in London and futures contract deliverable in London is this inter-deliverability factor.
The relocation of gold from predominantly Swiss refineries was prevented by a ban on passenger flights globally at the time. The other issue was the size of the bar. So in New York, it’s a 100-ounce bar that’s deliverable. Whereas the size of the bar traded in London is 400, and they’re not into deliverable. Apart from the existing stock that sits on exchange, any new 100-ounce or kilo bar must be produced to order. So from a refiner’s perspective, this is a just-in-time premium variety of gold, so you won’t usually find them lying around in volts, waiting to be traded, and so there are about five refineries in Switzerland; there may be eight in total, globally that regularly cast and deliver eligible exchange bars. The other aspect of this was two types of participants in the market.
The physical trades largely trade both markets of London and New York separately, but they’ll also trade both at the same time using an AFP, which is a single trade that simultaneously, in this example, buyers, futures, and sales London at a market rate that represents the price difference between the two. Then there are the financial electronic traders who trade fudges in New York and won’t hedge by trading OTC London. In most cases, the financial futures traders weren’t set up to trade the EFP with the OTC physical market. So when they were caught with shorter futures, they were only left with one option. They could only buy back their futures position on the exchange and thus driving the price higher. So physical hedges would normally close out their risk of London and New York by buying the EFP.
It’s a trade that simultaneously involves the purchase of the exchange in the sale of OTC or vice versa, at a rate differential in US dollars per ounce. So, you can buy the futures and sell the OTC in one trade or contract.
Yes, because it avoids leg lifting. So rather than having to go on and trade, if you have a physical trade, you are allowed to put it onto the exchange under the exchange rules. This means you can eliminate the risk between the two markets without going through two venues.
Yes. I mean, you’re not going to remove the two sets of fees on it, but it’s certainly removing the price differential risk that you’re going to run while you decide whether you are going to do the futures or the OTC.
For most people sitting there, watching this unfold, there wasn’t any correction; bid followed bid. So as the futures became bid and the prices rose, the electronic futures market makers chased the price higher. We’ve talked about how the futures traders didn’t use the EFP to liquidate their shorts. So if they did use the EFP, they wouldn’t have chased it as high. However, the FP market did become a liquid and probably wouldn’t help them in the end. But, the result was that the new futures prices rose much quicker than the London spot. As for the supply, without adjusting time, stock of hundred-ounce bars or kilo bars, and no refiner is open at the time to create them. The market was left traveling in one direction at a velocity.
If you had been fortunate enough to hold eligible material at one of the refineries, you could have thought you were in a better position, but then there were no flights. So one of the things that people don’t really know about the gold market is that gold isn’t moved around in a commercial way that is on freighters. They sit in the cargo hold of passenger aircraft. And if you’re traveling between gold hub to gold hub, you may well be sitting on a pile of gold underneath you, and that’s the way it’s moved. So when that mode of transport dried up, so was the ability to deliver gold from hub to hub. And after that, when things reopened in the refineries, we had this mass of flight bookings.
And so we ran out of capacity because of how much gold fits on an aircraft. With many airlines not moving passengers around, they quickly turned these planes into cargo planes. I’ve seen some pictures where they simply put them on the seats and stacked them neatly in places people usually would’ve been, which helped alleviate some of the problems. But in reality, the banks got caught with the short hedge and the negative variation margins, which ranged between several hundred million and a billion, according to what they stated publicly, such as the size of their market losses. They were huge in magnitude, probably six to seven standard deviations away from any market risk model. So we can say it was a Black Swan event. It definitely undermined the ability to manage market price risk by using this method of futures hedging versus London gold holdings.
Once they’d overcome the two of those five risks, you would’ve thought then it was plain sailing after there. So then, we introduced the other three risks which are the risk models, and the knowledge or ability to deliver, those were the limits. We mentioned that some participants that had delivered gold in that delivery month, reached their exchange limit. So the exchange place a limit on what you can deliver during the active month. And you weren’t allowed or able to make a second one. There were some exemptions permitted, but they weren’t the norm. The second problem was overcoming those obstacles. Some of the traders had metal in the right place, on the right side of the Atlantic, had the position limits, and were about to pull the trigger.
