Ukraine War: Corporate Energy Risk Analysis & Considerations
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Executive Summary
- NUS Consulting Group believes that while Russia may go through the motions of pursuing compromise, it will not seek any real settlement to the conflict unless and until it has achieved success. Unfortunately, President Putin's definition of success most likely requires, at a minimum, the taking of Kyiv and ousting of the current democratically elected Ukrainian government.
- International corporations need to identify the geographic areas of greatest concern. In short, the answer is Europe. Russia supplies over 30 percent of the European Union's natural gas requirements. In the short term, it will be difficult, to impossible, for Europe to fully replace its dependence on Russian gas with other sources.
- Should the Ukraine War escalate, there is a growing likelihood that Europe will experience an interruption in the flow of Russian gas supplies. An interruption in the flow of Russian gas would result in local governments and/or energy suppliers curtailing the availability of natural gas to businesses or, worse yet, suppliers claiming force majeure and canceling supply contracts with counterparties.
- In times of financial stress, credit strength always becomes a priority. Suppliers want clients with strong credit scores (or as an alternative request large deposits or parent guarantees) to secure a consumer's performance under the supply agreement. With the ranks of suppliers dwindling, remaining suppliers are in a strong position to pick and choose customers based upon overall credit risk.
- For businesses with European energy market exposure in 2022, we continue to recommend these positions be substantially hedged before any potential disruption in the flow of Russian energy to Europe. Once news breaks of an interruption in the flow of natural gas into Europe, it will be too late.
- Due to these extraordinary events, the possibility of supply disruption is no longer an unlikely tail risk. Consequently, businesses must consider and develop contingency plans to mitigate the potential impact on their European plants and facilities.
Background
Several weeks ago, NUS Consulting Group published a research note, "Ukraine Crisis - Scenario Analysis." In that document, we assessed the different potential scenarios the Russian invasion of Ukraine could take. We concluded the most likely path would be an extended and brutal assault designed to intimidate Ukraine into accepting Russia's initial terms and conditions.
The success of Ukraine in holding back Russia's military invasion has been a surprise to all observers. On the one hand, Ukraine's success, along with the West's severe economic sanctions, have potentially created an opportunity to sue for a mutually acceptable compromise to both parties. On the other hand, any equitable compromise would be seen as a defeat to Russia and President Putin. As such, we believe that while Russia may go through the motions of pursuing compromise, it will not seek any real settlement to the conflict unless and until it has achieved success. Unfortunately, President Putin's definition of success most likely requires, at a minimum, the taking of Kyiv and ousting of the current democratically elected Ukrainian government – i.e., the removal of President Zelinsky. Accordingly, NUS expects the conflict to steadily escalate with Russia continuing its assault led by missile and artillery strikes focused on critical military targets and major cities.
In light of the preceding, all energy-intensive organizations with European production facilities must answer this question: How does the Ukrainian War, and any potential further escalation, impact their energy supplies? In this research note, we attempt to answer this critical question and assist organizations in developing a strategy to address these extraordinary circumstances.
Geographic Areas of Concern
Initially, international corporations need to identify the geographic areas of greatest concern. In short, the answer is Europe. Russia supplies over 30 percent of the European Union's natural gas requirements. In general, and as one would expect, central and eastern Europe have a greater dependence while western Europe is less dependent. Clearly, North America has ample supplies of local natural gas due to the fracking revolution of the past decade. On the other hand, Asia has long been an importer of LNG, which Australia has predominantly supplied. Approximately 99 percent of Australian LNG exports go to China, Japan, and South Korea and are locked into long-term delivery
contracts.
In the short term, it will be difficult, to impossible, for Europe to fully replace its dependence on Russian gas with other sources. Europe has existing LNG terminals, but they are predominately located in western Europe – i.e., UK, Spain, France, the reason these countries are less dependent on Russia. At present, Germany has no LNG terminals – it intends to commence construction immediately, but the process takes at least two years. The Czech Republic, Slovakia, Hungary, and Romania, being landlocked states, are effectively completely dependent upon piped natural gas.
