Leestat/iStock via Getty Images
Leestat/iStock via Getty Images
The current high energy price environment in Europe risks becoming more or less permanent, given recent events that center around the Ukraine crisis. Europe's energy security challenges have their root in the 2014 confrontation over Ukraine. The EU severely misjudged its own natural gas import needs then. It figured that climate change initiatives will severely diminish natural gas demand. It also overestimated LNG availability, especially coming from America's shale boom. It switched from long-term contracts to spot contracts, believing that natural gas will continue to be in the buyer's market state for the foreseeable future. Russia was freed up to shift natural gas to other markets or for internal use as a result. Contrary to past expectations, EU demand for Russian gas increased about 25% in the 2014-2019 period. In response to further delays to the Nord Stream 2 pipeline, it seems Russia may have been nudged towards a final decision on the Power of Siberia 2 pipeline project. If it will be built, it will pit the EU and China against each other for gas from the same fields, with China probably favored as a customer by Russia, given closer relations. If this happens, the EU's energy crisis is set to become permanent, which will devastate its economy. Europe's petrochemical industry is likely to be the first victim, therefore investors should be aware of the more immediate risks. Russian assets are also likely to suffer a temporary downturn in their value if the Ukraine crisis intensifies, but there should be a swift recovery. Beyond its petrochemical industry, the entire economy of the EU is likely to suffer, therefore most companies with exposure to the EU consumer market are at risk of suffering a hit in coming years.
Europe's natural gas storage facilities that are meant to bridge the supply gap for the winter are currently over 600 Bcf short, which is a 23% shortfall compared with the five-year average.
It is important to understand that the current gap comes within the context of some industrial activities such as petrochemical plants, ceramic factories as well as a number of other industrial activities having been reduced for a number of months now. If it were not for the demand destruction that already took place year to date, the gap would be even larger.
Low spring inventories as well as a significant shortfall in wind and hydropower in some key producing parts of the EU played a major part in the current gap in natural gas inventories. This is the part that tends to be underplayed by most EU officials, as well as many national leaders, with the media doing its part to deflect from the issue. Russia's natural gas delivery policies received far more attention. On that front it gets complicated and it will get far more complicated going forward.
It is true that Russia mainly focused on fulfilling its contractual obligations this year. It has long-term delivery contracts, as well as minimum volume that it needs to send through Ukraine that it has to abide by. Russia is fulfilling those obligations. It is argued that it could do more, but it chooses not to, mostly because it wants to pressure the EU to start using the Nord Stream 2 pipeline which is complete, but not yet certified.
There may be something to that hypothesis, but there is also a lot more to it than that. Russia has increased deliveries to Turkey this year. It also sells a growing volume of gas in the form of LNG. It is also using ever more natural gas domestically, mostly in its own growing petrochemical industry. In fact, it is seeing record demand for natural gas this year from its domestic market. Given Russia's drive to add value to its gas by transforming it into products like fertilizer or other petrochemicals, we are likely to see further growth in Russia's domestic gas market, which means that less and less will be available for exports to Europe. On the other hand, there is no evidence to date that Europe's own natural gas demand levels are ready to reverse and start declining. At least not without some help from high prices which will destroy demand. It is unlikely therefore that we will see a flood of Russian gas into Europe that will close the inventory gap in 2022. In the absence of some really favorable weather next year, including high winds and warm winter weather, Europe will enter next year's heating season facing the same shortage dilemma it is facing currently.
Russia never signed up to be Europe's safety cushion in case that its energy policies fail. The EU has been pronouncing loudly that it intends to wean itself off the Russian gas dependency and Russia seems to have believed them, even though the EU actually increased its reliance on Russian gas dramatically last decade. Now, with the new frictions surrounding Ukraine and US & NATO on one hand and Russia on the other, it seems Nord Stream 2 is being held up in German regulations limbo as a way to gain leverage. Russia's response has not been idle, just as it has been the case since 2014 when the Ukraine issue became an irritant in the relationship. Russia immediately turned to China seemingly in an effort to speed up the decision-making for Power of Siberia 2, which is currently in the feasibility study phase. The important detail in regards to this pipeline is that it will mostly draw natural gas from Western Siberia fields that also supply gas to Europe and the bulk of gas for the domestic market. It seems that the current drama surrounding Nord Stream 2 may have nudged Russia towards pursuing a final deal on the project, which will have the capacity to deprive Europe of as much as 55 Bcm/year in natural gas supplies. What happens next in Ukraine may no longer matter in this regard.