And they were prevented from doing so by their risk managers, who said that this was creating more risk. And they were told to take the hedge off, move the goal back to an OTC vault, and don’t put anymore onto the exchange. So whilst people have thought that they’ve got the upper hand in this arbitrage, they hadn’t quite got it. There was another frustrating one that hadn’t been accustomed to delivering metal to exchange that; it’s quite a nuanced process. And if you haven’t done it before, you realize that you need an experienced person to complete the transfer efficiently in the timeframe allowed. Because no one’s going to help you to figure it out in a short timeframe. So we have a perfect storm.
It was shipped back to London because of the model factor. There’s always a number that a risk manager uses to say, what is fair value? So if you’re going to measure this differential and it’s only ever traded between $1 and $5 over the last 50 years, then that’s the number you’ll use. But if it throws out a $70 differential, it breaks all the dials on the dashboard. There’s no way of resetting it. A lot of these models are looked at regressively and they look at it over a period of time. So once it breaks, it doesn’t just break for that day or that month. It stays within the risk, sometime, for a year or two years thereafter until it levels out. It has some long term implications for the futures market.
Let’s look at the wider gold market. It wasn’t just London and New York that was affected by this. In China there was the largest discount ever seen to London. So from New Yorkit was monumental and the same was going on in India. You have to realize what the Western mantra is to hoard gold in times of turmoil. It’s the rainy day fund. Whereas the Asians tend to use gold in that time. Where there is turmoil, they tend to dishold and then they go to cash. This was their rainy day, and so they’re cashing out. And the opposite effect is happening. So you’ve got massive discounts in China and India and didn’t explore before somebody said why don’t you just connect those two, they have to remain within the country. And that’s probably one of the reasons why they went to an even deeper discount. In terms of broader, precious metals, we saw the same differentials occurring in silver and platinum, all the way down the supply chain to the coin market. We ended up around a hundred dollars premium. It wasn’t just London, New York. That was just one example of how the dislocation happened.
It’s not quite the same thing because the standards are very similar. You can move bars, but you don’t put silver on an aircraft when it’s $20 an ounce. Typically, you would ship silver by sea freight container and that’s when you can find them. We’ve all heard about the problems of supply chain management for a lack of vessels, a lack of containers and so silver got caught up in that very typical supply chain problem, even though the bars with the same size in London as they were in New York.
I think the answer to that was it happened in increments over a period of time. We’ve got the active futures months. So it did take a few months to unwind and when gold did start to flow into exchange at the end, we actually saw temporarily a discount to London, but that didn’t last very long. The answer is that it did resolve itself, as the four of the five main risks became manageable. Did the regulators get involve? Not really. CME is a self-regulatory organization and they were creating another delivery point in London for 400 ounce bars, but that contract was new and it wasn’t inter deliverable with the hundred ounce liquid futures contract, so it really didn’t have too much of an effect. Together, the traders and the risk managers thought it was more prudent to keep some gold in New York from now on. Certainly it’s the case when some traders keep more gold in New York than they ever did before.
Risk managers have longer memories than traders do. I think the traders were looking forward to getting back on the horse and do business as usual, but the risk manager’s never going to let them forget it. So the answer is that there’s a lot more prudence involved in managing those risks and positions. Many people did question this whole structure of the market and how it came to be and it led people to think about how to build a more fungible global system of liquidity, not just one in London, but in multiple delivery points. But as the market corrected itself, a lot of people lost interest in trying to find a long term resolution, it was just too hard to do. That idea got put on the back burner. Will it come back again? Maybe.
