A sharp rise in natural gas prices since August has put upward pressure on a host of commodities, including coal, electricity, and oil, while squeezing margins for industrial users. Forced curtailment of industrial activities has contributed to higher prices for other commodities, such as base metals and ammonia, where output is being reduced to save natural gas.

Given existing supply bottlenecks in shipping and computer chips, the run-up in commodity prices has fed renewed concerns about inflation and a potential negative growth impulse from constrained industrial output and higher spending on heating bills. The International Monetary Fund in October trimmed its forecast for global growth, citing risks that include rising fuel costs and accelerating inflation. Unfortunately, energy-price volatility could persist in the coming months.

Gas market sparks next leg up across commodities

A confluence of one-off and structural factors has left global natural gas inventories on the low end of the historical range entering into winter and pushed prices higher.

Cold temperatures in Europe and Russia lasting through spring this year limited the typical seasonal buildup of gas inventories. Weather issues have also curbed wind and hydro power production, increasing the call on thermal generation, including natural gas.

Delayed maintenance due to COVID-19 and underinvestment in upstream production limited capacity utilization at global liquefied natural gas (LNG) facilities to levels not much above 2020, when low prices prompted output reductions.

Compounding problems, low natural gas inventories and strong internal demand within Russia, and that country’s preference for exports through the southern corridor, have contributed to a decline in northern European imports of Russian gas.

In addition, the exceptional growth over the past year in industrial production – and the resulting power needs – due to pandemic-related global demand for goods contributed to recent energy shortfalls.

Other commodities get into the party

Ripple effects can be felt across the commodity complex, with higher demand and prices for competing fuels. Coal supply had dwindled after years of underinvestment amid policies in China and elsewhere aimed at curbing pollution. With more coal now being utilized for power generation, carbon prices in Europe’s emissions trading system began to rally, as coal plants emit more carbon per megawatt hour (MWh) of output.

This spiral higher, with gas, carbon and coal rising in tandem, ultimately contributed further to higher oil prices, which had been rising already. Simply put, there was nowhere to hide in the energy chain.

Beyond the pocketbooks of global consumers, a key casualty has been industrial users that are either being rationed by state policy (e.g., China and India) or constrained by high prices (Europe).

Resiliency and redundancy are lacking

Recent events have exposed what we believe are key conditions in the energy system: 1) underinvestment broadly in the supply side after years of low prices, 2) reduced system flexibility, and 3) the interconnected nature of all energy markets, including the role carbon prices play in setting substitution points between markets.

Although OPEC+ – which includes OPEC members and several other oil exporters – does retain some spare capacity in oil, and Russia likely does in natural gas, spare capacity appears to be falling across the energy supply chain, likely leaving the market more vulnerable to weather or political disruptions. With investors demanding greater emphasis on positioning companies for brown-to-green energy transitions and higher return of capital, upstream investment at the same price level is notably lower than what would have been expected only two years ago.

While renewables and environmental policies have broadly had deflationary impacts over the past decade as solar and wind capacities have grown, the hollowing out of baseload generation (coal and nuclear) has left the demand side less responsive to price changes. As the world looks to electrify automobiles and residential heating and cooling, investment in baseload power and storage will be needed to increase redundancies to help with the intermittent nature of renewables.

Though we argue it is needed to address climate change and will motivate use of additional non-hydrocarbon energy sources, carbon pricing is a potential source of additional upside pricing pressure for commodities. We estimate the rise in carbon prices over the past year has raised the level at which natural gas prices motivate substitution to coal by 15 to 20 euros per MWh, a non-trivial amount given European gas traded at 15 euros only a year ago.

What’s next?

There are signs that the situation could be easing. Gas demand has weakened, consistent with fuel substitution and decreases in industrial demand. European storage is showing signs of improvement, as are global LNG exports. China is focusing on increasing coal supplies, which are exhibiting nascent gains.

Still, the post-COVID world looks to be marked with increased volatility, and investors might look to commodity markets to hedge inflation risks. We remain positively disposed to carbon prices broadly, for which commodities may also be useful as a tool to hedge this policy-induced inflation impulse.

For PIMCO’s latest Secular Outlook, please read “Age of Transformation.”

For more insights on inflation, please visit our Inflation page.

Greg E. Sharenow is a portfolio manager focusing on commodities and real assets and is a regular contributor to the PIMCO Blog.