Energy Supply Risk
As previously discussed, should the Ukraine War escalate, there is a growing likelihood that Europe will experience an interruption in the flow of Russian gas supplies. Such an interruption could be triggered by the EU tightening sanctions in response to Russian military tactics employed in Ukraine (e.g., the targeting of civilians) or Russia attempting to counter crippling economic sanctions imposed by the West. We acknowledge that both sides would be reluctant to take such action - Europe needs Russian natural gas in the short term, and Russia needs the revenues generated from the sale of natural gas. However, it is essential to point out that rational decision-making does not
always prevail in times of war. Irrespective, an interruption in the flow of Russian gas would result in local governments and/or energy suppliers curtailing the availability of natural gas to businesses or, worse yet, suppliers claiming force majeure and canceling supply contracts with counterparties. Due to these extraordinary events, the possibility of supply disruption is no longer an unlikely tail risk. Consequently, businesses must consider and develop contingency plans to mitigate the potential impact on their European plants and facilities.
Even in the best scenario, where there is no interruption to Russian gas flows into Europe, businesses still need to be concerned. Specifically, under the current circumstances, it will be difficult For Europe to rebuild its natural gas stockpiles in the coming months. If Europe enters the coming winter season with exceptionally low natural gas inventories – businesses may find themselves in a similar position, where natural gas supply in Q4/22 and Q1/23 are constrained, and curtailed, forcing plant slowdowns or shutdowns.
It is important to note that the natural gas supply constraints will also adversely affect the European electricity markets. Over the past several years, as part of the region's sustainability and decarbonization initiatives, many countries have shuttered coal-fired generation plants and planned to decommission nuclear generation facilities. Electricity production from these plants was largely replaced by renewables and cleaner gas-fired generation plants. Accordingly, a shortage of available gas will result in a loss of electricity production. Undoubtedly, some of any loss will be made up by bringing some coal-fired generation back online and also extending the decommissioning dates for certain nuclear plants. Nevertheless, the end result will be a tight electricity market.
Conclusion and Action Items
As seen from the discussion above, while energy price is always a concern for corporations in these extraordinary times, we must also focus on the counterparty financial strength and supply availability. The former, credit strength, always becomes a priority during periods of financial stress. Consumers want to enter into agreements with suppliers with strong balance sheets that will be in a position to honor their supply obligations for the term of the supply contract. Unfortunately, large or national suppliers with solid balance sheets are typically the most expensive. On the other hand, suppliers want clients with strong credit scores (or as an alternative request large deposits or parent guarantees) to secure a consumer's performance under the supply agreement. With the ranks of suppliers dwindling, remaining suppliers are in a strong position to pick and choose customers based upon overall credit risk.
Unfortunately, the latter, supply availability, depends almost entirely on the course of the Ukraine War. Europe has not seen a large-scale conventional war for over seven decades. Moreover, we have never seen one involving a nuclear power with both strategic and tactical nuclear weapons (i.e., small nuclear warheads and delivery systems intended for use on the battlefield or for a limited strike). Accordingly, it is near impossible to draw on history to guide us in evaluating current events.
Consequently, NUS Consulting Group highly recommends as part of prudent planning that businesses review their facilities and processes to identify available flexibility in shifting work between countries and/or regions. In summary, the concept is to assess an organisation's ability, if required, to transition production from countries and/or regions highly dependent on Russian gas to those less dependent upon it. This could mean shifting some or all production for a limited period of time from central to western Europe or, if possible, from Europe to North America.
Finally, for businesses with European energy market exposure in 2022, we continue to recommend these positions be substantially hedged before any potential disruption in the flow of Russian energy to Europe. Once news breaks of an interruption in the flow of natural gas into Europe, it will be too late. With the extraordinary price volatility being experienced by the markets, prices offered by suppliers (which traditionally have a short shelf life) are now only valid for very short periods. As a result, businesses must be organized and agile, prepared to swiftly make trading/purchasing decisions or lose opportunities.
In short, we are recommending clients prepare for all contingencies. The adage "hope for the best, but prepare for the worst" seems the most appropriate under the current extraordinary circumstances.
More: Research Notes, Ukraine Crisis
