The Cure for High Prices? ... High Prices

October 14, 2021

Sources: Bloomberg and World Bank Group Sources: Bloomberg and World Bank Group

Throughout 2021, the world has experienced shortages in the supply of everything from semiconductors to truckers to commodities like lumber and natural gas. These shortages have resulted in consumers and companies trying to make increased purchases to ensure they have the supplies and parts they need. Bottlenecks are forming — for example, auto production has been curtailed because of a shortage of semiconductor parts. Couple these phenomena with the lower capital investment in 2020 due to the global pandemic and we have an environment with the potential for significant inflation — transitory or even longer-lasting.

The basic raw materials and commodities that feed into many of the world’s value chains have seen a serious spike in recent weeks. In this week’s chart, we can see how natural gas prices in both Europe and the U.S. have ratcheted higher. According to the World Bank Group, the price of natural gas is up almost 300% in Europe from the start of the year and about 100% in the U.S. These materially higher prices have increased not only the cost of power but the cost of plastics, fertilizers and fabrics, among many other products around the world.

Recently, some observers have been fanning fears about a shortage in supplies of natural gas or oil. The fear is that energy companies have found new religion as a result of the significantly lower commodity prices last year. They seemingly have underinvested relative to the increased global demand. Moreover, this spike in natural gas prices is happening during the “shoulder months” in the U.S. and Europe, when demand is usually the lowest (from more mild weather).

These energy companies have been running with a focus on returns on capital invested and generating free cash flow — as opposed to prior years when volume growth was the main priority. When will the higher prices deter some demand and help bring the supply/demand relationship back into balance? Or perhaps the higher commodity prices will allow energy companies to spend higher levels of capital investment to increase production to match the increased demand. Maybe it will be a combination of both scenarios — only time will tell. The real questions are: How long will these prices stay elevated and how much inflation will be long-lasting?

Key Takeaway    

There is no denying that many prices around the world have been increasing. Look at the price of gas, food, used cars and even homes, and it is apparent that costs are higher. As anyone who has had to order an appliance for their house or toilet paper during the pandemic can tell you, delays and shortages are real. Commodity prices can be volatile, but they are not going to rise indefinitely. As they say, the cure for high prices is … high prices.      

What we know is that as raw material costs continue to escalate, producers will eventually increase production. At the same time, consumers will be feeling the higher costs as they are passed through the value chain, and demand will diminish. Eventually, the supply will exceed the demand and prices will move lower again.

What we do not know is when we will hit that inflection point and how much higher prices will go. In the meantime, natural gas and other energy producers should have some nice tailwinds in the intermediate term. It will be interesting to see if capital will continue to flow back to the energy industry. Watch for companies across industries that are able to maintain or expand margins and sales volumes during this period of rising costs. Those select companies that have the pricing power and/or ability to manage costs are well positioned to see their enterprise values grow.

Tags: Inflation | COVID-19 pandemic | Commodity prices | Natural gas | Supply shortage | Energy producers

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