Energy Monitor - Energy prices to rise even further if supply disruptions increase

Gas prices reach record high levels… again

After the invasion of parts of Ukraine by Russia, markets have continued to price in the risk of supply shortages. The active month contract of Title Transfer Facility (TTF) topped the EUR 200/MWh mark before easing somewhat. Although Russian exports have continued up to now and even increased a bit, the risk of gas markets being affected due to either sanctions or self-sanctioning is rising every day. Recently, the Russian energy minister indicated that they may consider a ban on Russian gas exports via Nord Stream 1, a pipeline which runs from Russia directly to Germany. Such a measure may not hurt the EU in the very near term, but it would immediately create serious risks for building inventories for next winter. For Russian LNG, the shipments to Europe are already struggling. After the UK imposed a ban on Russian marine vessels, the landing of Russian LNG vessels has become more difficult. Alongside the month ahead contract, the year ahead contract is also on the rise and is trading above EUR 80/MWh, as shown in the figure below.

Several countries made references to their own individual dependency on the import of Russian gas. However, this is quite irrelevant. Due to the interconnection of European markets and the fact that the TTF is seen as the most important European benchmark, the only thing that really matters is the total European imports of Russian natural gas. Europe imports roughly 40% of its natural gas from Russia. The majority is transported via pipelines (roughly 80%) and is therefore more difficult to replace with Liquified Natural Gas (LNG).

Lack of alternatives

Earlier this week, the European Commission announced plans to reduce the EU dependency on Russian fossil fuels – mainly natural gas – as soon as possible. The EC indicated several options to reduce demand for Russian gas by 2/3rd in one year, to battle rising energy prices and to replenish gas inventories. These EU plans can be divided into two categories, but few details have been released up to now. First, the EU plans to diversify European gas supply. This can be done by increasing LNG imports from suppliers other than Russia, speeding up local (small) production projects, and increasing the production of biomethane and (green) hydrogen. The second category is to reduce demand of natural gas through higher efficiency, more use of renewable energy, electrification and tackling the infrastructure bottlenecks.

For several of these solutions, the timing of ‘within one year’ seems to be extremely ambitious and perhaps even unrealistic. At the same time, the International Energy Agency (IEA) also released a 10-step plan earlier this week to reduce the EU dependency on Russian gas. The IEA expects that a reduction of 1/3rd would be more realistic. However, the IEA largely does not take into account the alternative of more usage of coal fired power plants – something that Frans Timmermans, vice president of the European Commission, has indicated as being one of the plausible short term solutions. This would allow a switch from coal to renewables at a later stage, instead of using gas as a transition fuel.

Both plans strongly lean on the rise of LNG imports. However, there will not be enough LNG available to fill the gap which would come from lower gas supply from Russia – even if all available LNG were to be shipped towards Europe, a scenario which is not very likely. After all, gas importing countries in Asia will also be bidding for the available LNG supply to fill their inventories too. Before the escalation, markets were already nervous about refilling inventories before the next winter, with an expected fill rate of 75-80%. Now, EU policymakers are proposing an obligatory filling degree of 90%, whilst Russian supply has come under more pressure. This will drive prices up even further.

Oil prices on the rise due to self-sanctioning

Oil prices have been rising in recent weeks and days. Initially this was because companies started self-sanctioning in anticipation of possible future sanctions. Buyers of Russian oil preferred to reduce or even stop buying Russian oil to stem the risk of violating sanctions. Societal pressure not to purchase Russian oil on the spot markets also triggered fears of less supply being available. On top of that, the US and the UK implemented a full ban of Russian crude imports. At first this pushed oil prices even higher. As a result, Brent oil reached a high of almost USD 140/bbl. However, European leaders took a much softer approach as the EU dependency on Russian oil is, at approximately 30%, tenfold that of the US’ dependency.

In recent days, oil prices eased somewhat as the EU has not appeared willing to implement a full ban on Russian oil exports… yet. The correction lower continued on Wednesday after signals that Ukraine may be willing to discuss Russia’s demand of neutrality with certain conditions. Remarks by the United Arab Emirates also helped, suggesting that if prices remain this high for much longer, more production from OPEC may be needed. Still, the next OPEC+ meeting will be on 31 March. And at the moment, there is already room for higher production within the current production quotas.

