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Price storm: who did the European gas market turn

Salikhov Marcel R. President, Principal Director on Economic Studies, Head of the Economic Department

Forbes published a column "Price storm: Who did the European gas market turn" by Marcel Salikhov, President of the Institute for Energy and Finance.

Record gas prices in Europe have been helped by the rapid economic recovery and green energy challenges. There were also speculators. The short-term effect of the price crisis may be some softening of European requirements for Gazprom, but in the long-term, expensive gas will stimulate the EU to reduce its dependence on hydrocarbon imports, Marcel Salikhov, President of the Institute for Energy and Finance says.

On September 15, European gas prices set a historic record. According to Refinitiv, the spot price was $ 812 per 1,000 cubic meters. Prices have increased almost 20 times compared to July 2020. Such rapid growth would have been impossible without the coincidence of several reasons at once.

Asia, weather and speculators

First, the global economy and gas demand are recovering much faster than expected. This leads to a general increase in prices for all commodities, including natural gas. In addition, the spread of remote employment has led to additional increases in household demand for electricity and gas in Europe. Asian economies are also growing rapidly and are therefore buying more LNG. The Asian market is traditionally a premium market, so in the summer of 2021, “free” LNG supplies were reoriented specifically to Asia. This contributed to the rise in European prices due to the factor of arbitrage between markets.

Secondly, quotas on greenhouse gas emissions in Europe have almost tripled over the past year, which also contributed to the increase in gas prices. The more electricity producers have to pay for emissions, the more competitive gas generation is compared to coal. At the same time, the generation of electricity from renewable sources in the EU countries turned out to be below expectations this summer. At the end of August, calm weather became an additional factor - the reduction in output at wind farms provoked a jump in electricity prices in northern Europe and supported gas prices.

Third, speculators also played a role. Volatility in the gas futures market has increased sharply, which is likely to have attracted additional speculative capital. This was reflected in the growth of trading volumes and open positions in gas futures according to the Dutch TTF index - the main European hub and benchmark for the European market.

Finally, the fourth reason is the change in Gazprom's long-term strategy. In recent weeks, the Russian company has clearly not sought to increase supplies to the European market, making additional profits due to higher prices. For example, Gazprom did not reserve additional transit capacities of the Ukrainian gas transmission system in order to increase supplies. On the whole, Gazprom's position is rational both from the point of view of maximizing its own profits and as a reaction to the decisions in the field of energy policy adopted in the European Union over the past 10 years.

During this time, the share of gas supplies under contracts linked to oil prices from Gazprom has dramatically decreased - primarily under pressure from European regulators - in favor of supplies linked to hubs, in fact, to the exchange price of gas. In terms of the “old” system, when the contract price depended on the oil market and was quite stable, with a jump in prices at hubs, it was profitable for Gazprom to increase exports - this was the only way it could get additional profits.

Now that more than 80% of gas supplies to Europe are tied to hub prices, there are far fewer such incentives. Suppliers' incomes fluctuate in line with price dynamics anyway. So, if prices rise, Gazprom can take a wait-and-see attitude, limiting itself to fulfilling its long-term contractual obligations. From an economic point of view, the situation when gas is traded as a classic commodity, the price of which is formed by the current balance and supply, is more correct, but the market becomes volatile and unstable, because there are few large gas suppliers to Europe.

The problem for the European market was that all of these factors were acting at the same time, which led to an extreme price shock. The sharp rise in gas prices coincided with the completion of the Nord Stream 2 gas pipeline, which also prompted a lot of comments.

The Nord Stream factor

Nord Stream 2 has been completed, but has not yet been commissioned. According to Gazprom CEO Alexei Miller, NS2 could supply 5.6 billion cubic meters of gas to Europe this year, which would ease tensions on the market.

The jump in gas prices increases the chances of Gazprom to get an exception to the rules of the European gas market and to ensure the pipeline is loaded by 100%. The current rules oblige the owner of the gas pipeline to use only 50% of its capacity, the remaining 50% must be provided to other companies. However, under Russian law, only Gazprom has the right to export pipeline gas, so independent Russian producers do not even have the potential to use SP-2. There is a discussion about admitting independent companies to the pipe, but the decision is unlikely to be quick.

In the meantime, there is a legal conflict between European and Russian norms. From an economic point of view, using an expensive gas pipeline is half irrational. This worsens the economics of the project for Gazprom and limits supply opportunities for European consumers. However, the decisive factor in this issue, most likely, is the political factor. In the context of record high gas prices, which have already affected ordinary consumers, European regulators could make concessions.

Long term consequences

High gas prices in Europe are likely to remain until the end of the 2020-2021 heating season. This will be facilitated by the relatively low stock in underground gas storage (UGS). Seasonal growth in demand in winter should be compensated for, among other things, by additional imports, and not only by withdrawal from UGS facilities.

Record high gas prices in Europe will drive up the value of Russian exports. According to the Institute for Energy and Finance, based on data from the Federal Customs Service, the value of Russian pipeline exports will grow by $ 39-42 billion this year and will approach the record figures of 2013 ($ 67 billion per year). The value of LNG exports will also increase and will amount to $ 15-16 billion. Such indicators will increase federal budget revenues due to increased revenues from export duties and income taxes. Additional profits for Gazprom and Novatek will lead to an increase in dividends and have already increased their market capitalization.

However, everything is good in moderation. Too high prices will ultimately have a negative impact on the long-term prospects of gas in Europe. At current prices, almost any alternative, including heating houses with wood or using fuel oil for power generation, is more profitable than gas. In these conditions, consumers will try to reduce their consumption as much as possible, and all alternatives to natural gas will receive additional competitive advantages. As a result, renewable energy will receive additional public support as a way to get rid of extremely expensive hydrocarbon imports.

So, although the current situation is tactically advantageous for Gazprom, which makes it possible to accelerate the commissioning of SP-2 and obtain permission to use its capacity 100%, strategically extreme prices in key markets are unprofitable for Russian gas exports. The main task should be to maintain an optimal price balance, which will not give too great advantages to competitors.

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