The Cure for High Prices is… High Prices

Analysis

One of the highest input costs of food is energy. Energy and food are two of the most significant components of inflation.

Photo by Daniele Mezzadri / Shutterstock.com

Prices are essential economic signals, notes our corporate finance columnist Les Nemethy. High prices, whether for energy, foodstuffs, or whatever, are signs to the world to a) supply more, b) find a substitute, or c) conserve. And so, high energy and food markets today should eventually result in lower prices.

In today’s column, we first examine how this principle might apply to energy, then foodstuffs, and then discuss the impact on inflation.

A dramatic increase in gas prices, especially in Europe, has resulted in a glut and temporarily negative wholesale gas prices. There are more liquified natural gas (LNG) ships waiting to unload in Europe than available terminals. Storage tanks are pretty well full. All this is testimony to the enormous ability of economies to adapt when market forces are allowed to work. 

And yet, in the short- to medium-term, I am not optimistic about the world’s ability to solve the energy crisis, nor about the prospect of lower energy prices due to interference with markets. Some examples of market interference are discussed below:

1. In parallel to an energy crisis, we are witnessing the unfolding of a climate crisis. While the move away from carbon-bearing fuels is a laudable objective, the execution of the transition has been catastrophically managed, as will be described more fully below.

2. Despite high prices, oil and gas companies have curtailed capital expenditures and drilling, choosing to distribute cash to shareholders. Why invest when there is so much interference from environmentalists, politicians, and even activist-appointed board members? Case in point: U.S. President Joe Biden excoriates oil companies for not producing more and almost on the same day calls for “no drilling!” Oil and gas companies are legitimately concerned that they may end up with stranded assets, oil and gas that will not be sold, just stuck in the ground.

3. The United States is drawing down its strategic oil reserves. While the politically desirable objective of dampening prices is achieved, this also diminishes the price signal to conserve and increase supply. Various price caps and subsidies on oil and gas in the EU and elsewhere similarly muddle market signals.

4. Governments have taken many nuclear reactors off-stream (in Japan due to Fukushima, in Germany due to green pressure, and in France due to maintenance neglect), which once again puts pressure on energy markets.

Bringing on board new energy sources is capital intensive, whether hydrocarbon drilling, nuclear or alternative energy (building solar parks, establishing new mines, etc.) Recent increases in interest rates and cost of capital must be passed through to incentivize promoters to bring new capacity onstream. As energy prices are always determined at the margin, this will serve to increase the cost of all energy.

My prognosis is that energy prices will remain high for at least four or five years, even if there is a recession, because hydrocarbon-based energy still accounts for 84% of the global energy supply; alternatives appear incapable of taking up the slack sufficiently quickly and are constrained by the availability of critical minerals (such as copper, aluminum, and battery metals). Bringing new gas, oil, or nuclear projects on stream is capital-intensive and takes at least four or five years.

Energy and Food

One of the highest input costs of food is energy. Higher energy prices predestine the world to higher food prices. There are also other factors. For example, thefertilizer supply has been disrupted in the world because:

• Russia and Ukraine, two of the largest fertilizer exporters, have curtailed exports.

• Ammonium-based nitrogen, made with natural gas, has been curtailed by shutdowns due to volatility and uncertainty of gas supply. 

As of the date of this article in mid-November 2022, financial markets are breathing a collective sigh of relief at a recently announced lower-than-forecast inflation rate. This trend may be short-lived. Energy and food are two of the most significant components of inflation.

There are also lag effects: neither energy nor food price increases have been fully passed through to consumers.

• Many European countries are only now passing through higher gas prices toconsumers. 

• Farmers have been using up fertilizer inventories. It will be in spring 2023 that they must decide whether to pay higher fertilizer prices (which must inevitably be passed through to consumers) or to reduce fertilizer usage, resulting in poorer yields and ultimately being equally inflationary.

Other persistent sources of inflation are:

• Prices in the service sector and labor markets remain stubbornly high, and theratio of job openings to people seeking work remains very high.

• Rents remain high. 

• Globalization (which has a deflationary effect) is swinging to de-globalization (inflationary).

• Demographic trends are leading to alabor shortage (an inflationary effect).

• Inflationary expectations often take ona life of their own.

I would argue there is no way we are likely to approach 2% inflation in the coming years unless central banks hike interest rates enough to induce not just a recession but a full depression. Assuming they will not be prepared to pay this high political price, brace forgreater than 5% inflation.

Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president ofthe American Chamber ofCommerce in Hungary.

This article was first published in the Budapest Business Journal print issue of November 18, 2022.

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