Russia is an exporter of heavy sour crude or a blend with light sweet oil, also called Urals crude. This is typically a type of oil which has a relatively high percentage of sulphur. To refine this type of crude, refineries have set their cracking furnace in such a way that it is typically set solely for this type of crude. To change these settings is a time-consuming and costly process, so refineries prefer to always import a similar type of crude. If Russian exports come to a halt, it is not so easy to find other suppliers. Other producers of similar types of crude are Venezuela, Iran, Colombia, Canada and Saudi Arabia. With the investments in Venezuela being near zero in recent years, stepping up production and exports from there is not very likely. Iran cannot increase its exports due to existing sanctions. And even if a new nuclear deal were to be finalised in the coming weeks, it is still very unlikely that Iran will step up its exports as it is a close ally of Russia. Finally, Saudi Arabia will also be reluctant to increase production and exports as it would surpass its quota as agreed with OPEC+. The coalition of oil producing countries is led by both Saudi Arabia and Russia.

Oil and gas price scenarios

Following the news earlier this week of an official US and UK embargo on Russian oil imports, and ‘self-sanctioning’ moves by major oil and gas (and many other) companies, we have revised our scenarios describing how the Russia-Ukraine conflict will impact the European and US economies over the coming quarters. We now expect sanctions to lead to a lasting global trade re-alignment, with dependence on Russian energy and other commodities gradually – potentially more abruptly – reduced, and replaced with alternative sources. Even in the most optimistic de-escalation scenario, we cannot foresee a return to the situation of two weeks ago, given the withdrawal of western oil and gas companies from Russia and the knock-on effects this vacuum in technical expertise will have for future supplies. It is also highly unlikely the conditions for removing sanctions (which have not been specified) would be met even in a de-escalation scenario. The question then becomes how long this structural trade re-alignment takes, and how disruptive for economies it will be. Please find our recent updates with the implications on the macro economy here.

For the energy markets, the scenarios are the following. Our new base case acknowledges that physical supply disruptions are already happening, and we now see these disruptions getting worse over the coming months as embargoes and self-sanctioning moves come into effect. We expect that some supply disruptions could continue for at least a year. We expect some self-sanctioning in the oil markets and partially for LNG (spot market trade only). The US/UK oil ban is not expanded to Europe in our new base case, and Russian gas exports via the pipelines will continue as contracted. However, Russia will not fill the necessary additional supply of gas on spot markets, similar to the situation of recent months. Due to the higher prices, self-rationing of demand will occur. Note, we do not assume a complete cut-off in Russian oil and gas supplies to Europe in this scenario. 

In the negative scenario, we do expect a full Russian supply disruption. This means a full ban of exports of both Russian oil and gas. Furthermore, we expect this situation to remain in place for longer (up to two years). The impact of a gas cut-off is particularly negative, due to its reliance on physical (pipeline) infrastructure, and the lack of LNG terminal capacity to replace Russian supply in the near term. Europe will be in full competition with Asia on the LNG spot market. Even higher energy prices will result in lower demand. When this is not enough, governments may force industry stoppages to prevent physical shortages of energy related commodities.

In the positive scenario, we expect a more rapid trade re-alignment (disruptions lasting six months). We ascribe only a low probability to this scenario, which assumes a quicker realignment of global trade flows, shortening the disruption to energy and other supplies to around 6 months. The US and perhaps some OPEC countries like Saudi Arabia and the United Arab Emirates could raise oil output in order to fill the gap left by Russia, and/or Russian oil is bought by eg. China, freeing non-Russian supply to go to Europe. Another option is a de-escalation of the Russia/Ukraine war. Still, even if sanctions may be lifted at some point in time, we expect a large part of the self-sanctioning will remain in place. This will continue to lead to some shifts in global trade and a continuous move away from EU energy imports from Russia. So, even in this scenario, energy prices could continue trading higher for longer compared to pre-pandemic price levels.