IN FOCUS6-8 min read

Europe’s gas crisis: what does it mean for investors?

24/08/2022
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Authors

Emma Stevenson
Equities Correspondent

Europe’s precarious gas supply situation has been a prime focus for markets ever since the Russia-Ukraine conflict began at the end of February 2022.

The European Union (EU) and others were quick to apply sanctions to Russian oil. However, gas is a more complicated matter given the reliance of major European economies – most notably Germany – on natural gas from Russia.

The situation became even more critical when a major supply pipeline – Nord Stream 1 – was closed for maintenance in July 2022. While the pipeline has come back onstream, gas is being supplied at a reduced volume.

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Gas demand is lower in the summer, but this reduced supply puts in jeopardy the EU’s aim of filling gas storage sites to 80% capacity in November 2022, and to 90% in 2023.

We asked our investment experts what this means for Europe’s economies and markets.   

What is the impact on gas prices?

“Europe is facing an 18-24 month period of very high gas and electricity prices,” said Mark Lacey, Head of Global Resource Equities. “Europe has become and will remain the premium market for gas over this period, with prices above those in Asia or the US. This premium will last until we start to see meaningful new volumes come onstream from 2024/25.”

High prices can be tackled via two methods: a reduction in demand or an increase in supply. European countries are taking steps to tackle the demand side.

Azad Zangana, Senior European Economist and Strategist, said: “EU member states recently agreed to a voluntary 15% reduction in the consumption of gas, but this could become mandatory if supply continues to be disrupted.

“While energy inflation fell back from 42% year-on-year (y/y) to 39.7% y/y in the latest reading, we expect further price increases to keep energy and headline inflation elevated in the second half of this year, which in turn will reduce the spending power of households.”

The high prices may in themselves cause demand to drop as users limit their gas consumption.

Mark Lacey said: “Following a price increase of around 400% year-on-year, it is inevitable that some element of demand is destroyed. Gas demand in Europe will likely fall around 10% in 2022. Even at lower prices, it is unlikely to grow significantly in 2023 given the risk of recession.”

When will prices ease?

Demand for gas is not only high in Europe, but around the world. Countries are seeking to close down polluting coal plants and move to natural gas as an interim step towards reducing their greenhouse gas emissions. This means Europe is currently competing with countries such as India and China for LNG, with cargoes going to those who can pay the highest prices.

Another problem is that there is limited new LNG supply coming to the market over the next two years.

Mark Lacey said: “The main reason for this lack of supply is due to under-investment in upstream gas projects and project deferrals. This is largely because of the Covid-19 pandemic, as well as previously low regional gas prices.

“However, beyond the next 24 months, Europe starts to have some alternative options for supply of gas. That’s when we’ll start to see the ramp-up of new supply from the US and Qatar.”

That said, even when new LNG supply becomes available, gas prices are unlikely to come down to their previous levels given the growing demand from other regions and for gas as a transition fuel.

Mark Lacey said: “European (and Asian) gas prices have clear downside risk from current levels, but when they do ‘normalise’, they are likely to retrace to a higher base level. For example, rather than $5 - $10/mcf long term pricing, $12 - $18/Mcf pricing may be more sensible.”

This would have long-term implications for energy-intensive sectors like chemicals, even once the current crisis is over. They would still face higher costs than they had previously been used to, impacting their profitability.

Arianna Fox, European Equities Analyst, said: “This could cause a longer-term structural shift that would reduce the competitiveness of chemicals companies producing in Europe. Chemicals companies may seek to shift production to countries where the cost of gas is cheaper.”

Are there any winners?

In the medium to long term, a clear winner from the gas crisis is likely to be the renewable energy sector. The need to curb harmful emissions and to reduce reliance on Russian fossil fuel imports go hand in hand.

Renewable energy projects like wind or solar farms may not be instant solutions to the problem, but they are a lot quicker to get up and running than a nuclear power station, for example.

Higher power prices are also feeding into long-term contract prices for power, meaning investment returns on such projects now look more attractive.

Mark Lacey said: “Power purchase agreements (PPAs) have been increasing steadily from €40/Mwh in March 2021 to just under €100/Mwh in June 2022.

“This has a direct impact on renewable project returns, with developers noting that some project internal rates of return (a measure used to estimate profitability) have increased from 5-6% two years ago, to closer to 11-12% now.”

In May 2022, the EU unveiled its “RePowerEU” plan which is designed to phase out dependency on Russian gas and ensure a more diversified supply of power from lower emission sources. This summer’s crisis and the low gas volumes coming from Russia heighten the need for that phase-out to accelerate. Ultimately, this will bring prices down and make the EU more self-sufficient in terms of power generation.

But it may not be a straightforward journey towards renewables. For example, measures to cushion the gas price impact on consumers may have unintended consequences.

Economist Irene Lauro said: “Governments are providing measures to shield vulnerable households from rising energy prices via subsidies, scrapping surcharges or capping electricity prices.

“Subsidising energy consumption is important to help consumers with the cost of living crisis in the short run. But it can have some drawbacks, indirectly incentivising the use of fossil fuel energy and making the required switch from dirty to cleaner technologies even more expensive in the long run.”

However, in the near term, there is a clear winner that emerges from the current crisis: US gas producers. The higher gas prices make it economically viable to recover US gas than would have been possible with gas prices at $3.00/Mcf.

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Mark Lacey said: “More importantly, around two-thirds of the total US gas resource base is in Texas, Pennsylvania, West Virginia and Oklahoma. All of these markets have transportable access to international markets and are conveniently located to export gas to Europe at an attractive price of around $8.90/Mcf.

“This is also likely to boost long-term US gas prices. Rather than retracing back down to their domestic cost of around $3.00/Mcf, we think it makes more sense for prices to trade around $5.00-$6.00/Mcf. Clearly, this increases the attractiveness of US gas companies to investors.”

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Authors

Emma Stevenson
Equities Correspondent

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