This is Fine - European Industry Edition

A disclosure:

No one seems to believe me when I talk about this scenario in polite society. Bankers, analysts, politicians, journalists... everyone thinks me a worrier as I lay words to page. However, I am starting to feel a little more like Cassandra.

The Setup

As we all have been able to observe, the world currently has an energy supply problem.

For reasons too complicated to get into, which might form the basis of a future piece, the price of natural gas and energy is at a record high. At pixel, the price of natural gas is 9.28 USD per MMBtu (Henry Hub Index).

Some countries benefit a lot from this (Qatar for example), but most countries find this state of affairs distasteful.

No one more so than the constituent countries of the European Union, who have made natural gas a core constituent of their energy mix and are utterly dependent on imports. In fact, the EU's import energy dependency stood at 57.5% in 2020. That is why the price of gas in Europe is around 50 USD per MMBtu (TTF index)

The EU is therefore shifting its production of energy away from gas and towards coal and oil to allow them to fill those precious tanks before winter falls and consumption increases. In that regard, its efforts have been broadly successful in conserving gas:

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However, because everyone around the world needs energy, and there isn't enough to go around, the price for electricity as a whole is going through the roof. This is because all alternatives to natural gas have also seen their price multiply, even allowing for the logistics of transporting it all to Europe. France has already re-nationalised its electricity giant EDF a few months ago because it was forced to internalise electricity costs. Germany's own Uniper is being bailed out for similar reasons. And who can blame them when electricity prices in France looks like this:

And this chart might already be out of date, with the baseload contracts out a few months showing upwards of EUR 1,000 per MWh.

Usually, when charts go vertical like this one dear viewers, it tends to come back soon enough.

But what if this one does not? What if this situation lasts long enough?

This isn't only a problem of natural gas availability. France's nuclear production is set to decrease 20% because of maintenance (its a big problem), and Germany still refuses to extend its own nuclear operations.

The Rub

Imagine for a second that you are the president of a populous, industry-heavy country like Germany, Italy or France.

You are capable of internalising some costs for energy imports, even with prices at all time record highs. However, eventually, your finance minister will say that there is such a thing as the semblance of fiscal responsibility and the bill for doing so would be too high for the budget to handle. Some countries like Germany can afford it but Italy is on a shoestring budget, constrained by the EU rules on fiscal austerity it has been operating under for the past few decades.

Furthermore, pumping infinite amount of money is not really the answer to high energy prices, in the same way that fiscal relief for consumers only drives inflation higher, the only solution is fundamentally either increased production and shipping, or reduce energy use.

The former is out of your hands, so you will concentrate on the later.

You will do the usual things on the household side for energy savings: a campaign to turn off the lights, a plea to use less AC... but fundamentally these help very little. Consumers will have to cook food and stay warm during the winter, and no politician wants to see consumers be uncomfortable in freezing homes or deprive themselves of creature comforts... especially not when there are elections to win.

So who is left that can be made to reduce national energy consumption, whilst not losing any votes and delaying financial pain?
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Simple: Industry

^Industry

Industry in the EU consumes upwards of a quarter of all energy. Taken with the share of transport directly link to industrial activity, it might be substantially greater.

One thing to remember is that bad things happen when a national grid comes under pressure and demand outstrips supply. Having a 5% electricity deficit does not result in the lights being 5% dimmer or machines going 5% slower: things just stop. Chronic blackouts and brownouts will wreak havoc on the grid, and real damage can accompany them.

The same is true of manufacturing and industrial plants. Reduce power supply past a certain threshold and things just stop, entailing occasionally substantial restart cost.

So in order to solve things, the government will start by asking industrial players to cut gas consumption by 15% (thats already in the works).

If that doesn't work, rationing will start for the more energy/gas intensive industries (India is doing that already)

If that is still not enough, the next step will be compulsory shutdown for Industry (China is ahead of us)

Price Induced Destruction

However, we do not need government mandated shutdown to imaging a comprehensive collapse in industrial production. The invisible hand of the market is fully capable of handling it itself.

With energy/electricity prices increasing as they are , the unit economics for a lot of industry and manufacturing will quickly turn negative.

In other words, it is cheaper for them to do nothing, rather than produce. Electricity costs for high energy consuming businesses (like aluminium, or heavy industry) is upwards of 4% of revenue in ordinary times. If that goes up 10x, as the price of spot electricity has, it would become 40%. These businesses rarely operate at better than low double digit profit margins. No one would be profitable, and there is only so much costs can be passed on to customers.

This does not only affect big, energy intensive groups. We are seeing stories of SME's with bills up 8x over the same period last year. European SME's already battered by the pandemic and uneven access to fiscal support, will be in for another period of pain.

Consequences

So what would the consequences be? Well, the destruction in energy demand via unbearable input costs and government mandates will eventually reduce energy prices at some equilibrium level. But this will still entail a substantial industrial slowdown which might morph into a collapse if it perdures.

The government will then either bailout industry via direct subsidy, or by paying for energy itself and pass on the savings. In either case, there will be some winners and a lot of losers. If it does not do so, we are looking at enormous pain in a vital economic sector that has already been humbled by the demand destruction of the pandemic and supply chain havoc.

Beyond the effect on the Industrial sector, we will see further macroeconomic ramifications. This cycle will keep up inflationary trends because of supply destructions, which will pressure the central banks to keep hiking rates in the middle of a strong recessionary impulse. This might be bearable in the US, but Europe has its own problems in the area of monetary/fiscal policy and no one wants to utter the words "Euro-crisis Part 2". Whatever the response, GDP is certain to take a beating.

Once again, the "Old World" is showing self inflicted wounds. In the words of Leopardi:

"O patria mia,
vedo le mura e gli archi
E le colonne e i simulacri
e l'erme Torri degli avi nostri,
Ma la gloria non vedo"