Oil prices are now trading some way below their peaks, but natural gas prices continue to surge, and the rising cost of energy means a recession is looking increasingly likely, whatever politicians may say.
Higher energy costs feed inflation, act as a tax on consumers and can pressure corporate margins too. Since 1970, the oil price has doubled year-on-year six times and on four of those occasions the US and UK have gone into recession within the next two years. Everyone is waiting nervously to see if we make it five out of six in 2022-23.
Oil and gas prices are partly a function of supply and demand and therefore competition for the available supply. If free markets were left to their own devices, the best cure for high prices would be high prices, just as the best cure for low prices is low prices.
Low prices ultimately choke off supply as uneconomic, inefficient producers cut back or go out of business, and boost demand as users spot a bargain.
By contrast, high prices choke off demand, as users reduce consumption or seek cheaper alternatives, and usually boost supply, as producers look for a piece of the action.
There are some signs of high prices sowing the seeds of their own destruction, especially as the EU is looking to cut its consumption of natural gas by between 15 per cent and 20 per cent through a range of measures that range from cold showers to switching off neon signs at night.
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However, there are also three problems here.
The first is that geopolitics provides a complex additional range of influences, as the Russian invasion of Ukraine, unsuccessful American efforts to force down the price of crude by releasing its strategic reserves and Saudi Arabia’s warnings that OPEC may cut production if oil prices slide too much all make clear.
The second is that oil markets are not necessarily entirely free. OPEC’s influence may not be as strong as it was, as the bloc now controls barely a third of global supply, but it is still adjusting production in an attempt to manage prices. Moreover, governments around the world continue to try to buck the market. The UK, France, California and others are cutting fuel duties or air travel taxes, policies which only serve to boost or maintain demand at a time when constrained supply is a key part of the problem. Windfall taxes may not encourage fresh supply, while price caps leave energy suppliers facing increased input costs and strip them of the ability to protect themselves.
The third is that supply remains constrained. Sanctions are restricting consumption of Russia, Iranian and Venezuelan crude. In addition, for some time before COP26, politicians and the public were beseeching oil firms to drill fewer holes in the Earth’s crust, for entirely laudable and legitimate environmental reasons. Oil firms complied, as their lowly capital investment figures of the past five or six years suggest. Banks are still declining to finance new drilling, insurers are declining to insure new projects and money management firms are busy dumping oil and gas shares to signal their commitment to the ecological cause.
This is not to say such strategies are misguided, as they are designed to make the Earth a better place in the long run. But this cannot conceal how there may be uncomfortable short-term costs. Oil and gas prices were already rising before Moscow’s assault on Kyiv, while wind, solar and other renewable sources of energy still struggle to match hydrocarbons on a bang-for-buck (or energy returned on energy invested, EROIE) basis.
Moreover, policy so far, at least in the UK, has simply repeated the mistakes of the 1970s, a decade characterised by galloping inflation, industrial unrest, lofty interest rates and – from the narrow perspective of investment – appalling portfolio returns from cash, bonds and equities, especially on a real-terms, post-inflation basis. Only gold really shone and that was helped along the way by President Richard M. Nixon’s decision to withdraw the dollar from Bretton Woods and its $35-an-ounce peg in 1971.
Governments’ inability, or unwillingness, to stimulate investment in natural gas (and even oil) production, pipelines and infrastructure looks like a glaring omission, even if it may not provide an immediate fix or be palatable from an environmental perspective. Higher output could mean lower prices and help with inflation, to the benefit of hard-pressed consumers’ pockets. And lower oil and gas prices could presumably make it harder for Vladimir Putin to fund his war in Ukraine, as well, so increased oil supply could bring economic and geopolitical benefits (even if it would take time to effect).
Environmental campaigners would be understandably up in arms about such a policy shift but as the American economist and historian Thomas Sowell noted: “There are no solutions, only trade-offs.”
Russ Mould is investment director of AJ Bell.