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Inflation and the Energy Transition (part 5): Its structural, not transitory

  By: Matt Fernley

Posted on - 30 Sep 2021

Over the past several weeks I’ve published a series of blogs looking at what I believe is one of the least-appreciated impacts of the Energy Transition which could have serious implications for global economic growth, consumer health and social stability over the next 10-15 years; inflation. Unlike the Fed and many governments, I believe that the inflationary impact of the Energy Transition is structural, not transitory, and I believe that because governments and Central Banks haven’t worked through the effects of the Transition in detail, they’ve missed this huge risk to the global economy and social welfare.

The previous parts of the series that I’ve published are:

1. Impact of a moratorium on oil & gas exploration
2. The hidden cost of the EV roll out
3. Renewables in their current form are not the promised land
4. Cost pass through effects from materials

In this final part of the series I’m going to summarise the key issues from these parts and then discuss the implications of these issues.

1. Moratorium on oil & gas exploration

In the first part of the series, I discussed the crack down on oil and gas exploration and raised the point that it is too early. I pointed out that oil and gas fields have rapid production decline rates and that the hydrocarbon industry typically fills these production declines in utilising further exploration. A moratorium on exploration means that oil and gas output could drop by more than 50% within the next 10 years.

On the oil side, I further pointed out that demand is not going to fall by anywhere near that amount. Even with my current top-of-consensus EV sales forecasts, EVs will only be 20% of the global car park by 2030, so passenger transportation demand for oil could only fall by that amount. 19% of oil demand goes to electricity and I would hope that would be largely eliminated within the next 10-15 years, but other applications are not likely to be so elastic. [I would note here that it is practically impossible to increase the speed of EV build out because of structural supply shortages in the battery raw material supply chain]. Oil demand will fall nowhere near 50% over the next 10 years, meaning that we are building up a huge structural shortage of oil. In structural shortages, prices rise.

On the gas side, the situation is even more fraught. Gas is a key component of many grids and while some baseload gas generators are being phased out in preference for renewables, most of the phase out is focusing on more-polluting coal. While some gas peaker plants are being replaced by batteries, it is a relatively small percentage. Gas is likely to remain a major component of power grids for some time to come and research has indicated that grids with more than 30% Renewables and insufficient energy storage are unstable, requiring a higher percentage of peaker plants, which would primarily be gas.

The weak performance of wind power assets in Europe, coupled with forced closure of many gas production operations by the environmental lobby, has led to a shortage of gas in Europe over the past six months which has resulted in a more than doubling in local gas prices and in LNG prices. As a result, power prices have also risen substantially. We should expect that this is structural, not a transitory situation, as many governments seem to be suggesting.

Bottom line: Given the magnitude of the emerging supply/demand gap, I would expect oil prices to more than double over the next 5-10 years. Given that more than 80% of global passenger transportation will still utilise oil, that will feed directly into the consumer in terms of higher costs.

I would expect a similar situation in gas; prices have already risen substantially but could go materially higher (2x, 3x in my view) over the next 5-10 years. Given the use of gas in power generation and for heating in many parts of the world, this paints a painful picture for the consumer.

I would also point out that oil and gas are key components of petrochemicals and plastics. More on that later…

2. Hidden cost of the EV roll out

In part 2 of this series, I discussed the impacts of the widespread adoption of electric vehicles and cautioned that for quite a large percentage of the car-owning public, shifting to EVs would lead to higher all-in costs.

One of the key issues regarding EVs is their price. Currently the median price for European EVs is of the order of £30-35,000 per unit, but the median price for ICEs is of the order of £15-20,000 per unit. A key component of the cost/price of an EV is the battery and I cautioned that, in my view, battery prices are set to increase because the cost of raw materials in the battery will increase.

Despite the fact that auto manufacturers are realising substantial manufacturing efficiencies in EVs and lowering the cost of their production, I don’t think this will be enough to offset a rise in battery raw material prices (due to underinvestment in supply) which will likely mean that EVs on average continue to cost more than comparable ICEs.

I suggested that this then would result in a change in ownership structures for vehicles in the EV era. Data suggests that leasing is only 8% of car sales in the UK. It’s slightly higher in Europe, at up to 15% of sales but not a huge market in China, although it is set to grow from an estimated 2.5% in 2016 to 20% by 2026, according to KPMG.

Leasing is much more popular in the US with c.31% of vehicles being leased prior to the emergence of the shortage of vehicles in 2021.

My contention is that the significant upfront cost of EVs will likely lead to a substantial change in car ownership models over time.

