La Niña and Energy Supply Crunch Bolster Fears of Persistent Inflation

One thing we should all be aware of by now is that supply chain disruptions and shortages are pervasive, no matter what area of the global economy you’re examining. And as winter approaches in the northern hemisphere, the risk of shortages of critical winter fuels has become quite apparent to industries and governments the world over.

While some shortages like those of consumer electronics or yoga pants may be an inconvenience, energy shortages in winter can mean the difference between life or death. Even if residential energy needs can be met, winter energy shortages can mean severe curtailment of industrial and economic activity, thereby further disrupting the already strained supply of most other goods. Dependable and affordable energy is the lifeblood of the entire global economy and supply chain.

Much like the other shortages being seen in pockets of the economy around the world, the energy shortages in each nation follow from a combination of a vast number of events and policies that began months (or years) ago that are finally coming to bear, including government responses to COVID-19, the renewable energy transition, changes in oil and gas producer shareholder demands, weather events and many others.

In Europe, weakness in wind-powered electricity generation resulted in higher coal and natural gas demand this summer, following years of shutting in nuclear generation capacity. This followed a cold winter where Russian natural gas inventories were drawn down to multi-year lows amid cold temperatures and lower production. As a result of surging carbon emission prices and coal and natural gas prices, electricity prices have climbed to record highs across much of the continent. Under policies that cap prices, generators in the UK unable to pass along higher prices to consumers have gone out of business.

With weaker natural gas deliveries from Russia and stronger demand this summer, gas storage in Europe is at low levels – currently around 77% full, compared to 94% full this time last winter and 97% at this time in 2019. The UK’s National Balancing Point (NBP) for natural gas is up just over six-fold year-on-year, currently around $28 MMBtu. The Dutch natural gas benchmark TTF is up just over seven-fold year-on-year, currently around $32.50 MMBtu.

Newcastle coal shot to a record-high near $230 per metric ton earlier this month, a near four-fold increase year-on-year. Even amid the selloff and volatility seen over the past week, Newcastle coal is still holding over $195 per metric ton. Likewise, Rotterdam coal shot to record highs of $213 per metric ton and remains at seasonal record highs of nearly $170 per metric ton.

Of course, it’s not just European nations facing these issues, but developing and developed Asian nations as well. Last winter served as a warning, and foreshadowed what was to come this year, when a bidding war for spot LNG cargoes in the depths of cold temps in January sent the Japan Korea Marker (JKM) LNG price to what was then record-highs for the price point at over $27 MMBtu. China has been facing coal and natural gas shortages all year, suffering from electricity generation shortages since early this summer. As a result, they have been aggressively outbidding European and other nations for LNG cargoes on the spot market.

A hot summer in Japan amid shuttered nuclear electricity generation, weakness in Chinese coal production amid a resurgence in global demand for Chinese manufactured goods, and now an outlook for a cold winter in the region in the coming months has meant that the JKM LNG price has surged to new record-highs once more, well ahead of winter’s arrival. After hitting a near $33 premium to Henry Hub earlier this month, JKM is currently trading at a $28.11 MMBtu premium to Henry Hub, or near $34 MMBtu.

Due in large part to coal shortages, China has been facing brownouts and is curtailing industrial and manufacturing activity to keep residential users supplied. Chinese thermal coal prices are up over four-fold year-on-year, at $220.05 mt. India is critically short coal inventories as well and is also facing electricity shortages as a result. Indian thermal coal prices, likewise, are up more than four-fold year-on-year, at $222.35 mt.

Governments across Europe and Asia are getting desperate ahead of winter; particularly in Northeast Asia, with the prospect of a La Niña dominating winter weather pattern pointing to below normal temperatures in the region. In recent weeks, China announced the liberalization of electricity markets in order to keep electricity generators in business; allowing them to pass higher prices along to consumers. In Europe, Germany has announced a 43% cut to their renewable energy surcharge (to begin on January 1) to help households cope with soaring prices.

Outside of policy responses, market prices are working to prevent worsening winter energy shortages by incentivizing production, disincentivizing demand and making substitutes economical. Across Europe and Asia, electricity and natural gas prices have already risen to the point that they’re shutting in demand; meaning pricing out some users or industries to keep critical supply available elsewhere. Large electricity users like industrial and manufacturing facilities are turning to diesel generators for on-site generation where possible.

This on-site generation, in addition to the potential for some electricity grids to substitute fuel oil for natural gas this winter (and some households to substitute kerosene and heating oil for electricity), is helping support oil prices ahead of winter during what is normally a seasonally weak period for oil demand. This could boost oil demand 300,000-600,000 bpd this winter, depending on winter weather developments.

While this analysis of global markets may seem unnecessary if you’re only worried about US pricing, the buildout of US LNG export capacity over the past five years has forced those with US natural gas price exposure to increasingly care about global developments. The expansion from just 2 Bcf/day of export capacity to nearly 11 Bcf/day over the past five years means that natural gas prices are increasingly set in a global market like crude oil. While import/export capacity and other dynamics mean it is not yet a truly global market, the expanded export capacity has certainly increased exposure of US markets to the risks and developments in distant nations. This is why it was so important to start this blog by outlining the winter fuel shortages elsewhere.

In fact, the US-to-East-Asia arbitrage trade (displayed above by the spread between the JKM price for spot LNG and US Henry Hub natural gas) has been a key factor in the weakness in domestic natural gas storage builds this year. The record-high premium for east Asian LNG relative to Henry Hub US natural gas has meant a steady pull on US LNG volumes throughout 2021. This wide-open arbitrage between US and global markets has also been seen in Latin America this summer as Brazilian droughts meant lower hydroelectric production; and in Europe amid the need for higher LNG imports following low wind generation and low natural gas and coal inventories. Ultimately, both regions have had to compete with China’s voracious appetite for LNG this summer.

