From the Editor: Stagflation will limit LNG market diversification [Gas In Transition]

The World Bank published its Global Economic Prospects in June and it makes grim reading. Stagflation is prominent on the menu, an unwelcome combination of low growth and high inflation not seen since the 1970s.

Already, the bank expects global economic growth to slump this year. While 2021 saw a post-pandemic bounce to 5.7%, this year’s global GDP forecast has been slashed from 4.1%, a forecast made in January before Russia’s invasion of Ukraine, to just 2.9%.

The reduction predominantly reflects the surge in food and energy prices triggered by the war and the need to raise interest rates to contain inflation.

Moreover, while economic forecasts usually exhibit a reversion to trend, growth in 2023 is also forecast to remain low at just 3.0%. While 3.0% does not sound that bad in a developed country context, growth at this level globally is pretty much recessionary territory.

And while growth slows, inflation has re-emerged. Aggregate inflation in emerging and developing economies has reached over 9.4%, its highest level since 2008, while inflation in advanced economies, at 6.9%, is the highest since 1982, the bank says. The energy component of global consumer price inflation has risen sharply and is at its highest level since the early 1980s.

Slow growth and high prices are not a combination likely to encourage the growth of LNG import markets. For the next few years at least, LNG consumption looks like being a rich-country pursuit, with potential new market entrants falling back on existing assets – coal and oil-fired generation – and/or pursuing renewable alternatives, so far as investment conditions allow.

All fossil fuels are expensive

Although the bank finds both strong parallels and differences with the stagflation of the 1970s, a singular characteristic of the current oil price shock is that it is not confined to oil.

Coal and gas prices are also high, reducing the ability to substitute cheaper fuels for oil, and increasing the likelihood that renewable energy will attract investment, even if raw materials prices are proving inflationary in this sector as well.

In nominal terms, oil, gas and coal have all reached historic highs. But, in real terms, only the European natural gas price has reached an all-time high, substantially above its peak in 2008. Coal prices are close to their 2008 peak, while oil prices remain some way below, according to the bank’s analysis. The good news is that renewable energy remains competitive, despite supply-side inflation of its own, because of the relative rise in fossil fuel prices.

Energy prices are forecast to rise 52% in 2022, 47 percentage points higher than the bank’s previous projection. Oil prices are expected to moderate in 2023 as production increases, but they will remain much higher than previously forecast and well above the average of the last five years.

The report is clear about the economic consequences. High energy prices will reduce real disposable incomes, raise production costs, tighten financial conditions and constrain policy options. The bank suggests that the war-driven surge in energy prices will reduce global output by 0.8% after two years.

Emerging market risk

The impact will hit the poorest hardest. The bank observes that constrained gas supply will have a big impact on fertiliser production and electricity generation in poorer countries. High natural gas prices have pushed fertiliser prices to their highest level since 2010.  

Consumers in emerging and developing economies spend proportionately more of their incomes on food and energy, which means that high prices will weigh particularly heavily on consumption in these countries. Higher food prices are expected to result in an increase of 75mn people in extreme poverty by the end of this year relative to pre-pandemic projections, the bank estimates.

Stagflation is hard to reverse and the cure can be as bad as the disease. The first port of call is to increase interest rates in order to bring inflation under control. However, this increases debt servicing burdens and dampens growth. The bank observes that the interest rate increases needed to control inflation in the 1970s were so steep that they triggered a global recession, “along with a string of debt crises in developing economies, ushering in a ‘lost decade’ in some of them.”

According to the report, debt was already on an unsustainable path for many emerging and developing economies before Russia’s invasion of Ukraine, and fiscal sustainability is likely to be eroded further by weaker growth prospects and higher borrowing costs. External public debt in developing economies is at record levels. As financing conditions tighten and currencies depreciate, the bank sees debt distress spreading from low-income countries to middle-income countries.

The report says the risks for emerging and developing economies are tilted to the downside and include intensifying geopolitical tensions, rising inflation and food shortages, financial stress, rising borrowing costs, renewed outbreaks of COVID-19 and disruptions from disasters.

War to blame

The impact of Russia’s invasion of Ukraine has been to magnify pre-existing strains from the pandemic, such as bottlenecks in supply chains and significant increases in the price of many commodities, according to the report.

One of its key recommendations is the urgent need to “boost the supply of key food and energy commodities.” This is a huge challenge in the context of Russia’s invasion, owing to the massive disruption to agricultural exports and the shunning of Russian energy commodities.

However, it is also a clear indication that governments should support the expansion of gas production and export capacity to alleviate the shortages and high prices impacting both their own and developing economies.

Supply-side response

In the past, coal and gas have been the primary substitutes for oil, but today, as oil, coal and gas are all expensive and all are carbon-emitting fossil fuels, the primary substitution technologies are renewables. This substitution will take place, but it is more complex at the consumer end of the equation than switching between fossil fuels because of the necessary transformation from the consumption of energy as solid, liquid and gaseous fuels to electricity.

In the interim, transitional phase, there will also be a supply response, which can already be seen in the renewal of interest in LNG export capacity and upstream gas production more generally. The prospect of stagflation requires a supply-side response alongside demand reductions and substitution because in emerging market and developing economies, strong and stable growth is required to foster the investment needed to decarbonise their economies and this, in turn, requires affordable energy.

Gas prices, in particular, need to fall to stabilise fertiliser prices and other essential inputs which add to underlying inflation. And more gas is needed to reduce a reliance on coal and oil. Emphasising the importance of natural gas markets, the World Bank says “major production increases worldwide will be essential for breaking out of stagflation and restoring noninflationary growth.”