Gas prices in Europe hit a record high of $1,400 per 1,000 cubic meters (mcm) in October, which corresponded to oil prices of $160 per barrel (almost double the figures for oil). Although gas prices lessened in November, they still remain high: according to Eikon, the average was $897 per 1,000 mcm, a more than 5-fold increase over 12 months. This poses the question of whether the energy crisis is temporary or it heralds new unexpected structural problems for the energy markets.
A combination of factors
The steady rise in prices for natural gas, as well as for other commodities, has been observed throughout 2021. The main reasons were primarily associated with the rapid recovery of economic activity after severe quarantine regimes last year. Global financial markets were quickly bouncing back against the backdrop of stimulatory monetary policy and fiscal stimulus introduced by many countries. Further, 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 were the first to enter and emerge from the recession. This led to a strong increase in demand for gas 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 increased, gas prices in Asia also began to rise rapidly.
The Asian market is considered a premium market with higher prices than in Europe. LNG producers tend to focus on the Asian market, while the European market was seen 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 gas shortage in the market and reoriented free supply. 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 deliveries amounted to 5.3 million tons which is the same level as last August and 3% less than in September last year (hereinafter, the author’s calculations are based on data from the Eikon analytical platform).
Neither did American LNG become a ‘saviour’ for the European market during this difficult period. US LNG supply to the EU, which reached 2.5–3.0 million tons per month in the second quarter, has dropped to 1.0–1.2 million tons in recent months. American LNG producers have also shifted their focus to the Asian market to the detriment of the European one.
To some extent, the surge in prices and the shortage of LNG supply in the global market is a consequence of an investment pause that 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, plants have a high level of capacity utilisation 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 delay affects the market balance, albeit with a rather significant lag.
Quite often, there are accusations that Gazprom was the culprit in the European crisis, having contributed to it. However, current gas production in Russia is at all-time highs. In October 2021, production amounted to 65.81 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 during the cold winter last year. In these conditions, the possibilities for increasing gas export are limited. Nevertheless, in the first 7 months of 2021, the export of pipeline gas, according to the Federal Customs Service (link in Russian), increased by 11% compared to last year.
For a long time, the European gas market has had the opportunity to receive additional gas from Russia, if necessary. When free production capacities in Russia were exhausted, the market encountered serious difficulties. Moreover, decisions made in Europe 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 the spike in prices that simultaneously occurred in interconnected markets: the natural gas, coal and CO2 emissions markets. In this case, it is rather difficult to identify which is the cause and which is the effect. However, this synchronous growth fuels all related markets.
CO2 emissions prices reached 60 euros per ton this year, while last year they did not exceed 20–30 euros. The high cost of emissions disrupts the economy 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 depleted market.
Decarbonisation policy
For the most part, the current energy crisis in Europe is connected to the simultaneous impact of many separate factors, often barely related to each other, but that turned out to be involved simultaneously and all acting to the same direction. This means that as the influence of these factors ends, the market should stabilise and prices should decrease. However, the current situation also reveals mistakes in the European energy policy.
The European Union is one of the main driving forces of the global climate agenda and it sets ambitious targets for decarbonisation. 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 renewable energy sources increases, so do the requirements for the resilience of energy systems. Distributed generation requires a developed network infrastructure and a higher level of energy reserve capacity. However, this does not provide a guarantee against an unforeseen reduction in the generation of renewable energy and its replacement with traditional sources. Apparently, the approaches to reserving and decommissioning conventional facilities should be reconsidered.
For quite a long time, Europe has been dominated by the idea that LNG could improve energy security and reduce dependence on the largest supplier – Russia. The possibility of receiving LNG diversifies sources and strengthens the bargaining position, but does not imply low prices. The European market is becoming increasingly bound to the US and Asian gas markets. Therefore, a 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 annual percentage points. The percentage 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 would be a normal market reaction and would reduce demand. This is likely to cause a slowdown in the economy in the next two quarters, however, but unlikely to cause 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.
The rate of export duty on natural gas is 30%. Therefore, an increase in Gazprom’s export prices for Europe generates higher budget revenues. In 2020, the revenues stood at 439 billion rubles (versus 696 rubles billion (link in Russian) in 2019). However, prices being quoted at $1200/mcm in the futures market do not mean that Gazprom sells gas to Europe at the same price. Gazprom’s contracts are mainly tied to long-term forwards rather than spot prices. While the EU is a key market for Gazprom (accounting about 80% of pipeline gas exports, according to the Federal Customs Service), there are some other markets as well.
For example, Gazprom supplies gas to certain neighbour states at prices significantly lower than those currently in Europe. Prices for gas transmitted to China via the Power of Siberia pipeline are also notably lower (around $200/mcm). In July 2021, the average export price for Russian pipeline gas was $245/mcm, compared to the $466/mcm spot price at the Dutch TTF hub. Our estimates suggest that the average export price for Russian gas will be approximately $300–320/mcm in 2021 (versus $124/mcm in 2020). According to our assessment, this will increase export duty revenues to about 1.1 trillion rubles, which is 2.3 times more than in the previous year and 60% more compared to 2019.
Another channel will be Gazprom’s increased profit and, hence, a higher profit tax. We expect that Gazprom’s profit this year, driven by record high prices, will be around 2 trillion rubles. Accordingly, the profit tax payment will amount to around 400–420 billion rubles. Gazprom will also raise its dividend payouts, which could reach 1 trillion rubles. The state holds a 50% equity stake in the company and can thereby expect up to 500 billion rubles as dividends.
However, moderation is the key. Strange as it may seem, exorbitant prices keeping for an excessively long period will have an adverse impact in the long run. With the current gas prices, almost any alternative, such as wood to heat homes or heavy fuel oil to generate electricity, is more feasible than natural gas. Under these conditions, consumers will have to minimise gas consumption and all alternatives to natural gas will gain additional competitive advantages. There are calls in Europe for faster development of renewable energy sources to avoid the extremely expensive hydrocarbon imports. In the long term, persistently high prices will have a negative effect on demand and boost the competitive strength of alternatives, including renewables, in the electrical power sector.
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