The Energy Crisis of Europe

Econs.online has published a column by Marcel Salikhov, President of the Institute for Energy and Finance - “The Energy Crisis of Europe”.

There has never been such an expensive gas as it is now in Europe: over the year, prices have increased more than 15 times. The current situation raises the question, whether the current energy crisis is temporary, or it means structural problems in the functioning of energy markets.

A combination of factors

The steady rise in prices for natural gas, as well as for other commodities, was observed throughout the entire 2021. The main reasons were primarily associated with the rapid recovery of economic activity after severe quarantines last year. Global financial markets quickly recovered against the backdrop of loose monetary policy and fiscal stimulus by many countries. And the rapid recovery of the global economy contributed to the growth of commodity markets.

The gas market was also affected by the fact that Asian economies suffered and recovered faster than others. This has led to a strong increase in gas demand in the region. For example, in recent months, China's LNG imports have returned to double-digit growth rates after stagnating in the summer months of last year. As demand grew, gas prices in Asia also began to rise rapidly.

Traditionally, the Asian market is premium and prices are higher than in Europe. LNG producers tend to focus on the Asian market, while the European market has acted as a balancing one in recent years. The volumes that were not in demand in Asia found their buyers in Europe. However, rising demand in Asia has created a shortage in the market and reoriented free supplies. As a result, LNG imports to Europe began to decline in the first half of the year. The surge in European gas prices has not yet led to an increase in LNG imports: in September 2021, LNG supplies amounted to 5.3 million tons, which is at the level of August and 3% less than in September last year (hereinafter, the author's calculations based on data from the analytical platform Eikon).

American LNG also did not become a “savior” for the European market during a difficult period. US LNG supplies to the EU, which reached 2.5–3.0 million tonnes per month in the second quarter, have dropped to 1.0–1.2 million tonnes in recent months. American LNG producers have also reoriented themselves primarily to the Asian market to the detriment of the European one.

To some extent, the jump in prices and the shortage of LNG supply in the world market is a consequence of the investment pause that the producers took in 2014–2017 against the backdrop of low oil and gas prices. The short-term elasticity of LNG supply is rather low - by default the plants operate with a high level of capacity utilization and cannot ramp up production. The construction of a new LNG plant takes at least 4-5 years. Therefore, the cancellation of projects or their postponement affects the market balance, albeit with a rather significant lag.

Quite often, there are accusations that Gazprom was the culprit in the European crisis and contributed to it. However, current gas production in Russia is at historically high levels. In September 2021, production amounted to 61.1 billion cubic meters - a record high for this time of the year. Gazprom this year faced growing domestic demand and the need to replenish gas in underground storage facilities that were depleted last cold winter. In these conditions, the possibilities for increasing export supplies are limited. Nevertheless, in the first 7 months of 2021, the export of pipeline gas, according to the Federal Customs Service, increased by 11% compared to last year.

For a long time, the European gas market had the opportunity to receive additional gas from Russia, if necessary. When free production capacities in Russia were exhausted, the market faced serious difficulties. Moreover, decisions have been made in Europe that limit their own gas supply. The Dutch authorities this summer decided to accelerate the decommissioning of the largest gas field - Groningen. It also negatively affects the availability of gas supply.

Another feature of the current energy crisis in Europe is that the surge in prices simultaneously occurred in interconnected markets - the markets for natural gas, coal and CO2. In such a case, it is rather difficult to separate what is the cause and what is the effect. However, such synchronous growth is fueling all related markets.

CO2 prices reached 60 euros per tonne, while last year they did not exceed 20-30 euros. The high cost of emissions degrades the economics of coal plants and creates additional demand for gas generation. The decommissioning of coal plants appears to have worsened the resilience of energy systems in Europe.

CO2 prices reached 60 euros per tonne, while last year they did not exceed 20-30 euros. The high cost of emissions degrades the economics of coal plants and creates additional demand for gas generation. The decommissioning of coal plants appears to have worsened the resilience of energy systems in Europe. The main source of new capacities is renewable energy sources (RES) based on wind or sun. However, the decrease in the output of wind farms in the Nordic countries in September 2021 led to a jump in electricity prices and stimulated additional growth in gas demand in an already scarce market.

Decarbonization policy

For the most part, the current energy crisis in Europe is associated with the simultaneous action of many separate factors, usually little related to each other, but turned out to be involved simultaneously and unidirectionally. This means that as the influence of these factors ends, the market should stabilize and prices should decrease. However, the current situation also shows mistakes in European energy policy.

The European Union is one of the main driving forces of the global climate agenda and sets ambitious targets for decarbonization. This year, the European Commission set even more aggressive targets under the Fit for 55 package, which envisage a 55% reduction in emissions from 1990 levels by 2030. However, as the share of renewables increases, so does the requirements for ensuring the reliability of energy systems. Distributed generation requires a developed network infrastructure and a higher level of capacity redundancy. However, this does not provide a guarantee against an unforeseen reduction in the generation of renewable energy sources and its replacement with traditional sources. Apparently, the approaches to backing up and decommissioning of traditional generation should be reconsidered.

For quite a long time, Europe was dominated by the idea that LNG could improve energy security and reduce dependence on the largest supplier - Russia. The possibility of obtaining LNG creates a diversification of sources and strengthens the bargaining position, but does not mean low prices at all. The European market is becoming increasingly linked to the US and Asian gas markets. Therefore, the decline in production at hydropower plants in Brazil or new requirements for the quality of coal in China affect gas prices in Europe.

In the foreseeable future, Russia will remain the largest gas supplier to the EU, while the European market will remain the largest market for Gazprom. Therefore, it is important to maintain partnerships that are more focused on mutual economic benefits, rather than political motives. In particular, delays in the construction and commissioning of the Nord Stream 2 gas pipeline have clearly contributed to the current crisis situation.

Consequences of the energy crisis

For the European economy, the main consequences will be associated with additional consumer spending on energy resources and rising inflation. Most likely, the additional contribution to European inflation will exceed 0.5-0.7 percentage points in annual terms. The share of fuel in the consumer price index (CPI) of the euro area is currently about 6% (excluding petroleum products). Some energy-intensive industries may suspend their operations due to high gas prices, which is a normal market reaction and will reduce demand. It is likely that this will lead to a slowdown in economic dynamics in the next two quarters, but this is unlikely to lead to a full-scale economic crisis in the EU.

High gas prices in Europe mean additional revenues for Gazprom and the Russian state budget from gas export duties and increased income tax payments from Gazprom.