Catastrophic prediction for the Australian economy

Rising energy costs are so ‘ruinous’ it could see Australia plunge into recession before Christmas. There is, however, a simple solution.

Mining and extractive industries like oil and gas often say they are “saving Australia”. So their argument goes, when commodity prices are high, Australia can prosper no matter what happens elsewhere.

However, that has always been only half the argument, as commodity prices often fall, and when they do, extractive industries drag Australia down.

But what happens when commodity prices are so high that they are actually hurting Australia? And what is the appropriate response when these high prices are driven by human suffering such as war?

These are the crucial questions facing the Albanian government in the first days of office. Australian gas and coal miners impose economically ruinous international prices on the local economy due to the Ukrainian War and, if nothing is done soon, all Australians east of Western Australia will become impoverished much faster.

WA is OK because it has a domestic gas reservation policy, so its local price is less than 6 gigajoules (Gj).

The energy shock

Australian gas prices are traditionally around $3 Gj. Yesterday they hit $382 Gj for a brief period as the wholesale market failed. We are now see gas regulator set prices in other states at $40Gj.

These prices are much higher than the price we charge our export customers for the same gas, because the gas export cartel of Shell, Origin, Santos, Woodside and Exxon sent so much gas overseas that Australia is starved and cheated.

Gas plays an important role in setting the price of electricity in parts of Australia, particularly Victoria and South Australia. So these prices also go completely bananas.

Coal plays a larger role in New South Wales and Queensland, but coal and gas are interchangeable in the stationary electric fuel market, so follow each other’s prices. Coal traditionally costs $100 per ton. It is now $500 a ton.

In short, Australia’s east coast energy markets are collapsing and they could crush the economy.

Demand destruction for businesses

As things stand, gas bills could go up 500-1000%. It would wipe out what’s left of Australian manufacturing. Anything over about $7 Gj will reduce Australia’s industrial base.

The Albanian government has a mandate to repair manufacturing due to the fragility exposed by China and the pandemic in recent years. We will see the opposite as the post-2014 trend shutdown of industrial gas users accelerates dramatically:

Add to that rising coal prices and this effect on electricity prices, and we have a scenario where every East Coast business will see its energy bill increase by 100-200% over the next two years. If that happens, entire swaths will shut down, laying off workers and reducing investment.

Destruction of demand for households

Utility bills are only 3% of the CPI, but if they double or triple there is a corresponding income shock for every household east of WA. In fact, this is a reduction in real wages of 4 to 6% over the next two years.

This will come straight out of discretionary spending budgets and hammer the entire consumer sector, which accounts for 55% of GDP. Basically, that’s a hit of $20 billion to $33 billion in spending per year and double that in the second year.

This will break the growth.

CPI crisis, rate hikes and housing price crash

That’s right, 3%. 100 CPI is not much. But if that price doubles or triples, that’s gigantic. The RBA will have…wait…an additional 4-6% of inflation over the next two years to deal with.

But that’s not even the worst. Every business east of WA will have to pass on the new cost. So the 60% of the economy that is not tradable will add another 1.5-1.8% to the CPI each year. Negotiable can add it too. A total of 7.5 to 9.8% more inflation over two years.

This will lead to the runaway interest rates that futures markets were anticipating as the RBA is forced to tighten enough to “make room” for an economically empty, war-benefiting price shock.

A collapse in real estate prices would ensue, which, in turn, would crater the banking system. This would drive the Aussie dollar to the moon amid a recession triggering even more bottoms.

Fiscal demolition and inequitable distribution

The federal budget would be hammered on several fronts.

First, a recession would reduce income and dramatically increase spending.

Second, interest rate payments on the huge national debt would skyrocket.

Third, the poorer you are, the higher the proportion of utility bills in your spending. Much greater compensation would therefore be paid to low-income households.

Fourth, there would be some benefit in making profits from coal, but the gas cartel pays no taxes. So, incredibly, there is no benefit to be had from its increased export earnings.

What should the Albanian government do?

The war in Ukraine does not appear to be ending anytime soon, and the Russian sanctions regime that impedes the flow of gas and coal to Europe is virtually permanent. The European embargo on Russian coal does not even begin until August.

Gas and coal prices will eventually fall as global supply adjusts and investment in renewables soars, but not fast enough to prevent the aforementioned economic disaster for Australia. At the moment, the European war is the marginal price driver for global gas and coal prices.

The answer is simple for Australian gas prices. Retaining greater volumes of gas from export markets for Australia’s east coast economy does not even require political innovation or political risk. It is already bipartisan.

The Coalition created the Australian Domestic Gas Security Mechanism (ADGSM) in 2017. At the time of writing, gas prices have crashed from 20 Gj to 10 Gj. And that was only realized when Prime Minister Malcolm Turnbull threatened to trigger the deal chiefs.

All Anthony Albanese has to do is trigger the ADGSM and call the gas cartel leaders for a polite chat in which he clarifies that the local gas price will fall below 10 Gj in the near future or that it will trigger the ADGSM, as well as harden it with explicit price targets if necessary.

WA already has this policy and has a gas price of $5.50 Gj.

For coal, the answer is similar although a little more complex because the market is more fragmented.

A domestic coal security mechanism could apply a 100% levy on all domestic sales above $100 a ton. To encourage compliance, $20 per tonne of this royalty is returned to mines that meet the sale price criteria.

The fact is, there are many ways to lower energy prices. It is only a question of political will to fight against the profiteers of war.

If this courage fails the Albanian government, the entire economy of eastern Australia could fall into recession before the end of the year.

David Llewellyn-Smith is chief strategist at MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economics editor of The Diplomat, Asia-Pacific’s leading geopolitical and economic portal. He is co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review. MB Fund is underweight Australian iron ore mines.

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