The two things I’ve noticed, aside from the reduction in limits, was the greater use of forward London hedging. Whilst some believe that the futures is a much more efficient way of hedging because of its liquidity, simplicity and lack of counterparty risk. The alternative way was to go back to OTC forward hedging, that’s what we’ve seen when we look at the trade data. The 6 million ounce daily average of forwards and swaps on gold in London, after this event, became 10 million and it remained 10 million. I think, it’s still the same today and it had peaks of 15, 20 million ounce. What it means is that the system of using futures to hedge physical isn’t as widely used as it was before the dislocation event.
It’s not for one person to say what they would change, it’s for one person to listen to what everybody else would like to see. I think people would like to see a bigger and more developed gold market. I think they’d like to see the local centers being more included rather than acting as outlying hubs. The synergy is a global market rather than having outliers, and you’ll get more connectivity, you pull more liquidity, and that’s what everybody wants at the end of the day. Nobody wants to deal in a pool of liquidity that evaporates as this differential did in 2020. The deepest pool of liquidity will always win. It’s really up to the users of the market to come up and design their own future proof system that allows everybody to have access and to remove some of the barriers that we’ve seen in these examples, that can be very disruptive to the market.
In this episode, David Greely welcomes Beau Taylor, J.P. Morgan’s Former Global Head of Energy Sales & Trading, to recount his experience in the U.S. Natural Gas market following Hurricane Katrina. Together they explore the risk miscalculations, market conditions, and elements of human nature that led to one of the largest hedge fund collapses on record.
Greely and Taylor revisit how a multi-strategy hedge fund transformed into one big bet on winter natural gas prices, why their collapse didn’t lead to wider systematic distress in the financial market, and what learnings we can apply to manage volatility in today’s LNG markets better.
BT: Natural gas, at the time, was an emerging market that was in the process of attempting to mature. Natural gas trading began in earnest with a number of pipeline companies, such as Enron. They began to make markets and trade the contracts much more aggressively, but, at the time, you had a largely surplus market where you had excess supply. You ultimately had to go to a price where you incentivized power facilities to burn gas, to balance the market whenever prices would get too high. The inverse would take place, and you’d incentivize power plants to burn oil or alternative fuels. For a number of years, natural gas largely stayed in a relatively well-defined range, regardless of what the weather was, what happened with a hurricane or tropical events, or what happened in anything.
Hurricane Katrina was an interesting one because, I think, it caught people off guard. You had a scenario where you had a hurricane that largely looked like it was going to go into Florida, potentially as far north as hit land in Georgia or North Carolina. The market, not that they were sleeping on it, but the market had run up a little bit the weekend, on Friday before the weekend of Hurricane Katrina. The market sold off because it looked like a non-event. As soon as that happened, over the weekend, Hurricane Katrina hit the coast of Florida instead of dissipating. It made it to the other side of the coast of Florida, hit the warm waters of the Gulf, strengthened to an insanely strong hurricane, and started heading right towards the meat of the US natural gas market production.
At that point, anybody looking at balances for natural gas could see a credible scenario where the US simply would not have enough natural gas to get through winter. If enough production was damaged, if enough production could not come back online in the market, wasn’t able to fill storage, at the point that they’d anticipate that they needed to make it through the winter almost immediately. The price of natural gas doubled. You came home on Friday, and my natural gas is trading at $7 in MM BTU. When you woke up on Monday, natural gas was trading at $15 plus in MM BTU. The market was largely unglued because this was a scenario that the market hadn’t priced in. The market did not have a number for how you price the potential to run out of natural gas.
Natural gas was incredibly volatile for a period of time. I think what happened during that period of time, whether it be the risk models that a number of people managed to use to manage risk, whether it be a number of the training models, whether even be option pricing models, everybody kind of recognized at that time that there are these known unknowns that exist. As soon as it looked like natural gas was going to settle down, all of a sudden, Hurricane Rita came through. Right after that follows almost the identical track. It went a little bit further west. So while Katrina took out a lot of the stuff and the Central Gulf, Rita came through and took out a number of the things in the Western Gulf. I think you had a credible crisis situation that the market largely wasn’t ready for.
