The Great Game of energy

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With the resumption of the global economic cycle, the prices of natural gas, coal and electricity have risen, particularly in Europe and China, to the point that in China the government has had to intervene to ration the consumption of electricity and calm the price of coal.

Is this the unwanted effect of the post-pandemic recovery only? Probably not. Other trends, triggered by green transition, geopolitics and ESG policies are underway and could make higher energy costs structural.

Green transition and ESG policies. All governments of advanced economies are adopting zero carbon footprint policies but without coordination. The increase in prices reflects this proceeding in no particular order: forcing traditional energy producers to pay for the carbon footprint when the country in which they operate has not yet invested enough in alternative technologies is, for the moment, only an additional cost that is then add to prices. In practice, traditional production is discouraged without there still being sufficient alternatives to cover demand. Natural gas has suffered the strongest impact, both because it is part of the production process of many industries, and because it is preferred over the more polluting coal.

In the last decade, traditional energy producers have encountered increasing difficulties and resistance to finance the construction of new plants (for example, for the extraction of coal or oil exploration), which has contributed to making the sector unprepared to support the recent strong increase in demand.

In the global movement towards the suppression of pollutants, China has acted surprisingly very decisively by limiting the production of coal, which increased the internal demand for gas and immediately impacted Europe (heavily dependent on natural gas).

It should be remembered that natural gas is a regional product, little transported (which is slowly changing with liquefied natural gas, LNG), which directly and locally competes with coal in the generation of electricity. What is therefore pushing the price of gas (LNG in particular) is that China had restricted coal production.

The point is that LNG is a relatively small market compared to global gas production, where essentially only China and Europe operate. The United States, on the other hand, has a lot of natural gas but limited capacity to extract and export it. The price of gas in the United States, in fact, is about one third of that of Europe and China, but it is unthinkable that infrastructure for the transport of LNG will be created in the short term.

The green transition is therefore taking place by limiting the offer and making it more expensive. At the moment there is not much that can be done to adjust the supply capacity to produce more gas or coal because the plants cannot restart quickly. The most viable solution is shale gas (methane gas extracted from unconventional fields). According to Luca Zanotti, president of Tenaris (one of the main global producers of pipes and services for oil and gas research and production) the increase in demand registered by his company is the signal that shale production is growing, fueled by rising oil prices and the need to restore production capacity that had been suspended.

In the meantime, it is interesting to note that banks and producers have been invited by the ECB to carry out a portfolio stress test, a request that clearly intends to understand what the impact on corporate capital would be in the event that the loans granted (banks side ) and investments (on the producer side) linked to oil had their value decreased following the green transition. In the long term this could certainly happen, but in the short term the value of these investments is going up (and by a lot) precisely because the transition is not proceeding organically.

The decisive weight of the Iranian variable

Among the variables that influence (and will influence) prices, we must consider the geopolitical evolution. Negotiation on nuclear power between Iran and the rest of the world is of central importance. A quick background can help better understand the situation. Donald Trump had canceled the framework agreement reached in 2015 by the P5 + 1 (UN Security Council and European Union) under which Iran undertook to eliminate its medium-enriched uranium reserves, cut by 98 % low-enriched uranium reserves and reduce gas centrifuges by two-thirds for thirteen years. The American denunciation of the agreement was also accompanied by the reintroduction of economic sanctions. Iran initially did not react and continued to negotiate the terms but then decided to call Trump’s bluff by carrying out some attacks on US allies (Saudi Arabia, Yemen) and American forces in Iraq. The United States did not respond and Iran began to enrich uranium again. Washington estimates that Iran is within months of having enough material to assemble a nuclear weapon. Any attempt at an agreement with Iran is therefore collapsing. It is likely that Iran wants to repeat the threat made by Japan in the past: not actually creating an atomic bomb but pileing up the material and skills to build one.

It is very likely that Israel and the United States will not be confortable with this. Joe Biden’s new negotiating team is attempting to reopen a table with Iran, in turn with a renewed Iranian team after the elections, but returning to the 2015 agreement seems impossible. Too many thinhs have changed. The negotiation is also affected by American domestic policy (today concentrated on fiscal and infrastructural plans crucial for the post-pandemic economy) and the orientation of the new administration to disengage from any oil conflict (Afghanistan, Iran). Iran could accelerate and put itself in a position to produce a bomb in a few months if not weeks and, if this happens, Israel and the United States could not stand by and watch.

The possible use of any “kinetic pressure” on Iran in the current phase of tension in the energy markets could cause a shock. The fact that a significant part of Iranian oil production is sold to China highlights the extent of the possible impact on oil prices and economic growth. In short, Iran has managed to put itself in a central and strong position.

Russia is in a similar position of negotiating advantage and can now impose the quantities of gas and oil most appropriate to its own interest on the countries of the European Union and beyond (India too depends a lot on energy imports from Russia). As a consequence, after years of diminishing returns and financing difficulties, energy producers (and the governments of their countries) can then decide on rules and prices.

Markets are likely to normalize with a return on investment in natural gas and the ability to export it, but the process will be long. The outcome will probably also be a change in the ranking of needs with the United States self-sufficient in oil, thanks to shale production (which can be adjusted to demand much more quickly than other forms of extraction). To date, the demand for oil is still 2-3% lower than pre-Covid levels, mainly due to the reduction in transport (especially commercial aviation). Therefore, the United States has no interest in fighting a new war for oil. In the world, however, there is a lot of unused production capacity: Saudi Arabia, Russia and the ability of the United States to greatly increase production could absorb the effects of a possible Iranian crisis. Of course, however, the other participants in the negotiations with Iran (Germany, France, Great Britain, China and Russia) are much more dependent on oil and this will have its weight.