Market Thinking

making sense of the narrative

The lamps are going out..

Two of the main drivers to low inflation over the last decade – cheap exports from China and low energy prices from Russia – are both disappearing, meaning at the very least a reset higher in the overall price level. The fact that both are, at least in part, a consequence of US led bellicosity against the two other leading Nuclear Powers may be a coincidence, but if someone did have a plan to inflate away western debt, part of it might look rather like this. Either way, with high dependency on both, Europe in particular looks set for a difficult winter.

 ‘The lamps are going out all over Europe, we shall not see them lit again in our lifetime’.

Sir Edward Grey, August 1914

The famous quote by Sir Edward Grey was made on the eve of the First World War as he realised that Great Britain was about to go to war with Germany but, much as we recognise the unpleasant uptick in bellicosity between ‘The West’ and the two largest Nuclear Powers of Russia and China, we are not quoting him for any reasons of historical martial parallel. Rather we are observing the fact that the, largely self induced, energy crisis in Europe is, quite literally, going to resort in power outages and deprivation across Europe this coming winter.

As with Covid, we do not believe that there has been a single over-arching plan, rather that there are a number of agendas that have been brought to the fore to exploit the circumstances we find ourselves in. Thus the green agenda that has allocated vast amounts of resources to energy generation that is unsuitable for base load while at the same time closing coal and (thus far) not investing in new nuclear has left Europe heavily dependent on natural gas. Indeed, the nature of renewables is such that by switching from Nuclear, as Germany has done, the dependency on gas to provide base load has risen. While some eco purists insist that even gas must go, that is not the real problem at the moment, rather it is the dependence on gas supply from Russia at a time when many governments had, not so cleverly, decided to switch from fixed contract to spot pricing and at the same time decided not to fill up gas storage. In effect a classic commodity cycle mistake.

If we then throw into the mix the geopolitics of the giant NordStream 2 pipeline and the expansion of the pipelines to China then we amplify the effect. For a long time, Asia has paid a premium for gas, principally Liquified Natural Gas (LNG) exports from Australia and the Middle East, but also latterly from the US West Coast thanks to to the fracking boom which famously led to West Coast import terminals being turned into export ones. Now that Russia has added Nordstream 2 and also opened up the new ‘Power of Siberia’ Pipeline we would need to update the map below, (struggling to find one online) but it is a good illustration of the situation more generally.

The switch of supply to the more profitable Asian demand means that, while Russia is meeting all its contractual obligations to Europe, it is under no pressure to ease price levels to meet demands from European customers who are ‘short’ supply. Meanwhile, ironically partly due to western pressure on energy ‘polluter’ China, the biggest user of energy in the world is increasing switching to become a major competitor for Europe for supplies of Russian gas. Other potential pipeline supplies for Europe from the middle east are suffering from disputes (Algeria) or were originally planned to go through Syria, either from Qatar or Iran and are thus no longer viable.

Gas Pipelines and Inflation Pipelines

This is of course, literally power politics. The US has consistently tried to prevent Nordstream 2 being built – which essentially doubles the gas supply from St Petersburg to Germany, since they do not wish Europe and Russia to become too co-dependent. It also threatens to upset a number of other countries benefiting from transit arrangements, like Poland and, particularly Ukraine. The latter is, of course, politically highly sensitive, ever since the coup in 2014 that installed a pro-US government and the subsequent ‘re-absorption’ of Crimea by Russia to regain control of its naval bases (amongst other things). A bad winter with no power (Ukraine famously failed to ensure enough gas for itself recently and suggested people in the countryside stocking up on manure to burn!) would likely put the US backed government under a lot of pressure, especially as Nordstream 2 will likely cost Ukraine $3bn or so in revenue from transit fees. This, in our view, is the real likely source of tension in the breakaway Donbass region of Eastern Ukraine, the need to distract from poor domestic conditions, not by Russia, but by Ukraine.

Ultimately, this is literally GeoPolitics 101 and the concept of the Global Heartland from Mackinder originated at the turn of the last century. Combining Europe’s technological advantages with the cheap energy of central Asia – not just Russia, but also Iran and the ‘Stans – and the connection to China’s consumers via the Belt and Road initiative, offers significant benefits to the population of all three areas, but, obviously, at the expense of US power dominance. As such, keeping the Global Heartland fractured has been, and remains, a key driver of US foreign policy and while everyone plays along nicely, everyone knows this. The tensions emerge when the population of Europe starts to pay too high a price for US power politics. Now may be one of those times.

The fact is that the ongoing geo-politics have combined with a toxic mix of Global Green Policies forcing greater dependency on gas in Europe, new pipelines to the East increasing competition for gas from China and short-sighted attitudes on pricing and storage to more or less guarantee that Europe faces an energy crisis this winter. At the same time, the higher cost of fuel is not only putting Europe at a competitive disadvantage to the US, but the knock on impacts to inflation are meaningful. Natural Gas is an important component of fertilizers for example and the impact on food prices is already now in the inflation ‘pipeline’.

Meanwhile, just as the geo-political pressure from the US against Russia is ending the advantage of cheap energy in Europe, so similar tactics against China are leading to China reducing its excess capacity (in just about everything) and thus removing itself as not only a source of demand for Europe, but also a source of cheaper supply. Meeting with one of the smartest ‘on the ground’ China experts we know earlier this month, they reported that (having just come in from the mainland) the atmosphere in China was one of exasperation and, increasingly, isolation. The relentless, full spectrum, propaganda from the west against China is puzzling the ordinary Chinese who just want to trade, travel and make money. Their leaders, meanwhile, appear to be scaling back their internationalism and One Belt One Road has evidently been put on the back burner for now and there appears to be a recognition that providing cheap imports for the west is no longer a business model that suits the Chinese. We have long noted that the ‘consensus’ view in the west that China can not survive without exports is now a decade or more out of date. On the contrary, many countries like Australia, Canada and Brazil are very dependent on Chinese imports, while many more are dependent on invisible imports, like tourism and education. Trade benefits all sides, shutting it down for geo-political reasons is thus far from cost free. As we noted with the zero Covid policies in Hong Kong – ‘while they might not actually have a plan to get rid of all the expats, if they did, it would look a lot like this’, so it is with the otherwise puzzling bellicose stance of US foreign policy at the moment. ‘If they did want to undermine the competition from not only China, but also Europe more generally, while at the same time deliberately raising price levels (and inflate away debt), then ending both cheap energy from Russia and cheap imports from China would certainly be a way to achieve those aims.’

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