When you have an in-product, nobody’s prepared to turn off the heat during the wintertime. You’ve got to have some mechanism to balance that. Mechanism becomes price, but if that’s the case, the market has shown you that prices could go well beyond the realm of volatility that had ever been witnessed. Hurricane Katrina and Rita started a new era in natural gas trading, where all of a sudden, now we’re pricing for scarcity. We’re not pricing for abundance. Everybody had to utilize all the models, whether they’d be fundamental models, pricing models, or various technical models, which had to be readjusted. You were simply trading in a new era, and from that point on, the sky was the limit in terms of people’s beliefs, in terms of where prices could go, and how far away they could go.
Were they delusional? Who knows, but you began to have a number of people trading very differently than they had in the past. For instance, spread trading became very aggressively traded. People would begin to trade the front winter contracts and sell the contracts further back in the storage season by putting a price on how likely you were to run out of natural gas and, if it did happen, what would the risk parameters be. You started seeing similar things with option pricing models where calls became much more expensive than puts because, in a crisis situation, there wasn’t any known top for where the market could go. In risk models, people might have assumed that you had a certain amount of risk, short natural gas contracts, but that risk became much higher.
Even a modest amount of money going into Katrina, cutting across Florida, you lost insane amounts of money on Monday morning when you came back. Once again, a number of the traditional capital providers were forced to provide less capital simply because now we’re in a new regime, in a new era where prices were potentially going to go much higher. That was largely on the heels of the various merchants, whether it be Enron, Diana G, or some other people who had financial problems in the early 2000s. You had a scenario where you had fewer liquidity providers than you had in the past. A number of the banks had gotten into the business and were able to provide liquidity, but they were in a position where they couldn’t provide as much liquidity as they could in the past. They were looking at new risk models and riskier contracts. The market was calling for hedge funds to come in and provide additional liquidity. At that point, the only way to balance the market and liquidity was to find speculative capital willing to come in and take the other side of the commercial business. That would allow the markets to remain in balance, remain stable.
Katrina was the beginning of a new era that, in many ways, is echoing itself even today.
Traditionally spread trading commodities is largely a function of what the physical market looks like at the time. For example, if you were in deficit, you need to attract commodities out of storage, and the near-term contracts will trade above the future contracts. It’ll incentivize people to bring a physical commodity to market. Conversely, if you’re in a scenario where you have excess, you need to create an incentive for people to store that excess. So the front month contract will trade below the forward contracts because people will buy the prompt contract. They’ll put into storage, and they can maintain an arbitrage by selling those forward contracts. Generally, natural gas spread trading certainly wasn’t anything new. There were certainly lots of people who traded very actively across the curve.
The difference was that for a number of years, you had a relatively predictable curve shift largely dependent on current fundamentals. And so, whatever the market needed to incentivize, the curve would largely function as a way to incentivize what it required in the physical market. What hurricane Katrina and Rita showed was that if you have a scenario where you have extreme tightness – you could have a window where prices go substantially higher than anything you’d ever anticipated before. Therefore people became much more comfortable purchasing spread contracts beyond anything that might even have a historical basis. The market has shown that if something bad happens – you can have a payout on an event that’s dramatic. The other thing you have with spreads is there’s a lot of implicit leverage in spreads.
Whether it be the margin that you have to apply for futures, or contracts, the margin that you might have to apply for swaps because you have an offsetting buy-in sale, you can take a much larger position. Suppose you’re making a bet that gas will run out by the end of winter. In that case, you can make that bet with substantial leverage without having to put up as much capital as if you were going to make that bet. For example, buying the futures contract outright without that offset. I think for a number of reasons, a lot of people were becoming enticed to make these different bets. Plus, from a pricing standpoint, many people were looking at the model similarly, right? They’re looking at a model that had insufficient commodities to meet demand.
