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Surging energy prices and stagflation

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Surging energy prices and stagflation

Energy prices are under pressure and many observers fear the return of stagflation, a situation where inflation is high and economic growth stagnates. The price of Brent crude and the US WTI have both doubled in a year. The price of natural gas in the US market has also doubled since October 2020. How have these rapid rises come about and are fears of stagflation warranted or exaggerated?

GianLuigi Mandruzzato
GianLuigi Mandruzzato

What is driving prices higher?

Several factors explain the surge in energy prices. There has been increased consumption due to work-from-home conditions and the economic recovery. In addition, China has increased gas imports from Russia to compensate for the closure of coal-fired power plants to reduce CO2 emissions. Finally, droughts in Latin America and unfavourable weather conditions in Europe during the summer have reduced electricity production from renewable sources and increased demand for fossil fuels.

On the supply side, OPEC+ production limits pushed up the prices of both crude oil and natural gas, which is often extracted with the same rigs. In addition, Hurricane Ida limited US shale oil production for much of September. Finally, Russia has been exporting less natural gas to Europe as a means of increasing its own domestic supplies for the winter.

The result of all this is that stocks of energy raw materials are low. Petroleum product inventories in OECD countries have fallen below the 2015-19 average. The same is true for natural gas, with many observers pointing out that the low storage capacity utilisation rate in Europe of only around 75%, compared to the seasonal average of around 90 %, is the main cause of the recent steep rise in prices. However, increased gas storage capacity means that the current level of stocks is overall in line with the historical average.

With regard to oil, while OPEC+ dashed hopes of a faster normalisation of its production at its meeting on 4 October, the increases planned for the coming months and the additional output expected from other producers, especially the US, should keep the market well supplied.

So there seems to be no reason to fear a structural shortage of energy commodities. This is also what investors seem to think: the oil and gas futures contracts see falling prices in 2022.

How big is the risk to inflation?

There are widespread fears that the energy price shock will lead to a persistent rise in inflation, with negative repercussions for growth. Recovery from the pandemic is also likely to suffer as high energy prices constrain the production of goods and services, exacerbating the supply chain disruptions that have emerged over the past twelve months.

Tensions over the price of European gas could ease if Russia increases its gas exports. It should not be forgotten that, despite increased demand from China, the EU absorbs about 75% of Russian gas exports, so it is in Moscow's interest to find a solution as soon as possible. It is therefore not surprising that Putin has recently voiced his support to increasing gas flows to Europe and that this has been enough, even in the absence of details, to push prices down.

If futures are a good guide to the evolution of oil and natural gas prices, energy commodity inflation is expected to peak by the end of 2021 and fall in 2022, especially in the second half of the year. While the energy price shock will increase the inflation rate in the coming months in both the US and the eurozone, its direct impact will be less severe over the coming year.

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