Between Russia's efforts to diversify its market away from Europe, as well as its industrialization efforts at home, and Europe's strategic mistake of assuming that Russia will always want to fight for European market share and that it will always be a buyers' market in spot markets, there is a very real danger of Europe getting stuck fighting for scarce LNG supplies to keep supplies at a bare minimum needed. Beyond the fact that Russia may sell very limited volumes of gas on the EU spot market in the foreseeable future, it may actually become reluctant to renew some long-term contracts when the current ones will expire in the coming years.
This will lead to very high operating costs for a number of EU industries, especially in the petrochemical sector, but not only. Ultimately, the EU is nowhere near ready to do more with less natural gas, and there are very few economical alternatives to Russian gas. The potential gap in natural gas supplies in Europe may become insurmountable. The price spikes that will occur, especially during periods of low wind, solar, and hydropower will decimate Europe's economy with every occurrence. The damage will become increasingly permanent as more and more industrial establishments will correctly conclude that the current crisis has a permanent feel to it, with periods of low energy prices being only brief interludes. They will shut down and move their operations elsewhere, or just go bust.
As the chart above shows, it is not just the chemical and petrochemical industries that have a high natural gas input. Natural gas is found as a feedstock or as an energy source in many industries and it cannot be easily replaced in certain applications. It could be replaced with coal in some circumstances, which is an undesirable option given Europe's goals of cutting emissions. It is also undesirable in economical terms, given that widespread replacement of natural gas with coal would lead to emissions credit prices exploding.
With carbon trading expansion to many industrial sectors and emissions tax schemes on the horizon, a further strain on Europe's industrial activities is to be expected.
The rise in energy and input prices has already had a severe impact on EU industrial activities in the last months of this year, which risks price increases as well as other issues down the road. The latest reports suggest that industrial activity disruptions due to high energy prices are widespread, ranging from aluminum and zinc smelters in France to Romania's largest fertilizer plant. A less covered industry, which does not figure as prominently in stats as well as in the attention of the markets and policymakers is the EU ceramics industry, which employs 200,000 people, predominantly in already struggling economies such as Italy and Spain. Natural gas ovens are the dominant source of heat needed to cure ceramic products. Europe's ceramics industry may actually become the earliest victim of the current energy crisis. It is heavily exposed to natural gas prices or availability.
As the chart above shows, EU industrial production is already on a long-term trend of decline. It never fully recovered from the 2008 crisis, while now, after a sharp post-COVID recovery, it is once more showing early signs of yet another downturn. If the high energy environment in Europe will persist going forward, this will become the decade where Europe will become a post-industrial society and it will not be a particularly pleasant experience
The EU currently consumes roughly 500 Bcm of natural gas, 40% of which is supplied by Russia.
The working hypothesis in the Western World is that Russia is very much actively aiming to dominate the EU gas market. The argument goes that it wants to use it as leverage and influence. It is less clear to me what that leverage is supposed to achieve in terms of Russia's economic and geostrategic goals. The economic and geopolitical weight of the EU in the world is fading rather fast, so gaining economic or other influence in the EU is accordingly a shrinking prize.
Expectations continue to be that EU natural gas is on an imminent path of demand decline due to green initiatives. There seems to be, at least publicly, very little awareness of the potential risk of Russia's pivot towards the East, as well as its intentions to develop value-added activities, such as turning the natural gas into fertilizer domestically and selling that, rather than just selling the natural gas. Everyone seems completely convinced that Russia is aiming to sell as much gas as possible to Europe, even as it becomes a progressively smaller market for gas suppliers.
I myself thought the same way until last year. I am convinced that Russia did indeed aim for the goal of gaining a commanding position in the EU gas market until recently. There are signs however of a change in Russia's calculations. The change in Russia's perspective seems to be due to two, or possibly three factors. First and foremost, there is the increased hostility it is faced with, in its relations with the Western World. Secondly, it may be a reflection of the fact that Asia is increasingly becoming the world's economic center of gravity. Just a decade ago, Europe was the largest economy by continents. North America was second, with Asia only in the third spot. Currently, Asia is number one, with Europe down in the third spot. By the end of the decade, Asia's economy could come close to equaling that of Europe and North America combined. It would be foolish for Russia to continue focusing on Europe, which is progressively sliding into economic and geopolitical irrelevance. It is increasingly focusing on satisfying China's growing natural gas demand, and it also seems to aim for India with LNG exports. The third factor is Russia's desire to become more than just a raw materials supplier, as I already touched on.