A number of people are pricing out this kind of hope, for lack a better term, that if something goes wrong, we will have a significant asymmetric payout. You mentioned Amaranth. They had made a significant amount of money because they’d correctly predicted that if things got tied, or if there was a tropical event, or if there was some other thing that occurred – prices could go substantially higher in one contract versus another. They were one of the first big winners on some of these spread trades. They’d been relatively ahead of the curve, specifically when you mention the risk and how it looks.
A bank doesn’t necessarily have to make all of its money and energy. They tend to be incredibly quantitative about a number of different things when they’re looking at risk, and a bank is going to be agnostic as to what the product is. I’m not saying they view everything as a widget, but they’ll certainly say that we’re going to normalize things to units of risk. For example, at a place like JP Morgan or any other big banks, they would typically say, if you’ve got significant volatility that’s occurred in the recent past, it’s going to factor heavily into that risk model. It’s going to create an impact. It will limit what people can take in terms of risk in the bank’s books and balance sheets.
The other issue with banks is that banks don’t necessarily have to be in energy. They’ve got lots and lots of different things they’ll attempt to make money on. So if they view, whether it be natural gas or any product, as being excessively risky, at any point in time, you’ll have liquidity, and that’s going to pull back out of that market. So following Rita and Katrina, investment banks had a way of calibrating risk that tended to be much more conservative. It tended to be limiting in terms of risk. It tended to take some of the liquidity out of the market, even as additional banks were getting in. The financial players, the non-bank financial players, such as the hedge funds and others, employed teams of incredibly bright people in the field of risk. A number of the banks and financial institutions felt like this could easily get over our heads. We want to make sure that we aren’t in a position to be adversely affected by these events.
They used sophisticated techniques to calibrate and determine what that risk may look like. Many of these people were very comfortable in how they looked at how they were calibrating. They were very comfortable in terms of the market’s liquidity and how they would view it going forward. So even then, you had an interesting dialectical where the banks were becoming more conservative. The non-bank participants were becoming more aggressive. The banks viewed this as excessively risky, and a number of the non-bank participants viewed it as highly opportunistic with scenarios that could throw off insanely high profits. If, for example, you had a scenario where prices did get incredibly tight, they were looking at asymmetric payouts in general.
They had profited from the Katrina and Rita debacle and were getting more aggressive as other people pulled out. They were coming in to fill the liquidity gap largely left by the non-bank participants or the bank participants, the pipeline companies, and others that had pulled out. At this point, you had teams of PhDs who’d become incredibly comfortable with risk metrics. The flaw in their risk analysis was that they assumed a traditional level of liquidity for the market, where banks aggressively grew the risk in the market. At a time, the banks were pulling back; traditionally, you had a number of the pipeline players and others, the physical players that were extremely aggressive, that had largely pulled back.
Marginal liquidity was being traded back and forth amongst the hedge funds. The belief was that the liquidity pool happened to be substantially different and deeper than you might have seen in the real world when things began to come unglued. I think that dichotomy between how the banks and financial players looked at it versus how the non-bank players looked at it. It gave rise to volatility, where most of the people passing futures back and forth between each other weren’t the people who had any intention of buying natural gas or selling natural gas in the physical market. People were largely making paper bets on the ultimate end of winter balances in natural gas.
You created a false sense of security. In some cases, you had echo chambers where the people looking at risk the same way were sharing ideas and comfort levels. There was a general belief that the market was in a new paradigm, and there was a new way to profit from the new paradigm. In contrast, there might have been a historical precedent, which may lead to more opportunity and put substantial capital behind those bets.
It’s always amorphous, attempting to figure out exactly who has what and what the ultimate scale was, but what you certainly see over time is that you’ll see a number of people who will take concentrated bets. And the general belief is that people believe they can be the market. People sometimes think they have a deep enough balance sheet to take on enough risk to wait out the other people coming in on the other side. For example, in a scenario like a March or April spread where the higher that market goes, the more physical incentives for different players who can store or withdraw from storage, to come in and make bets against. So when something gets out of whack, there’s this belief that the old rules never applied. Still, the physical players are substantially larger than any financial player.