A key selling point for EVs is their lower operating costs because of replacement of oil for cheaper electricity and the lower mechanical complexity of EV engines which is likely to mean lower running costs. While this contention is correct, it only tells half the story.

In an analysis by Battery Materials Review, we looked at the cost of ownership for EVs and comparable ICEs based on size and mileage. While true operating costs were lower, other costs such as insurance (due to the higher upfront value of EVs) and financing, were higher. For low mileage users and ownership on finance, all-in costs were actually higher for EVs.

The takeaway of the analysis is that unless you are a high mileage driver (greater than 40,000 miles per year) ownership costs of buying an EV on credit are likely to be higher; it is only with leasing that the cost of ownership for EVs would be cheaper currently.

Given that it will take some time for that change in consumer behaviour to happen, we are looking at the switch to EVs to be inflationary for the consumer and that’s ignoring the likely impact of having to invest in home charging equipment or pay up for charging fees because of the need to invest in infrastructure for the EV roll out.

Bottom line: For urban consumers (c.60% of the population) travelling low mileages, depending on the model EVs could cost as much as 10-20% more per annum to run than ICEs. On the flip side, for high mileage consumers, EVs could be up to 30% cheaper…

3. The risks of the renewables roll out

There’s been a lot of excitement in the Renewables sector over the past few years as the Levelised Cost of Energy (LCOE) for renewable energy projects has fallen below US$100/kWh. In many cases the LCOE for Renewables is below hydrocarbon generation. Now, that’s great, but unfortunately there is one big skeleton in that closet. This data is only for power generation.

But the costs around renewables are larger than that. The Renewables role out encompasses significant requirements for investments in transmission and distribution (T&D) infrastructure as well as storage, and here’s why:

Renewable plants need to be sited in regions with high wind and solar resources; often these places are not close to major demand centres. This means that substantial investment in T&D infrastructure is needed to transport the power.

Renewable plants are generally much smaller than existing power plants. BNEF forecasts that the median size of power plants will fall by 60% between 2020-40. That means multiple Renewable plants (and their T&D infrastructure) will be needed to replace the power generated by one coal or gas plant.

A fascinating study by the US’s National Renewable Energy Lab concluded that a large grid system with greater than 30% of power from renewable energy will be unstable without substantial investments in energy storage. Due to the variability of renewable power generation, major long duration storage investments are necessary. In addition to this, hydrocarbon-powered peaker capacity is also a necessity and it’s expensive to run this capacity in that sort of manner.

Bottom line: In addition to the huge cost of plants is a substantial cost in T&D capacity. BNEF estimates that at least US$14tn needs to be spent by 2050. That’s over US$600bn per year and ignores the requirements of stationary storage. Power companies are incapable of absorbing this cost themselves and it’s likely that a substantial proportion of this higher cost will be passed along to the consumer in the form of higher retail power prices…

4. Cost pass through effects from materials

This is one area which is often glossed over or forgotten about by analysts considering the energy transition, but it’s a key element which could have very substantial cost impacts for all segments of the global economy.

There are three key elements to consider in my view:

• Direct costs of decarbonisation of industrial processes: I used the example of the steel industry in my article, highlighting that the levelized cost of zero carbon steel is over double what it is for current steel production, in some cases. The higher production costs of decarbonised material are likely to be an issue all through the metals complex, and in the petrochemicals space as well where the addition of CCS (Carbon Capture and Storage) technology is likely to raise operating costs substantially.

• Impact of China’s quest for net zero: China is, in many ways, the factory of the world and this is even more pronounced in primary metals and materials. While many commentators have complained about China’s slow pace of change, one of the areas where China is starting to move quite fast is in the area of power-intensive industries. For many years China has been overproducing steel and aluminium, leading to huge exports of these products. Now China is clamping down on this overproduction, but the world has come to depend on low-cost Chinese exports. As China closes its domestic production plants, the world will need to replace this supply, either by re-opening mothballed production capacity or building more. Whichever it does, the new supply will almost-certainly be higher-cost than what it replaced, requiring higher selling prices. This is also likely to be an issue in smaller materials segments like REE and graphite where China is reigning in its domestic production. These are vital materials to the energy transition.

• Pass through effects in petrochemicals: Plastics are some of the most important materials in current usage. Petrochemically-derived materials are used in all elements of the global economy, in construction (pipes), in manufacturing (multiple applications) and in domestic consumption (manufactured goods, clothing, packaging). The key raw materials for petrochemicals are oil and gas. As I noted in the first blog in this series, I expect oil and gas prices to double at least, over the next 10 years. Given that petrochemicals is a margin business, that’s not great news for petrochemical and downstream product prices.

