Uncertainty reigns in energy prices

With energy prices breaking record after record, the focus has moved substantially towards the energy market. This is not only because of the energy transition, as part of climate policy, but high energy prices also confront consumers, producers and policymakers with the consequences of major changes in this crucial market. That other factors could start determining energy prices was just a matter of time. More flexibility in supply through a larger percentage of sustainable energy, like solar and wind, would make energy prices more volatile because of higher intermittency. The corona crisis and the decline in investments in fossil fuels such as coal, oil and gas have led to the current energy crisis. But this was not prominent on the radar.

From demand to supply

By their very nature, commodity prices are highly sensitive to changes in supply anddemand. Nevertheless, the dominant driver can differ from commodity to commodity. For the gas market in north-western Europe, the demand side was the most uncertain factor. At times of above-average cold fronts or - increasingly - heat waves, the demand for gas increases rapidly. This gas is used for heating in the winter or for generating electricity in the summer for cooling purposes (air conditioning). As a result, a price spike of a few days or weeks in winter is common. And once the cold front moves away and the snow melts again, the demand for natural gas declines and the price of gas drops immediately.

But there was an additional factor this year. Since the beginning of March, gas priceshave been on the rise. After a more severe 2020/21 winter, stocks were at a relatively low level. In addition, the demand for gas was above average (more consumption for electricity generation as a result of more demand for electricity and less supply of sustainable energy), which meant that the build-up of new stocks lagged behind. In the past, we could always fall back on higher gas production from the Groningen gas field and/or higher imports. But with the drastic reduction of gas production in Groningen, this alternative has disappeared. Production from the Groningen field may only be increased at times of severe winter when the supply of gas to households is threatened.

At the same time, we see that the supply of natural gas from Russia is under pressure. Russiadoes not supply more gas than it needs to under the current contracts. And the number of contracts is also decreasing. The focus has shifted towards more sustainable energy. ‘We’ would like to get rid of gas quickly, so the parties involved appear to very reluctant to enter into new long-term contracts. They were very confident that if we needed extra gas, we could buy it on the open market. And that would be the case, too, if the importers in Asia - especially China - did not constantly pay more than we did. As a result, almost all of the liquid natural gas available and not yet contracted for end up in Asia.

All this means that gas inventories are particularly low for this time of year, the gasprice is high, and while the real winter has yet to begin. Whereas in the past the gas market, and thus the gas price, was mainly dominated by the demand side, it now appears that the power in the industry has shifted from the buyer to the supplier. And at times of possible extreme cold this winter, the current shortage will only lead to more price volatility and new record prices.

From supply to demand

For the oil market, almost the opposite is true. In the past, the demand for oil grew byabout 1-2% per year. The uncertainty for oil prices was mainly on the supply side. A severe storm in the Gulf of Mexico or geopolitical unrest in the Middle East caused prices to rise rapidly because supply was (potentially) under pressure. Investments in oil and gas production has also decreased as a result of climate policy. Obviously, supply-related problems still affect the price. However, the price is more dominated by the uncertainties on the demand side. The first major lockdowns in March and April 2020 to combat the coronavirus saw a significant drop in demand for oil. As a result, oil prices fell to their lowest point in many years. Brent oil was trading at less than $20 a barrel. WestTexas Intermediate (WTI) - the American benchmark - even fell to a negativeprice of -37 dollars per barrel. Since then, prices have rallied strongly.

The decisive intervention of OPEC+ (various OPEC producers, supplemented bynon-OPEC producers led by Russia) to balance the supply/demand ratio by reducing oil production led to the initial price recovery. And the recovery of the economy due to the vaccines led to more demand for oil. As a result, the price of oil rose above the level it was at before the COVID19 outbreak. Nevertheless, the market remains very nervous about uncertainties in the demand for oil. A phenomenon that has now become much more dominant.

As uncertainties increase, so does the price

Next to the existing uncertainties the following drivers also continue to play a role. Thehigher US dollar has resulted in record petrol prices even though oil prices are still far below the peak in 2008 of USD 146/barrel Second high coal and gas prices have had their impact on electricity prices as well. And finally, the CO2 price (EU ETS) has reached a new record of over EUR 90/ton.

Investments in fossil fuels are under pressure due to disinvestment and are currently inline with the scenario required to achieve zero CO2 emissions by 2050. This is in spite the fact that the development of the necessary sustainable alternatives is not going nearly fast enough, since investments should be at least three times as high according to the NetZero2050 scenario of the International Energy Agency. In short, the erosion of the supply side does not go hand in hand with the development of the sustainable alternative. It causes an increasing risk of energy shortages and blackouts. Fortunately, the Netherlands is not yet at that stage, but it will increase uncertainty about the level of energy prices in the coming years. It is therefore important for policy makers to offer as much certainty as possible, on both the supply and demand sides, in order to prevent unnecessary price volatility. After all, the transition has only just begun.