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Energy demand has long had a clear link with economic growth. Economic activity increases and demand for energy rises. At times of recession, demand for energy falls. It is this simple equation that has weighed on energy markets over the past few months. The world economy is struggling, therefore demand for energy is likely to slide.
In reality, the picture is far more nuanced. The global economy is undoubtedly weakening and that will put pressure on energy demand. However, this needs to be set against a longer-term upward trend in energy usage. Energy demand now sits above pre-pandemic levels, 2 having resumed its multi-decade trend in 2021. At the same time, European governments are seeking to stockpile energy resources (notably oil and gas), which is helping shore up demand.
However, the real support for energy prices is coming from the supply side. Supply remains constrained, not just from the war in Ukraine but also because of longer-term considerations. Energy companies have been wary on capital expenditure, given the uncertain rewards of bringing on new fossil fuel supply at a time of energy transition. While governments have eased restrictions on new supply, it will take time to bring it to reality.3
At the same time, any hope of a short-term supply boost from alternative sources, such as OPEC, appears optimistic. The consortium has agreed to a small rise in production, around 100,000 barrels a day. 4 However, it is still supplying around two million barrels a day less than in spring 2020. Attempts by oil-importing nations to increase supply have been rebuffed. 5
A shift in the energy mix
Against this backdrop, we continue to see a favourable supply/demand balance for energy in aggregate. However, the energy mix will, almost certainly change. In the short term, governments are looking for quick fixes to resolve the lack of supply from Russia. The Eurozone member states have committed to a 15% reduction in gas demand, 6 for example.
Germany and France have agreed an energy swap deal, which sees Germany provide France with electricity and France provide Germany with gas in the event of shortages. The EU is also planning a short-term boost for coal. In the UK, the incoming government of Liz Truss has granted new oil and gas exploration licences and lifted the moratorium on fracking for shale gas.6
In the longer term, governments are seeking greater energy independence, which will accelerate the move towards renewables. Europe’s €210bn package8 to reduce dependency on Russian fossil fuels will include a significant increase in solar and wind power investment. The European Commission is now targeting 45% of the energy mix from renewables by 2030.9 In the UK, Prime Minister Truss has said there will be investment in new sources of energy supply, including nuclear, wind and solar.6
A change in thinking
The Ukraine crisis has prompted a wider and more sober reappraisal of the realities of the energy transition by investors generally – and the role that fossil fuels need to play in the short term. BlackRock CEO Larry Fink stated in his 2020 annual letter to CEOs that “climate risk is investment risk”, observing that “with the impact of sustainability on investment returns increasing, we believe that sustainable investing is the strongest foundation for client portfolios going forward.”
This is certainly true, but he also added: “divesting from entire sectors – or simply passing carbon-intensive assets from public markets to private markets – will not get the world to net zero”. In it, he makes the point that “companies must ensure that people continue to have access to reliable and affordable energy sources. This is the only way we will create a green economy that is fair, just and avoids societal discord. Any plan that focuses solely on limiting supply and fails to address demand for hydrocarbons will drive up energy prices for those who can least afford it, resulting in greater polarisation around climate change and eroding progress”.
The Ukraine crisis has exposed the complexities of the way the world sources and uses energy. This is why we believe it is so important to have exposure to the energy sector in its entirely and to be able to allocate flexibly between different segments. Demand remains intact and supply constrained, but the world’s energy mix will remain in constant flux. It is precisely this uncertainty that requires a fully flexible approach to the energy transition which underpins the changes we made in the Trust’s holdings in 2020 to incorporate the full spectrum of old and new energy.
1 Refinitiv, 31 Sept 2022
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