Adding up all three factors, it is possible that by the time the Power of Siberia 2 pipeline, which is yet to be completely agreed on will be completed, the EU could lose as much as 100 Bcm/year in supplies, which is a fifth of Europe's yearly demand. The new pipeline to China could divert as much as 55 Bcm/year once it would be completed. LNG exports are also set to increase substantially in the coming years. In 2019, Russia exported 29 million tons of LNG. It aims for as high as 65 million tons/year by 2024. The 36 million ton increase is equivalent to almost 50 Bcm. The new pipeline and the increase in LNG alone amount to over 100 Bcm. Then there are the domestic plans meant to develop Russia's own industrial activities, which require more natural gas. If Russia's domestic demand were to rise by 10%, which is entirely possible, it would require an additional 50 Bcm/year or so in supplies to cover.
Russia most likely aims to increase domestic production of natural gas, in order to cover some of the increase in exports to customers outside of the EU, as well as its growing domestic demand. Not all the gas that it aims to sell through a new pipeline to China or all LNG will be diverted from Europe's current supplies. It does provide Russia with the capacity to divert those supplies away from Europe when these projects will be completed. It further diminishes the EU market in terms of importance for Russia's natural gas exports. Even though Russia will most likely opt to significantly increase natural gas production in the coming years in order to facilitate the above-mentioned plans, I find it hard to see how it can meet all of these new proposed obligations solely through production growth. It is therefore very likely that Russia will start to limit exports to the EU to mostly long-term contractual obligations. Furthermore, it will likely allow some of those contracts to expire rather than renewing them when the time comes. The transit agreement with Ukraine will also be allowed to expire.
Back in 2014, I wrote an article explaining why I believed that the historical significance of the Ukraine crisis that was unfolding back then may be nothing less than the root cause of what may become known as the beginning of the end of the EU. In my article; "Ukraine Crisis: A Decision That May Have Sealed The Fate Of The EU", I explained the fact that events were set into motion then, which risked destabilizing the EU economically, due in large part to the threat to its energy supplies. It is increasingly clear that since then its energy security has deteriorated, and evidence suggests that it risks taking an even greater hit in the next few years.
By the middle of this decade, the EU will be faced with a gaping hole in its natural gas supplies. One might argue that there are prospects for remediation of the situation, but personally, I doubt it. The EU is set to further reduce its nuclear power output, with Germany likely to completely lose its nuclear fleet by this time next year. Belgium is also interested in phasing out its fleet by the middle of the decade. Coal-powered plants are also set to be decommissioned in the coming years.
It is assumed that intermittent sources of energy can make up for these reductions in electricity generation and more. The overall idea seems to be that if enough windmills and solar panels will be installed, at some point there will be enough electrical production from these sources, as well as a few other green sources to completely and comfortably cover demand. An ample deployment of battery storage capacity would help to steady daily or even weekly fluctuations of the grid, but that will take a very long time to achieve. There is also the great hydrogen hope, but that too is a long way off. In the absence of affordable long-term storage solutions, it is hard to imagine how the EU will handle the transition to renewables that is supposed to greatly reduce its reliance on natural gas.
There is of course the LNG option. The recent announcements in regards to LNG shipments originally destined for Asia heading for Europe instead may be an indication of what is to come for the EU.
Basically, natural gas prices will have to rise to a level where LNG sellers will find it more profitable to sell to the EU, or for Asian customers to opt to re-sell already contracted volumes of LNG, due to the higher price that European customers will be willing to pay on the spot markets. It will constitute yet another source of tension between EU countries. Those who secured ample natural gas supplies through long-term contracts will fare better than those who opted to rely more heavily on spot market supplies. Animosity will likely erupt as households will suffer in certain countries, while in others they will fare better. Industrial activities may also migrate to countries that can offer cheaper natural gas supplies.
Further animosity will be on display between countries that are opting to retain and even enhance their nuclear power capacities, versus those that are renouncing those capacities for environmental reasons. France managed to form a nuclear power coalition of sorts with East European EU members that are mostly in favor of nuclear power, in order to push to have it recognized as green energy since it does not produce greenhouse emissions. A number of countries that are pushing to abandon nuclear and coal as sources of electricity are of course worried that they may be faced with a severe competitive economic handicap within the EU, given that some of the countries within the EU that are pursuing nuclear power are also signing long-term natural gas supply contracts. Hungary is one such example, where it is set to commission two new nuclear reactors this decade, and it also signed a new long-term contract for Russian natural gas, which makes natural gas cheaper in Hungary than in many other countries where LNG is set to play a far more prominent role going forward.
The energy policy pursued by the EU took a dangerous turn three decades ago when it decided to unilaterally save the world from climate change. It is the only significant economy that actually reduced emissions compared with 1990 levels since then. The costs to the EU economy include the highest energy prices of any major economy. The energy crisis we are seeing unfold right now in the EU is a combination of the mistake made three decades ago, as well as the mistake made last decade, namely pushing Russia towards an Eastern as well as an inward pivot. Russia is by far the EU's most important source of energy. The EU bet its future on adopting intermittent sources of energy as an alternative and then when the 2014 Ukraine crisis unfolded it also opted to destroy its relationship with Russia. It did so many years, or perhaps decades before it was ready to do so from an energy security point of view.
