There are perils to intervention, even with the best intentions

Looking at the profits of energy companies over the last year and listening to the opinions of voters has tempted some politicians to intervene in the energy markets. While it is usually done with the best intentions, it’s a temptation that should probably have been resisted as far as possible. Short-term political expediency does not often translate into long-term economic coherence, suggests Kay Rieck, an experienced market observer and investor.

Intervening in a free market is sometimes necessary but it should be done as delicately as possible.

The biggest problem with intervention, even when it is done with the right intentions, is that no matter how clever the theory or comprehensive the model, it is impossible to take the law of unintended consequences into account. One need only look at various domestic energy markets over the last year or so to see that fact writ large.

The seduction of cheap energy

First, some context. Even before Russia’s tanks made their way over the border into Ukraine, changes in global weather patterns had been driving up the cost of energy globally. Winter 2020/21 was particularly cold in Europe, a dry summer in South America reduced the efficiency of hydropower, while a heatwave in North America drove people to using air conditioning more. All of which meant that natural gas storage was very low and different regions of the world were in a bidding war for gas.

Meanwhile, over the last decade or so, President Putin’s Russia has been increasingly bellicose, but at the same time western Europe has let itself be seduced by the cheap energy that Russia offered.

This has put western Europe into something of an energy predicament and complicated manoeuvrings since Russia began what it likes to euphemistically call its special operation at the end of February 2022. On the one hand, Europe and the West has tried to use as many political and economic tools as it has at its disposal to try and discourage Putin’s adventures. On the other they have been forced to continue paying Russia for natural gas. Imposing economic sanctions on Russia while spending billions buying its gas has not, politically, been a good look.

It’s not exactly been economically astute either. The price of natural gas was already high and subsequently rose precipitously, making it difficult to heat homes and forcing businesses of all kinds to rethink their investment plans, business models and, in plenty of cases, whether they can even afford to keep trading. And this is before people in Europe start needing to heat their homes to get through winter 2022/23.

The return of Harry Hindsight

It’s easy to point at the politicians from a decade ago and say that they should have seen this coming. Putin has never been quiet about his ambitions to restore Russia as a global political and economic superpower, but we have all benefited from an era of cheap power and low interest rates.

It’s very doubtful that anyone would have achieved re-election at any point in the last decade if they had campaigned on a platform of more expensive energy, even if, from the perspective of the end of 2022, they would have saved us all a lot of hardship if they had tried a little harder. I suggested in a previous article that Harry Hindsight is the best trader on the financial markets. He’s probably also the most, or perhaps even the only, effective politician.

So as winter tightens its grip on western Europe, we find ourselves in a position where most of the region’s governments have spent more than a year scrambling to ensure energy supplies while energy suppliers make what even the most impartial observer would say are eye-wateringly large profits.

Can’t make a Molotov cocktail without fossil fuel

Before we all man the hastily erected barricades outside the corporate head offices of the major oil and gas companies, there are a few points that are worth making.

Firstly, oil and gas companies are not directly responsible for the political and military situation in Ukraine. That honour belongs, in the main, to a handful of men (I’m willing to be proved wrong but it does appear to be predominantly men) who haunt the corridors of the Kremlin dreaming of historical glories from days gone by.

Secondly, oil and gas companies have come into this off the back of the various national lockdowns of 2020 and 2021, when the price of oil fell to historical lows. The point here is not that they had it tough two years ago and as a result deserve record profits this year, but they should take some credit for not approaching governments in search of handouts when the economic conditions were spectacularly bad.

Thirdly, the level of volatility in the political and economic situation means that there is a risk that if governments do become heavy handed and step in to redistribute some of the oil and gas companies’ profits, they could cause more damage that the returns are worth.

Let’s look at some of the interventions that have been attempted so far.

In the autumn of 2021, the Spanish government implemented some far reaching and very generous support for their people, helping them avoid the worst of the rising energy costs. Their intervention was so extensive that Spanish energy consumption is said to have actually risen during the summer of 2022 as voters took the opportunity of subsidised energy to run their air-conditioning units even more than usual. This did not help Spain enhance its energy reserves.

Meanwhile, the possibly well-meaning but certainly impressively short-lived Liz Truss government in the UK promised to provide energy support to the British public for the next two years. This was as spectacularly generous as it was economically incoherent given that not even Harry Hindsight knows where the energy market is going to be in two years. It created a risk that the British government could potentially find itself in a position of forcing its electorate to pay over the odds for its energy in six-months’ time if the political situation eased.

To highlight the weird interconnectedness of it all, it appears that the energy crisis has ended up being a positive for the Spanish tourist board. There are suggestions that a higher number of British people are heading to Spain for longer winter holidays that usual as they try to avoid the high cost of energy and overall inflation in the UK.

Obviously there have been other counties that have approached the energy markets with a little more finesse, but that’s rather the point. There is always a temptation for politicians to be seen as doing something big, when they, and the people that elect, them would be significantly better off if they did something effective.

The immutable and ironic law of unintended consequences

The bottom line is that governments really do not have a great deal of control over the energy markets. This means they really should be careful when making pronouncements about support packages and extremely cautious trying to implement windfall taxes.

The price of energy has eased in recent weeks, which has made the need for consumer support slightly less imperative. There are several reasons for the price easing, one of which is the wide discussion about how difficult the winter has the potential to be which has nudged consumers into constraining their energy consumption across most of Europe. The autumn has also been relatively benign from a weather perspective, which has meant that people have tended to reach for an extra jumper rather than turning on the heating in their homes.

The third and most ironic reason for the lower-than-expected volatility has come about because of China’s ongoing commitment to its zero Covid-19 policy. This has meant that regions of the country have still been going into and out of lockdown, which is constraining economic activity. This has lowered economic output which in turn has reduced demand for energy and eased pressure on the global energy markets.

This is all positive in the short-term, but autumn has now given way to winter in Europe so people are turning on their domestic heating. China is also starting to step back from its zero Covid policy. At a certain point it will remove the shackles completely, economic activity will start to increase and demand for energy will rise. When demand rises, prices tend to quickly follow.

It is difficult to know what the future holds for the energy markets, but what is abundantly clear is that governments need to be careful when they intervene. Intervention is not always a mistake, but it should only be done with extreme caution.