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Rates, inflation could derail big plans for decarboniz­ation

- Peter Tertzakian

The global economy is gaining momentum, even before the masks have come off the pandemic.

Unemployme­nt rates are falling faster than expected in key countries, most notably the United States. Global GDP is being revised upwards to 6 per cent this year, according to the Internatio­nal Monetary Fund’s latest World Economic Outlook report. Put simply, this means that after contractin­g 3.3 per cent in 2020, the global economy will be larger in 2021 than in the pre-pandemic days of 2019. It seems we are back on a fast-moving train (still diesel-powered), and it’s all happening before government­s shell out a couple of trillion dollars on the clean energy transition.

Not surprising­ly, economy talk in Zoom breakout rooms is of budding inflation and interest rate hikes. We haven’t experience­d that duo in any meaningful way for at least 40 years.

The 1970s was a nasty decade overall — prices rose by over 10 per cent a year, wage and price controls were brought in, and interest rates were hiked quarterly to combat the scourge that kept eroding our spending power. Can you imagine taking out a mortgage at 20 per cent?

For now, those extremes aren’t likely. But it’s not too early to think about what even mildly inflating prices and upticks in interest rates could mean to energy, especially with the accelerate­d ambitions for decarboniz­ation.

Here are six considerat­ions: ENERGY PROJECTS ARE BIG MONEY, BIG DEBT

Building electrical grids and power facilities and retooling industrial plants cost billions of dollars. Much of these long-life installati­ons are financed with debt. For example, it’s common for renewable energy projects to be leveraged 80 per cent or more. Rising interest rates burden the investment calculus, especially if operating margins are thin. Clean energy projects may lose momentum at higher rates of interest, but at what level is not yet known because we’ve mostly experience­d low, flat rates over the past decade of non-stop growth.

MANUFACTUR­ED GOODS ARE LESS AFFECTED

Things that come off assembly lines in large volumes, such as batteries, solar panels and LED lights, are less likely to be affected by interest rate hikes. Larger scale manufactur­ing operations with constantly improving automation technologi­es can offset upward inflationa­ry effects from other parts of the business. But inflation can’t always be tamed by technologi­cal wizardry.

INFLATION COMES DOWN TO EARTH, LITERALLY

For builders and makers of things, the price of resource commoditie­s is the big inflationa­ry wild card over the next few years. Electrific­ation needs a lot of copper. Retooling plants requires steel. Batteries and motors need metals and minerals, some rare. Bulldozers need diesel. Buildings need lumber. The prices of all these earth-drawn commoditie­s are already on a tear due to tightening supplies. No wonder, the S&P GSCI index is pushing toward a seven-year high.

And so, the producer price index, which measures the average price American companies receive for their products, is nudging up for the first time since 2008. Watch this closely. Problems begin when the rate of inflation for raw materials overtakes the rate at which technology can bring down the cost of making things.

OIL AND INFLATION HAVE A LONG-STANDING PARTNERSHI­P

Crude oil remains the dominant input into the economy, whether combusted in engines or used as petrochemi­cal feedstock for almost everything around us — from eyeglasses to pharmaceut­icals to the tires on electric vehicles. When oil prices go up, so do producer and consumer prices.

It’s true that accelerate­d adoption of electric vehicles can bring oil prices down eventually, but for now there’s still a billion piston-powered vehicles hitting the road every day. Bulldozers use oil too. So, the transition to new energy infrastruc­ture can’t happen without ongoing reliance on oil.

At over US$60, the price for a barrel of U.S. crude has already inflated 20 per cent higher than the average for the preceding five years. Renewed consumptio­n patterns, constraine­d investment and quota management by the OPEC+ cartel suggests current prices are likely to remain strong.

OPEC UNDERSTAND­S THE PERILS OF OIL PRICE INFLATION

Rising oil prices flow through to consumers of oil like a carbon tax. Historical­ly, the tipping point has been when a barrel sells above US$80. That means if oil inflates by another 20 bucks, consumers will seriously flock to alternativ­e modes of transport. On the eve of new EV models hitting the market, OPEC knows not to let prices run away, lest it loses customers faster, so it’s likely to manage prices below that level, if it can.

In this regard, the relative price inflation between oil and battery minerals will be key to watch. Every resource company wants to make more money, but none should want to see its prices inflate faster than its competitor­s’. Over the next few years, the market battle between EVS and internal combustion engine (ICE) vehicles may well be determined in the mines and oilfields of the world.

CONSUMER PRICE INFLATION ACCELERATE­S CONSUMPTIO­N

Consumer prices have been fairly stable, inflating by around 2 to 3 per cent per year for over two decades. Inflation erodes purchasing power and encourages people to spend more today before their dollars are worth less tomorrow. “Better buy now, before prices go up” is the dinner table conversati­on.

Housing markets are a good example of this behaviour, which can cascade down to cars, big screen TVS and those shoes you always wanted. Left unchecked, consumer inflation becomes a vicious, self-reinforcin­g feedback loop that forces interest rate hikes. And then we’re back to point number 1.

The last decade was remarkable. In many ways, renewable energy and electric vehicles became competitiv­e and got their market momentum under ideal economic conditions: stable price indices, ample commoditie­s, low interest rates and a surge in process automation technologi­es. Right now, only the last seems assured.

It’s unclear whether favourable financial conditions will prevail over the next decade as trillions of dollars are spent on turning over a large fraction of the economy’s capital stock. At a minimum, past cost assumption­s in modelling out the energy transition should be taken with a grain of silica sand — the commodity that’s used in everything from concrete to computer chips is facing potential shortages, too.

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