Have high prices already cured high prices?

We all know that the effects of the Ukraine war are, due to our gas and thermal coal exports, finding their way into customers’ bills for east-coast Australian gas and electricity. Commentary on electricity pricing became a major political storm when the Albanese Government’s first budget forecast electricity price increases of 20 per cent and 30 per cent for the current and next financial years.  Calls for knee-jerk market interventions, which are far easier said than done, started immediately. Market intervention, if attempted, run the risk of many unintended consequences.

A huge challenge for governments considering intervention in wholesale markets is that consumer prices lag many months, if not years, behind wholesale spot and forward prices. Customers are only just starting to feel the effects of events that happened some time ago.

But after a year of relentless rises in wholesale prices, there may now be some good customer news in the pipeline (if you’ll excuse the pun). Gas, coal and electricity prices across the world, and in Australia, have taken a major correction downwards in the last two months from historically high levels, a trend that could well continue. Regardless of your view on the merits of intervention, it seems the time for it is now behind us, and the best thing now would be to wait and watch how this correction pans out.

We take a brief look at the correction and its drivers below.

Gas Prices

Your author discussed the extreme circumstances facing European gas supply observed during a recent visit to Germany.  However, that was in early September at the time of the inexplicable sabotage of the Nordstream pipelines, and remarkable as the situation then was, the improvements since have also been remarkable.

Europe has been extraordinarily successful in preparing itself for the coming winter, with gas storages now sitting at an unprecedented 95 per cent full, exceeding the 80 per cent European Union target set at the start of the crisis. See figure 1. This is thanks to:

• Government mandates;
• Demand reductions due to both price and government requests;
• The market responding to the risk of even higher prices in the winter by storing summer gas; and
• A very mild European autumn, i.e. some much needed good luck.

Figure 1: European Gas Storage Stocks

Source: The Economist

The realisation that things are not as bad as feared has quickly emerged in European gas wholesale markets, which have taken an extraordinary tumble as shown in Figure 2. European spot gas has even traded below AUD$15/GJ in recent days and at one time below zero when Liquified Natural Gas (LNG) transporting ships were struggling to offload their cargoes into a full network.

The old cliché that “the best antidote to high prices are high prices” may well be coming into play.

Figure 2: European and Eastern Australian Gas Spot Prices

Source: Trading Economics (Natural Gas EU Dutch TTF), Neo_Express analysis of AEMO data

Australian East-coast Gas Markets

Since the winter crisis that caused east coast gas markets to trigger statutory caps, spot markets for Australian gas have eased considerably as seen in figure 2. Whilst the government will claim some credit through the pressure it has brought to bear on exporters, more mundane facts come to bear. The Australian Energy Market Operator (AEMO) noted this began in August, as milder domestic demand conditions and LNG plants reaching their export capacity resulted in the domestic price separating from the world price.

International Coal Markets

The world thermal coal price is potentially as important to Australian east coast electricity prices as the gas price. This has also been falling in parallel with international gas prices as shown in figure 3 below. There are many reasons that might be behind this.

Firstly, there is a degree of fungibility between black coal and LNG as electricity utilities can often switch between the fuels. Secondly, the world economic outlook is looking weak, particularly in China, by far the largest coal consumer globally. Thirdly, coal is abundant and options exist to relatively quickly increase supply in response to the recent high prices. This includes Australian miners who are recovering from the wet weather problems that affected them early in 2022.

Figure 3: Newcastle Coal Price in USD$/tonne

Source: Trading Economics (Coal)

Australian Electricity Futures Contracts

The first places to observe a turn in local market sentiment is in the price of futures, which are traded by the people whose job it is to know about the future, or at least the forces of today that are likely to play out in the spot markets of the future. After months of raging bulls, the bears have taken over and on 31 October, the market experienced the greatest single day fall in its history.

The most dramatic falls have occurred since the federal budget, on 25 October, but this seems a co-incidence. Traders will be more focused on the underlying supply and demand conditions for energy, particularly internationally.

Figure 4: Victorian Electricity Calendar 2023 Futures Contracts

Source: Global-Roam analysis of Australian Stock Exchange (ASX)

Interventions

Since the budget, the media run article after article proposing various interventions in Australian east coast energy markets. Often not fully thought through, these typically either take the form of:

• A kind of “windfall tax” on producers who are assumed to be making above normal profits being returned as cash subsidies to consumers. Whilst superficially economically attractive, it is exceedingly difficult to identify who is truly winning or losing from high prices at any time, with most energy being traded under long-term arrangements. And all parties have an incentive to represent or restructure their circumstances to optimise their position around such a tax and subsidy.
• A form of “price cap”. Gas and coal are bilaterally traded and so this is not simply a matter of adjusting some kind of market rule. For example, a law that limits the price of bilateral contracts would lead to shortfalls and “black markets” where desperate buyers and sellers seek to circumvent the law. More likely government would seek to divert fuel destined for export into the domestic market until domestic prices were observed to fall to some kind of target range. This, however, creates sovereign risk concerns regarding impact on existing agreements with international customers.

As can be seen, no approach is straightforward nor without negative consequences, so governments should intervene with great trepidation. Treasury Secretary Stephen Kennedy’s opening statement to Senate Estimates on 8 November recognised these concerns but nevertheless suggested that:

“…in the current circumstances….interventions that address the higher domestic thermal coal and gas prices are likely to be optimal”.

However, he then also noted:

“Given the hopefully temporary nature of the energy shock, measures to address the price increases should also be temporary and regularly reviewed. Even if the war in Ukraine persists, global supply and demand will adjust over time.”

It would appear from the very recent direction of movement of international and local commodities that the “current circumstances” being referred to by Dr Kennedy may be already, or very soon, behind us. If so, it could be a great relief for all parties in averting his call for a very problematic intervention. Certainly, the government should not take any irreversible decisions whilst markets are moving favourably.