Driving Blindly into Long Recession, High Inflation

Europe and the US are driving blindly into a major, potentially years-long recession accompanied by high inflation. Low-income households will be hit hard. Policy responses are impossible to predict, but if people are to avoid going cold in winter and baking in summer, those responses will need to include price controls or focused subsidies on fuel. One of the many problems is that those measures would prolong what by then might have gained the status of a depression.

The energy transition will benefit. That much is even clearer now than it was a few days ago. But the process won’t be fun or easy.

The only response from Western governments that could do a lot to improve the underlying situation over the next year or two would be to let Russian commodities flow again — assuming the Russians would feel like providing them to markets. In the current frenzy, welcoming Russian oil back is difficult to imagine. Whether that will change once the breadth and depth of the economic damage becomes apparent is, again, impossible to predict.

Demand Must Fall

How can anyone say with such conviction that a recession will result from slashing Russian oil, gas and other commodity sales? It’s simple. The inflation we’re seeing in commodity prices isn’t primarily driven by speculators and it isn’t driven at all by rising costs of production. Commodities from wheat, to oil, to nickel cost hugely more at the moment primarily because, without Russian supply, there isn’t enough of those commodities around to cover demand at recent levels of economic activity.

Prices will continue to rise until demand falls enough to equal supply or Russian supplies return. Developing alternative sources of fossil fuels or metals big enough to cover the gap would take years.

A few numbers on oil markets should illustrate the point. Global oil demand today stands at around 100 million barrels per day, meaning that percentages and volume figures are conveniently similar.

Russia produces roughly 10% of the world’s crude oil and exports around three-quarters of that, or roughly 7.5 million b/d. That may not sound like all that much — just 7.5% of global supply — but the world’s oil industry runs on incredibly thin margins of spare capacity, about 2.5% before the invasion. The situation isn’t much different in most commodities. It’s part of the same system-wide drive for “efficiency” that brought us just-in-time inventories.

Much of that unutilized oil capacity belongs to Saudi Arabia, which worked hand-and-glove with Russia to create a floor under oil prices during most of the pandemic, after a brief worldwide price collapse when the two countries took to price warring — pulling US oil futures prices into negative territory at one stage. The Saudis have shown no inclination to turn on their best “Opec-Plus” buddies again.

Truth is, even if the Saudis turned up the taps, prices might not fall back much, because everybody in oil markets would then know that there was basically no replacement oil to be had if anything broke down or somebody else took to fighting harder, disrupting production, like the Libyans or Iraqis.

Meanwhile, even before the US and UK announced their ban on Russian oil purchases, estimates by oil specialists were that Russian sales of crude and products had fallen by up to 3 million b/d, a figure that looked set to rise to 5 million b/d by the end of this week. Whether or not Europe and US-friendly Asian countries such as Japan and South Korea follow suit in formally cutting all Russian oil purchases, many oil companies in those countries are frightened enough of US sanctions enforcers that they’re halting deals with Russia voluntarily, “self-sanctioning,” as it has been dubbed.

Natural Gas, Too

Nor is there enough spare natural gas production and transport capacity available in the world to replace Russia flows should Europe’s purchases of that fuel largely halt. There’s been talk of using liquefied natural gas (LNG) moved by tanker to replace Russian pipeline gas in Europe. In fact, Russia sells more gas to Europe than the entire capacity of any one of the top three LNG exporters: the US, Qatar and Australia. Meanwhile, their existing output is already spoken for, much of it under multi-decade-long contracts to Japan, China and South Korea; and their expansion plans won’t make much additional capacity available before mid-decade. Even then, the volumes are tiny compared to what Europe uses from Russia now.

German Chancellor Olaf Scholz has figured out that cutting off Russian natural gas would be disastrous for Europe’s economy and has said purchases won’t be stopped. But it’s unclear whether he and his EU colleagues can keep supplies flowing, due to those same corporate and banking fears of financial sanctions that are hitting oil sales.

Given a few months or years, new natural gas supplies could replace a portion of any loss from Russia, whether from ramping up US shale production, increasing Italian natural gas purchases from Algeria or squeezing a bit more out of domestic European fields. But the quickly available volumes aren’t nearly big enough to offset a loss of all Russian supply.

In fact, volumes of natural gas equal to those currently at risk from Russia aren’t likely to ever materialize elsewhere. Bringing new production and LNG transportation capacity online can easily take a decade, even assuming companies could short-circuit the years it now takes to make corporate decisions to commit the billions of dollars of capital involved and to get needed government permits. It will be quicker — and cheaper — for Western governments to accelerate energy efficiency measures such as insulating buildings and installing heat pumps, to expand solar and wind generating capacity, and to put in battery storage.

Knowing this, for-profit oil and gas companies will be loath to invest in building new LNG capacity that won’t pay for itself and start making them serious money for at least another five to 10 years after it comes online. For most projects, that means payback wouldn’t come until 2035 at the earliest. By that date, Germany and the US, among others, have said they aim to generate 100% of electricity from renewables, and several car companies have said they expect to be selling only EVs or other “zero-emission,” i.e. non oil-burning, passenger vehicles.

New Renewables Potential

At these gas and coal prices, it’s pretty easy for solar and wind power to compete even without subsidies and other government incentives, although to speed things up, governments will probably increase those incentives nonetheless. And at gasoline prices that could easily double again from current levels of $4-$5 per gallon in the US, the many new EV models slated to come onto the market this year will look attractive to many more people than they might have when pump prices were barely over $2. That will hit oil demand head-on.

There’s a lot we don’t know at this early stage in the pan-Western conflict with Russia, including whether it will stay cold or heat up beyond war-ravaged Ukraine. But as this brief discussion of energy market dynamics illustrates, we know a lot more than we’re bothering to think about. In the climate of near-hysteria that has developed on either side of the Atlantic, such thoughtlessness can be a very dangerous thing.