One important point to make here is regarding the circular economy. Many commentators suggest that recycling could replace significant primary raw material requirements. How effective recycling could be at replacing raw materials output varies by industry. In some industries, lithium-ion batteries for example, materials can be 90% recycled. In others, recycling availability may only be of the order of 20%. In all industries, it generally costs more to utilise secondary material. I’m a big fan of recycling but readers should be aware that it’s not the panacea that many people make it out to be. Products derived from recycled materials are almost all more expensive than those derived from primary sources of materials.

Bottom line: The over-riding takeaway is that there will be significant increases in the cost of producing, and hence selling prices, of primary materials production, which will pass through the manufacturing chain and affect both industry and the consumer. Some of this impact may be soaked up by industry, but a large proportion of it is likely to be passed on to the consumer over time through higher product prices.

Structural inflation throughout the 2020s

Perhaps reading each successive point in this blog has felt like the steady drip, drip, drip of water torture. Maybe that’s to do with my writing style as much as the views I’ve presented!

I’ve constructed this article to emphasise the substantial number of drivers of high inflation associated with the Energy Transition. Any one of these drivers, taken separately, would likely contribute to inflationary moves. But when you consider all of them, I hope you can see that inflation, and significant inflationary pressure, is likely to be a major consequence of the energy transition.

And it’s certainly not transitory, as many commentators and politicians are suggesting. In my view the inflationary impacts are likely to be long-term and structural.

Inflation has started at the raw materials end of the industrial complex, but it will cascade right through the economy over the next few years, and it’s not going away. There are a few easy wins that policy makers should be considering to mitigate the effects of the energy transition on inflation:

• End the moratorium on oil and gas exploration. While environmentalists will feel this is a move in the wrong direction, I can’t help but feel that many of the people pushing for this don’t fully understand its true implications. They don’t want hydrocarbon production to grow, and I fully support that. But I don’t believe that they understand the real implications of the moratorium on exploration. I truly believe that the world must decarbonise but, in my view, the entire energy transition is at risk if oil and gas prices rise by multiples over the next 10 years, as looks likely. The impact of this, on its own, has the potential to push hundreds of millions of people worldwide below the poverty line.

• Stop blocking, and in fact make it easier to build, new mining projects in base and energy materials. I understand a wish to keep the mining industry as clean as possible. But the number of major new projects that are being blocked at the moment by environmental campaigners and unsupportive planning regulations is extremely substantial. If we don’t get these new copper, lithium, nickel, manganese etc operations then there will be no energy transition. It’s as easy as that. I already believe that it will be extremely difficult to hit even 2030-35 governmental targets for EV sales based on the new metals capacity that can be built.

Build strategic reserves of key materials and resources. One of the reasons for the run up in gas prices is that storage has been at historic lows. Just where I live, I know of at least three gas storage sites which have been knocked down and converted into housing in the last five years. They haven’t been replaced. China and the US have built strategic reserves of oil for emergencies, both of these and Japan are looking into building strategic reserves of critical metals. It’s time that other governments adopted this tactic. And nowhere is this more necessary than in gas, which looks like being the key energy source for emergencies during this transition period. When Renewables don’t work, the world turns to gas. Strategic reserves will help to minimise price rises and volatility for key materials.

Lower raw materials prices will have substantial implications for the global economy. Lower battery materials prices will allow EV prices to fall, removing EV costs as a driver of inflation; a more balanced supply/demand environment for oil and gas will remove power prices as a driver of inflation and both will lower cost pass through effects into the wider economy. While huge infrastructure build out is needed for Renewables, even it will be cheaper if input costs are lower.

While primary industries are not loved by environmentalists (and, as a result, by governments) they really are the key to getting the Energy Transition back on track. Absent large-scale investment in metals supply, and some investment in oil and gas exploration to keep production from declining too far too fast, the next 10 years is set to be a rapidly inflationary period for the world’s economy.

A discussion of the social impacts of this inflation is outside the scope of this article, but suffice it to say that, in my view, if something is not done rapidly at the policy level about the causes of inflation, then the social impacts of such an extended period of high inflation will be extremely detrimental globally. The wealth gap is already huge in today’s world. I can only see it getting larger if inflation remains at elevated levels over the longer term. Hundreds of millions of people are at risk.

Matt Fernley is Editor of Battery Materials Review and Head of Research for Westbeck Capital’s Volta Energy Transition Fund.


Topics

Aluminium Batteries Battery Materials Capex Cement CPI Credit Decarbonisation Distribution Energy Transition ESS EVs Gas Graphite Inflation Infrastructure Leasing Lithium Materials Nickel Oil Petrochemicals Power PPI Renewables Solar Steel Transmission Wind