Back in 2018, Russia bailed out the EU when its natural gas inventories became depleted due to a late winter cold wave, along with other factors, left it dangerously low on supplies. That moment might have been the last chance for the EU to responsibly secure its energy supply system. Unfortunately, the EU learned the wrong lessons then. It thought that it can afford to assume that Russia will always want to sell it as much natural gas as the EU wants, with spare capacities always on standby for the EU to rely on in case that it needs more. As we can see now, Russia is not interested in being an unwanted, yet simultaneously indispensable partner for the EU and its energy security. Russia has already done much to pivot away from Europe, and if it will sign a new deal with China for a new natural gas pipeline, it will be a final blow for EU energy security this decade and beyond, that will have crippling effects on its economy and its socio-political viability.
As Europe's petrochemicals industry is likely to be hit the hardest and sooner than other industries, there are obvious implications for stocks like BASF (OTCQX:BASFY). Metals manufacturers like ThyssenKrupp (OTCPK:TYEKF) will find that their energy input costs are taking a serious bite out of competitiveness and profitability. Further down the line, the entire EU economy is set to suffer as a result of high energy prices. Keeping this in mind, European companies that are more international in their sales and operations are set to do better than companies that are more dependent on the EU market. For instance, Renault (OTCPK:RNLSY) is likely to suffer more from a downturn in vehicle sales than Daimler (OTCPK:DMLRY) or Volkswagen (OTCPK:VWAGY). Country-specific ETFs or region-specific European ETFs will also reflect the same trend, where ETFs that are more heavily focused on German assets that tend to be more international in terms of operations and sales are set to do better than ETFs that focus more on countries like Belgium or the Netherlands, which have more exposure to the EU consumer market and less to the rest of the world. This is something that is reflected in EU trade data, which is a decent indicator in this regard.
US multinationals that have heavy exposure to the EU are also set to take a significant hit. For instance, Ford (F) is still far more exposed to the EU market than GM (GM). GM sold its Opel division a few years back, which greatly reduced its exposure to the EU market.
There is no telling just how bad the economic situation in the EU can become. There is the obvious immediate effect of many industries becoming uncompetitive given high wage costs, high environmental regulation costs, and on top of it rising energy prices, with occasional rolling blackouts becoming a distinct possibility. There are also systemic effects such as rising inflation rates resulting from high energy prices, which can force the ECB to remove its accommodative policies. Euro-area governments are currently paying next to nothing in interest on their debt. An increase in borrowing costs can put the squeeze on EU economies because governments will have to get used once more to paying interest on their debt. For instance, Italy, with its current debt/GDP ratio of over 150% would see interest costs eventually rise by 3% of GDP if interest rates were to rise only 2%. If Italy will have to respond by gradually cutting its government expenditures by 3% of GDP or more in response, it would be quite a shock to its economy. There are many EU countries facing this predicament. Countries like Germany that have lower debt/GDP ratios will suffer indirectly as the overall EU economy is set to slow down dramatically.
It was just recently reported that global oil & gas discoveries were the lowest this year since 1946.
There may be some more zealous EU leaders, and members of the general population who may believe in the hypothesis that cutting the EU economy away from its main oil & gas supplier can produce the desired shift to green energy, thus it can greatly reduce the EU contribution of greenhouse gas emissions. The current reality is that the EU economy remains greatly dependent on oil & gas consumption. It consumes about 5 billion barrels of oil per year, as well as about 500 Bcm of natural gas. As we can see from the Rystad data, global average discoveries of oil and gas in the past seven years only average to about the demand of oil & gas that the EU alone consumes each year.
This may arguably present a further reason to advocate for further reductions in oil and gas demand because clearly we will soon be faced with a global market situation where we will not come close to satisfying global demand for oil and gas. This may happen at some point this decade, and I do believe it will be a deep economic shock for the entire world. What the EU is doing however by continuing its policy of estrangement from its most important oil & gas supplier is not helping to break its dependence on oil & gas. All it is achieving is getting a head start of many years on the energy crisis that will likely engulf the entire global economy. In other words, by the time the entire world will be in crisis, the EU economy will be already much weakened and hollowed out, at which point it will still be subjected to another economic shock along with the rest of the world. Ironically, it will probably leave it less prepared to face the impending global energy crisis than most other major economies. The outlook for the EU economy is looking increasingly bleak, which has some very obvious risk/reward implications for investors.
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Disclosure: I/we have a beneficial long position in the shares of F either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.