And so, when you have metrics that create substantial incentives for people in the physical market to react and act differently than they might have, you’ll enhance liquidity coming into the market against your position. And it almost doesn’t matter how right you think you are in the short term; you’ll have substantial liquidity to balance the market from the physical players. Look at the situation like the March-April, where you had the spread up to a level where anybody that had any storage whatsoever was incentivized to sell their storage forward into that contract. They were incentivized to buy futures contracts to refill storage in the back end. So even if you’d gotten to a lower storage level, some physical players felt like they had it within their system to monetize that.
At that point, once the market becomes more balanced, even if you’ve got a substantial balance sheet, or even if you’ve got a scenario where you’ve got the fundamentals behind you; if the incentive structure changes and you get a balance of liquidity, effectively, you’re making a bet that looks right, in case of normalizing within the weather. The chances are things will collapse, go back to lower levels, and certainly look to the extent that you have another tropical event. Or if you have something that causes weather to be much colder or something of that nature, it can certainly go higher. It’s just that you might not have as much company to push prices much higher, and I think some of the things the PhDs and others would forget about when they were looking at the different models they were coming up with. In contrast, when Hurricane Katrina hit – you didn’t have time to balance your system largely because half your system was gone.
It was either underwater or wiped out by the hurricane, versus if you’re attempting to trade something a season in advance, the different participants in the physical market have time to react to those incentives and time to optimize their assets and take advantage of the incentives that the market’s providing. I sometimes think if you’ve not been in that market your entire career, the way a number of these PhDs and other people have been in the risk department, I think they are more focused on the different outcomes that you could have in a heavy tropical season or other things like that, without focusing on the fact that if you’ve got a different set of incentives and a different set of timing for how quickly people can react, you’re probably going to get very different outcomes. And I think that naive in terms of the scale and scope of the physical players and what they can do within their system to balance the market. Sometimes it can lead people to take risks that may be in excess of the risk they anticipated that they were taking.
We’re all humans; we’re moist robots where we respond to stimuli in certain ways; we’re prone to want to believe the good things. We’re prone to wanting to believe almost as a protective mechanism from psychology that these bad things can’t happen to me, and if I were wrong, I’d be able to get out, and if I’m right, I’m going to make all this money. You see it a lot in a market like natural gas, where there’s the opportunity to make a lot of money quickly. But the inverse is that there’s an opportunity to lose an insane amount of money quickly. As humans and traders, we believe we will be on the right side of the big moves. But, unfortunately, many people kind of line up on the same side of the trade, and for a variety of reasons, whatever the fundamental outlook you were looking at, it can change very rapidly.
In a market like natural gas, figuring out what to do two days in advance is not easy. So, figuring out what will be six months or a year in advance is virtually impossible. A lot of times, what people would do is make bets predicated on large statistical analysis; in a different range of outcomes and how these other things could happen. But Mike Tyson once said everybody has a plan until they get punched in the face, which is what happens in natural gas. If you look at what happened, even with the fall going into what we described as the Amaranth collapse, you had a scenario where you had a heat wave coming in August prices were starting to rally.
It looked like Brian Hunter and the other people that were aggressively in this market; they were going to be proven right and that they were going to make a lot of money, and almost overnight, the forward weather outlook changed. You had some tropical events that seemed to dissipate. You had some heat events that seemed to dissipate. Then literally, almost overnight, you went from a scenario where the market looked incredibly tight to a scenario where the market looked potentially extremely loose. And so if you’ve got a large position on, and you’ve got limited ability to defend that position, or so to say to add incremental capital, you’re largely a slave to whatever the market wants to do at the time. Even with the best analysis, even with the best team around you, even with the best insights, even with the best of everything, you can still lose an obnoxious amount of money because some unpredictable variable can change almost instantly and leave you extremely vulnerable.
