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11 Aug 2022
How Russia is Affecting the Energy Crisis
With most of Europe deep into the holiday season, few are focused on the current energy crisis. Undoubtedly once corporate procurement managers and commodities traders return from their holidays, reality will quickly set in. Recently, European electricity and natural gas prices have hit extraordinary levels. These prices not only apply to the next few months but also to calendar year 2023 (CAL23) products. Consequently, the pain from the current energy crisis will be felt much longer than even the most pessimistic market analysts initially anticipated.
There can be little doubt that Russia has weaponized the supply of energy. Equally, despite the political rhetoric, there is little Europe can do quickly to reverse decades of policy that made the region dependent on Russian energy. Like many other Russian wars throughout history, winter will play a pivotal role in this crisis. As colder weather sets in, the political and economic pressure on Europe will increase exponentially. To provide some context, in a typical year, most European countries enter the winter season with robust gas in storage, and even with the regular flow of daily natural gas from Russia, they exit the winter with storage depleted. This year most of Europe will enter the winter season with moderate gas storage levels and daily natural gas flow from Russia at 20 percent of the normal rate (provided Russia does not reduce pipeline flows further). Assuming an average winter, under these circumstances, it will not be long before many countries deplete their natural gas inventories.
For this reason, it is highly likely that many European countries will implement some level of natural gas rationing before or during the winter. Even with rationing, energy prices will remain extraordinarily high, placing pressure on corporates as well as the domestic market (i.e., residential consumers) who are already feeling the strain from the highest level of inflation in years.
Putin's Energy Strategy
The question is - how much political and economic pain can Europe withstand? Clearly, this is a central part of President Putin's overall strategy. His goal is to apply enough pressure to splinter Europe's support for Ukraine and negotiate the lifting of sanctions (possibly the commissioning of Nord Stream 2). On the other hand, should Europe be able to suffer through the winter and not capitulate, the tables will have turned. Much depends on the severity of this coming winter in Europe.
Energy Market Impact
We are in a highly uncertain and volatile environment, making it exceedingly difficult to predict future outcomes. However, dispassionately assessing the situation, it seems that the balance tilts in favor of President Putin. In the end, the intense economic and political pressure will likely force Europe to seek a compromise with Russia on Ukraine to minimize the overall impact on businesses and citizens. Depending upon the shape of such compromise, energy prices across the region most likely will drop from their current extraordinary levels to merely expensive (by historical comparison). Organizations with some market exposure will secure some benefit as the market pulls back, while others will have to wait for 2024.
Should a deal on Ukraine come to pass, both parties will know it was undertaken under duress, and each will work as swiftly as possible to minimize the other's future leverage. This means Europe will push to secure alternative energy (i.e., natural gas and oil) from alternative sources and expand the development of renewable generation. At the same time, Russia will seek other customers (e.g., China, India, etc.) for its energy exports and attempt to detach itself from the West's financial systems.
Considering this situation holistically, an extended period of high energy prices will negatively impact the European economies. Little can be done now to avoid this outcome – many businesses have already locked in today's energy prices for 2023, which will negatively impact budgets and profitability. In addition, domestic consumers will be forced to pick up a substantial portion of the bill for supporting energy suppliers through the crisis. The current energy crisis is one that the market has not experienced before. Accordingly, there is very little history upon which to draw comparisons or lessons. What is absolutely clear is that navigating the next months will require prudence, pragmatism, and composure to deal with the day-to-day stress of the evolving crisis. Moreover, to the extent possible, corporations should develop contingency plans to shift production away from European countries that are highly dependent on Russian natural gas to less dependent countries in the region or to North American plants.
More: Energy Market Commentary, Natural Gas, Nord Stream 2, Oil, Ukraine Crisis