A combination of all the factors we have just discussed has meant record-strong US LNG exports this year. US LNG exports were up around 50%, or 3 Bcf/d year-on-year in the first seven months of the year, averaging 9.1 Bcf/d.

Looking at the weekly US natural gas storage changes this year compared to years prior, you can see the enormous impact of the brutal winter storm in Texas in February; and the impact of record exports and slow production growth this summer. US natural gas inventories are currently 4.2% below the 5-year average, and 11.7% below year-ago levels.

Below, you can see the impact of the severe winter storm on natural gas production in February and March, when the frigid temperatures shut in production across Texas and caused lingering infrastructure damage. Despite the strength in prices this year, US production is expected to hold below 2019 levels here in Q4 2021 and Q1 2022 before moving to new highs later in 2022.

Front month Henry Hub natural gas futures are currently trading around $5.88 MMbtu, which is down slightly from the highs of nearly $6.44 MMBtu seen earlier this month. But when you zoom out, we’re still trading at seasonal multi-year highs, and December through March futures are still trading between $5.68-$6.15 MMBtu.

While natural gas prices in the US are admittedly still just a fraction of global prices currently, the multi-year highs in US gas prices still have significant implications. Not because prices signal that we’re likely to run out of gas in the US, but because -just like everywhere else in the world- surging gas prices mean hardship for households, industries and the economy; particularly because 90% of US homes are heated by natural gas or electricity.

Given our meteorology team’s outlook for La Niña inspired colder-than-normal temps in the northern plains and northern Rockies this winter (and given the concentration of propane use in that region), domestic propane demand should be very strong this winter. And while high oil prices and low inventories of diesel fuel mean higher heating oil prices this winter, it’s important to note that only around 4% of US households use heating oil. Even more importantly, that fuel oil use is heavily concentrated in the northeast, where our meteorology team is expecting to see warmer-than-normal temps on average this winter.

With 39% of US homes heated by electricity, when it comes to natural gas demand and prices, it’s important to remember natural gas is also now the largest source of fuel for electricity generation in the US as well, making up nearly 40% of the generation mix over the first seven months of 2021.

Given both the rapid growth in US natural gas consumption at power generators and the rapid growth in LNG exports, comparing natural gas inventories today to the five-year average can be misleading when trying to understand the true supply/demand balance or how relatively tight the market is compared to prior periods. When you adjust inventories and put them in terms of days of demand cover including exports, you can see that inventories are actually near the bottom of the five-year range for the seasonal period.

Likewise, due to a surge in global demand for propane and a record pace of US propane exports this year -as well as 17 months of refinery runs well below their pre-Covid norms limiting propane production- propane inventories are far below the bottom of their five-year range when put in terms of days of total demand cover. At $1.45 gal, US propane futures are currently trading at their highest since February 2014 and their highest for the seasonal period since 2011. Something else to note is that butane prices have also skyrocketed for similar reasons to propane over the past year and are one of the reasons winter blend gasoline prices are as high as they are today.

With our meteorology team forecasting the La Niña-inspired winter weather this year to lead to the highest number of gas weighted heating degree days since winter 2018-2019, this should mean continued pressure on natural gas inventories and support for prices this winter.

Drawing from the EIA’s outlook, consumers are expected to spend far more to heat their homes this winter, with natural gas users expected to see a 30% increase. Propane users are expected to see expenditures rise 54% and heating oil users are expected to see a 43% increase. When you look at where the underlying commodity prices are currently, even amid an unexpected warmer-than-usual temperature development this winter, heating and energy expenditures in the US will be significantly higher year-on-year. A potential colder-than-expected winter temperature development could lead natural gas users to see a 50% increase and propane users a near doubling of household heating expenditures.

Of course, it’s not just household expenses that are at risk this winter, but industrial, manufacturing and global economic growth that is at risk as well. Producer prices have already surged to record highs in many nations. The ripple effect throughout the economy caused by higher energy prices should simultaneously mean higher prices and lower output, which signals the risk of a stagflationary macroeconomic development this winter.

To emphasize the ripple effect of surging natural gas and electricity prices, you can look at base metals prices like aluminum, copper and zinc shooting higher as the energy-intensive production of the metals are curtailed in places like Europe and China. Earlier this month, aluminum traded on the London Metal Exchange hit its highest since 2008, and prices in Shanghai hit their highest since 2006. Copper inventories on the London Metal Exchange recently dropped to their lowest in decades, sending spot market copper to its largest premium to futures in nearly a decade.

Natural gas is also a key feedstock for making nitrogen fertilizers for the agriculture industry. Surging natural gas prices have already led to surging fertilizer prices this year and fertilizer supply is likely to continue to suffer this winter amid high natural gas prices in Europe and Asia. This will pressure farmer profit margins, and ultimately trickle into food prices and household budgets once more. I am highlighting prices in the UK in this chart following the recent shut-ins at fertilizer producers in the region amid surging natural gas prices.

And this is with food price inflation already surging over the past year.

Energy prices truly touch every sector of the global economy. And while the old market adage that the cure for high prices is high prices, when those high prices potentially mean people are unable to heat their home or entire industries are shuttered this outlook is not much consolation. A slowing global economy seems destined this winter amid high natural gas, coal and oil prices. This means that broader supply chain issues are likely to get worse before they get better. Russian efforts to send higher natural gas volumes to Europe and Chinese efforts to boost coal production should be expected to create price volatility in the coming weeks, but it is likely too little too late on both fronts to shore up supplies and normalize prices for this winter. Unless most all regions globally see their winter temperature forecasts trend warmer in the coming months, it’s unlikely that this is the last you’ll hear of the winter energy supply crunch.