This is why things such as liquidity management and various different other risk management techniques are so important. Liquidity is kind of there when you don’t need it, but it’s not always there when you do need it, and a lot of people get a false sense of confidence and self-assurance when we’re in a market, and things are going their way, and they don’t think they have to worry about getting out. They just assume that there will always be lots of bids to sell, and if you’re trying to buy lots of offers and when things turn on a dime. You’ve got an outsized position in the market; you’re just in a position where it’s really difficult to get out, and at that point, you are at the mercy of the market for where they’re going to let you out.
At that point, it’s almost impossible to figure out your true risk because your risk has nothing to do with fundamentals at that time. It simply has to do with liquidity and how you have to price this to find the liquidity you need to exit a significant position. You’ve seen it happen in natural gas. You’ve seen it happen in oil. You’ve seen it happen in virtually every market, and unfortunately, time and time and time again, traders find themselves in these positions, not because of ill intentions or anything of that nature, but because of human nature because they’re very comfortable when things are going their way, and people aren’t always prepared for what the world looks like when things
go the other way and what that liquidity profile will look like then.
Think about the size and scale of that position by any metric. It was a large position in the absence of liquidity for a hedge fund, which has limited capital, which has investors who can redeem and has a scenario where when things go poorly, there are a number of risk management constraints. The kick forced the funds to act in certain different ways, and unfortunately, when there’s a hedge fund that has a big position, and there’s no way out of it; once you’re at risk of exceeding whatever the capital is in that entity and if that risk gets transferred to a significant financial institution, like a large commercial bank or a large investment bank that has access to liquidity through various different government entities, that has a significant balance sheet that can create their liquidity in multiple different ways.
It might be a big loss. It might be something that could dent the balance sheet in one way, shape or form, but it’s not something that could take that financial institution down. And in the case of Amaranth, when that risk went from relatively weekends, which is an investor product that had limited ability to post additional equity, to a large global investment bank in a commercial bank that had a substantial $3 trillion balance sheet. The risk to the mark and the systematic risk at that point was dramatically different. I think it’s the reason you see the fed step in, and you see all these other different government entities step in to provide liquidity when things get funky and in a number of financial markets because ultimately, you need something much larger to provide the liquidity that you need to balance the market.
In the case of Amaranth, because it was isolated largely to one market that was dislocated, it was isolated largely to one firm that was participating significantly in that dislocation. Those positions could be transferred to a large global financial institution with a substantial balance sheet. Simply at that point, the systematic risk effectively disappeared. That risk wasn’t going to be large enough to take down a bank the size and the scale of JP Morgan. It could have dented earnings, it could have done a number of different things, but it wasn’t going to be able to provide the liquidity of those futures and other products needed. At that point, the systematic risk in the market was largely gone. It was simply a matter of trying to buy a little bit of time to find little liquidity, to balance out the pricing so that the market could get back to functioning in a much more normal way, which happened almost instantaneously within a few days. Market conditions were largely back to normal.
It’s a great question, and it’s quite scary because, many times, people don’t necessarily know and learn from past mistakes and past things that have happened in the marketplace. But we went through a significant transition from traditional drilling techniques to shale drilling techniques, which ushered in largely a 10-plus year period of lower prices and less volatility. All the things that are good for consumers in the economy, in general, and now for a variety of reasons, the market is much more focused on lower sources of carbon to produce electricity, lower sources of carbon to heat and provide various different forms of energy and attempting to transition that in a relatively expedited fashion while we don’t have the infrastructure in place to do that.
It’s a challenge on a number of fronts because a number of the best technologies that we have for low carbon tend to be things such as solar or wind, which largely depend on whether the wind blows, whether the sun shines, and how long the sun shines. But, you can make a case, an aggregate as to over the year, how many hours you should get. Still, you don’t know exactly what it will look like every day or even the following day, how it will look, and unfortunately, what that requires. It requires substantial backup generation, which tends to be inefficient and not particularly clean to subsidize.
