Investment Insight | Polar Vortex is coming

The Polar Vortex is a large area of low pressure and cold air around the Earth's North Pole. It's a long-documented weather pattern that typically goes unnoticed by those of us not living in the Arctic Circle, except for when occasionally the air pressure and winds shift.

In this Investment Insight, we talk weather. We discuss why climate change induced weather events are having a direct impact on increasing energy costs. Finally, we explain how weather will influence the returns generated by positions we hold in natural gas and heating oil.

What is a Polar Vortex event?

When stable, the Polar Vortex remains closer to the North Pole, constrained by a strong polar jet stream which keeps the cold air from moving into the mid-latitude continents below i.e., Europe, United States, China (the 'Continents').

The polar jet stream is sustained by a temperature difference between the Continents and the polar region. When the temperature difference across the jet stream is large, it tends to be strong and keeps the Polar Vortex stable. But when the temperature difference is small, the jet stream tends to be weaker and more susceptible to twisting and curving, firing cold air into the Continents.

The Polar Vortex has become more extreme

The increase in global temperatures is warming the higher latitudes such as the Arctic and reducing the temperature difference between the Continents and polar regions.

This reduction in temperature difference weakens and destabilises the polar jet stream, sending polar air further south. Think of a blender in the sky that's not turning fast enough, and all the contents pour out. This is essentially what a Polar Vortex breaking off looks like.

Continued warmer weather caused by climate change will further weaken the polar jet stream, bringing rise to more extreme and unusual weather patterns. It also explains why we get colder weather with global warming, as much as that sounds counterintuitive.

Natural gas

Our research and analysis of the weather, partnering alongside global experts in Polar Vortex weather systems, is forecasting a colder than average winter.

The tight natural gas supply and demand dynamic outlined in Investment Insight | 17 September 2021 | The natural gas price squeeze means a colder than normal Northern Hemisphere winter will cause gas prices to increase further.

NZ Funds' positioning

European gas prices are already at record highs, up over 300% this year. United States gas prices have the potential to follow suit. This could have negative consequences for inflation, economic growth and share market returns. By investing in natural gas in clients' Growth and Inflation Categories, we can mitigate some of these risks while continuing to grow clients' capital.

What could bring the heat out of the market in the short term? One possibility is substitution, which has begun to happen in some places. Europe is burning more coal than this time last year. Some power plants in Pakistan and Bangladesh switched to oil from LNG. Another possibility is an increase in gas supply from Russia. But Russia is already running near maximum production and there are limitations on how much gas can be transported into Europe. A final possibility is that warmer weather reduces the demand for gas. But meteorologists are already forecasting a cold winter. Gas prices are unlikely to come down to earth soon.

Why Natural Gas?

Natural Gas is one of the mainstays of global energy. Where it replaces more polluting fuels, it improves air quality and limits emissions of carbon dioxide. Since 2010, coal-to-gas switching has saved around 500 million tonnes of CO2 - an effect equivalent to putting an extra 200 million electric vehicles running on zero-carbon electricity on the road over the same period.

In China for example, 60% of power is generated by coal, but environmentally friendly policies such as replacing coal-burning boilers with gas ones has meant more reliance on natural gas. In the first half of the year, gas generation grew quicker than coal or hydropower.

Intelligent investment approach

In Investment Insight | 28 May 2021 | Be patient, trust the process we highlighted the challenge for investors is how to rethink the traditional 60/40 portfolio (60% growth assets and 40% income assets), and specifically how to maintain diversification.

We believe bonds and shares still have a critical role to play in portfolios, but strategies require a global reach and must be liquid and flexible enough to reflect the investment regime. Why? Because bonds and shares alone are not going to generate the returns investors have become accustomed to over the past 10 years. For example, in last week's Investment Insight | 15 October 2021 | Interest rate risks we highlighted the negative returns generated by traditionally stable bond indices this year.

The investment regime is changing, inflation is firmly part of the economic outlook and interest rates are volatile and increasing. As an active manager we search for opportunities that protect portfolios against the risks of a change in investment regime, in this case higher inflation and interest rates. Furthermore, we seek opportunities to continue to grow and compound returns even when the traditional asset classes are under pressure.

Source: Bloomberg, NZ Funds research.
For more information please contact NZ Funds.

This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.

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James Grigor is Chief Investment Officer for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. James' comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.

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