Back To The 1970s? EU-Russia Energy War Hots Up

Back To The 1970s? EU-Russia Energy War Hots Up

cemagraphics

By Sergei Vakulenko

Europe, and probably the global economy as a whole, are already headed for a recession. Economic slowdown usually leads to a reduction in energy demand, which should help, but this time the potential shortfall is too big, and energy shortage-induced stoppages will probably deepen the recession and accelerate inflation, similar to the 1970s.

As European spot prices for gas break new records, it is becoming clear that natural gas will be one of the major battlefields of the geoeconomic war between Russia and the West. Back in March—just two weeks after Russia invaded Ukraine—the EU Commission published the outline of a plan to end the EU’s dependence on Russian fossil fuels by 2030. The plan called for reducing Russian gas imports by two-thirds by the end of 2022. It took more than two months to develop the details of the plan, but the main aspects changed little. The Oxford Institute for Energy Studies analyzed the viability of the plan and found that while theoretically doable, it would be costly and difficult to implement.

Since then, the EU has been focusing on sanctioning Russian oil, on the basis that it will be much easier for Europe to find a replacement for it than Russian gas, and thus the cost to Europe of oil sanctions will be lower. By the beginning of May, however, it was already becoming clear that Russia might focus on gas in its economic war with Europe for precisely the same reason: that it would have the biggest impact on Europe, and a more limited effect on Russia. Some preparatory steps were already made in April and May, and now the hostilities are in full swing.

Why Gas?

Despite a popular perception that gas exports are a major source of funding for Putin’s war chest, in reality, Gazprom (OTCPK:OGZPY) revenues play a minor role in the Russian budget compared with oil. Until the 2021 spike in gas prices, gas levies (export duty and mineral extraction tax) provided about 10 percent of the state budget, while oil supplied over 30 percent. The reason is that oil in Russia is taxed more heavily than gas, and there is much less difference in oil taxation between domestic consumption and exports.

If Russia stops selling gas to Europe, its budget losses may reach $40 billion. That’s certainly a significant sum for the Russian government, but it is an easier sacrifice than oil. And if gas sales are not stopped altogether, but merely curtailed, much of the monetary loss could be recouped through price growth. Gazprom CEO Alexey Miller boasted recently that decreased exports to the EU are fully compensated for by higher prices, and his company couldn’t be happier about it.

Unlike embargoed oil, any Gazprom pipeline gas diverted from Europe has nowhere else to go. Russia may maximize its gas power generation, freeing up some coal volumes that could be sent to the global markets; it might increase production of gas-intensive goods, such as ammonia and nitrogen fertilizer; but the flexibility in these channels is quite limited. The unsold volumes are therefore a net subtraction from the global energy balance, and any LNG volumes diverted to Europe will mean a deficit somewhere else, which may lead to a bidding war among energy buyers.

This is where Europe’s dependence on Russian gas comes into play. In 2021 Europe received 40 percent of its total gas needs by pipeline from Russia, plus an additional 5 percent as LNG. In monetary terms, the 99 billion euros paid for Russian gas represents about 5 percent of European energy imports. That may not sound like much, but there are many high value-adding industries—cement, steelmaking, glass, chemical industries—that depend on gas as a feedstock or energy source. Many of these production facilities are concentrated in Germany and generate thousands of jobs. This fact, along with the skyrocketing energy bills for European households, explains why the Kremlin might have decided that the time is ripe to use gas to inflict pain on the EU.

Why Now?

Gazprom’s timing for launching its offensive can be explained by the specifics of the European gas market. Gas demand is seasonal, with summer air-conditioning demand peaks in Mediterranean Europe—mostly met by LNG—and winter heating peaks in the rest of the continent. Excluding Spain, Portugal, and small island nations, Europe consumes on average 130 billion cubic meters (bcm) from April to September, and 270 bcm from October to March. It is accordingly most vulnerable to gas supply pressure in winter, at the peak of demand, but resilience can be built in advance by filling gas storage facilities. The nominal volume of the EU’s total storage capacity is about 100 billion m3, but it never goes below 20 billion m3. Eighty percent of that capacity is concentrated in Germany, France, the Netherlands, Austria, and Italy. Then there is approximately 30 billion m3 more capacity available in Ukraine, mostly in the west of the country.

If Russia wants to put maximum pressure on Europe by curtailing gas supplies, it needs to act quickly. There is little rationale for Russia to allow Europe to stock up on gas before winter. Nor is there any hope in Moscow of catching Europe unprepared and lulling it into a sense of security before starting a supply squeeze in the middle of winter.

According to ENTSO-G data collated by the Bruegel thinktank, Russia is currently exporting about 150 million m3 a day to the EU: a third of what it was a year ago, and of the average levels in previous years. So far, Europe has managed to compensate for the shortfall via increased imports from Norway and LNG purchases, and to fill gas storage at the usual pace, though storage levels are closer to the bottom than last year due to the reduced supply from Russia. The more time passes, the more keenly that reduction will make itself felt.

In the summer of 2021, the LNG market was booming because of droughts—which limited hydropower generation capacity—and heat waves, which drove power demand for air conditioning in markets from Brazil to Japan, leading to increased demand and price spikes. In 2022, the weather has been much milder, which helps Europe. On the other hand, U.S. LNG export capacity took a major hit on June 8 when an accident at the Freeport LNG plant caused a shutdown that might last for three months or longer, reducing U.S. export capacity by 17 percent and removing the equivalent of 60 million m3 a day from the global supply pool. Other disruptions, like the most recent strike of Norwegian gas workers, are also playing into the Kremlin’s hands.

What’s Next?

So far, Russia has refrained from announcing any gas sale embargoes. The mechanisms of gas supply curtailments used by Moscow include a combination of changing payment requirements, retaliatory sanctions against formerly Russian-controlled entities placed under administration by EU countries, references to technical problems caused by the non-delivery of equipment by Western companies, and a refusal to use the alternative supply routes offered by Ukraine to bypass the conflict zone. Russia’s goal in this PR campaign is to make any gas problems look like they are entirely self-inflicted by the Western coalition, while Russia is trying its best to keep to its side of the bargain.

However, the trendline is clear. This is why Europe and Germany, in particular, have already started to brace themselves for severe energy shortages in the coming winter, drawing up rationing plans and industry closure schedules. Europe, and probably the global economy as a whole, are already headed for a recession. Economic slowdown usually leads to a reduction in energy demand, which should help, but this time the potential shortfall is too big, and energy shortage-induced stoppages will probably deepen the recession and accelerate inflation, similar to the 1970s.

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Originally Posted on: https://seekingalpha.com/article/4521976-back-to-the-1970s-eu-russia-energy-war-hots-up?source=feed_tag_commodities
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