I think a lot of people have very good intentions; there’s a substantial amount of capital flowing into this in various different forms, whether it be research, whether it be infrastructure, whether it be other different things. We’ve got a booming global economy that’s becoming increasingly energy intensive. The present industries require extremely highly fine-tuned power. Power interruptions create massive problems. When we’ve got a system that depends on reliability, it creates issues for everything we do. You’re attempting to change that system with things that don’t have that same level of reliability.
For example, if you look at Europe, which became largely dependent on Russian natural gas, they cut off a number of their nukes because of Fukushima to usher in larger-scale renewables across the continent. You had a scenario where for a variety of reasons, they hadn’t gotten quite the output that they might have expected from the renewables when they needed it. They’ve had trouble securing gas from Russia due to the Ukraine crisis. You’ve got a scenario where even without cold weather, you have industrial shutdowns, and other things like that are occurring because they’re struggling to get the fuel they need. Now they’re looking at making changes such as not necessarily closing nuclear facilities that they’d attempted to close otherwise.
You’ve got a very finely tuned energy system, and you’re disrupting that system. You’re disrupting that
system with newer technology; that newer technology requires a substantial amount of backup if, for whatever reason, you don’t get the output that you anticipated due to not having natural gas. Largely that backup in Europe is coal, and now you’ve got largely the worst of both worlds. You’ve got extremely high prices and a low level of reliability, and you’re going to have some of the highest carbon output they’ve had in years because they’ve been forced to depend on coal generation to fill the gaps. When you look forward and see the same things occurring in the United States, where you’re going to have a much more volatile regime where everything’s working well, there’s the potential for prices to go negative.
If there’s too much wind, sun, or anything, you can potentially have too much power for the system, and you have to find a way to sync that power one way or the other. Conversely, if you’re not getting the conditions you need, you’re likely to see substantially higher prices, and there are two trains of thought. One train of thought – we should do a little bit more of everything, and if we do that, at least we’ll have reliability and give ourselves a chance to get to whatever that endpoint is. But do it in a very responsible way. And others feel like we’re here right now; we need to do it. We need to kind of force the issue. Unfortunately, suppose you’re wrong by forcing the issue. In that case, you end up with situations like the one you currently have in Europe, where you have low-level reliability and extremely high prices. You have a scenario where you have a much worse carbon footprint than you would’ve had if you were simply smart about the mix of resources you use and your transition responsibly.
I think, unfortunately, what happens is that you have these cycles, and a number of the people that
were extremely active. Fifteen years ago, when these things occurred, they moved on to other things over time and throughout their career. Conversely, people can read about these things. Still, a lot of times, until they’ve been on the other side of a trade that they couldn’t control, it’s hard to know how painful that can be or how difficult it is to manage in that situation. And on top of that, you probably have less investor capital in the space because people have pulled back from investing in funds that focus on hydrocarbons. And the banks have largely been focused on facilitating consumer businesses.
You don’t have the same level of trading that you’ve seen out of the pipeline companies and the physical companies. And so you’ve got a market that’s much more vulnerable now than it’s been in quite some time with a backdrop. That’s potentially much more volatile than it’s been in quite some time, and I think that combinations are very dangerous. I think anybody attempting to trade in those markets and take advantage of what they view as opportunities just has to be careful; they have to be thoughtful. They have to look back to the lessons of the past. If they’re smart about it, there is massive untapped potential, and I think you will have one of the most interesting tradings ranges you’ve had in years over the course of the next few years. But I think a tremendous amount of money can potentially be made during that window. But if people aren’t careful, if they don’t learn the lessons in the past, if they don’t recognize their flaws and their human nature, they will find themselves extremely exposed. And I think history could repeat itself time and time again.
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For the final track of our Summer Playlist, we sit down with Edelman’s Global Climate Chair, Robert Casamento, to explore the role of communication in unlocking necessary climate action.
Insightful for organizational and global leaders alike, Robert and David Greely cover how to use our common goal of 1.5° to align on practical solutions that meet short and long term energy and infrastructure needs.
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