Russia, Gas And The European Union: An Explosive Mix

Author

Eric Chaney

Senior Fellow - Economy

Ukraine and Russia: Destined for Conflict?

At his press conference in Moscow on February 1, Hungarian Prime Minister Viktor Orban should have opened the eyes of anyone who believed that trade in natural gas is politically untainted. Under the approving gaze of Vladimir Putin, he bluntly stated that "Hungary will be protected in case of any problems in the European gas market, thanks to contracts with our Russian partners."

Shortly before, Faith Birol, Director of the International Energy Agency, departed from his usually diplomatic language to assert that tensions in the European gas market "appear to be due to the behavior of Russia’s state-controlled gas supplier," Gazprom, though this was not referenced by name. As the economic recovery gathered pace in Europe during the final quarter of 2021, Russian gas deliveries were 25% lower than in late 2020. According to Mr. Birol, Russia could easily increase its gas supply to Europe by a third.

Russia’s restraint, at a time when market prices have almost doubled in Europe, seems to indicate that political considerations have outweighed commercial interests. In fact, it is likely that Russia is winning on both sides, politically and commercially, as we shall later see.

Gas: Russia’s geopolitical weapon

The Ukraine crisis has spotlighted the geopolitical significance of Nord Stream 2 - a pipeline stretching from the Gulf of Finland to Germany, which would double Russia’s underwater export capacity to Western Europe, thus independent from transit countries. A common view is that one of the aims of Russian aggression is to secure this infrastructure and depoliticize it, at least in the direction West-East.

This is not the first time that Russia has used hydrocarbons as a tool to increase political pressure.

In 2003, Latvia saw its oil supply cut off under the pretext of mistreating the country’s Russian-speaking minority. Shortly after the 2005 election of the pro-Western Viktor Yushchenko, Ukraine’s gas supply dried up during the depths of winter. In 2006, Gazprom doubled the price of gas exported to Georgia after Russian officers were accused of espionage. 2006 also saw Russia citing a ‘leak’ as the reason for reduced supplies to Lithuania - after a Lithuanian refiner was sold to a Polish company in preference to a Russian bid.

While politically significant, these maneuvers were mere skirmishes compared to the current crisis. There are interesting parallels between today and the 1973 oil crisis, when Saudi Arabia led a group of Middle Eastern oil producers in an embargo of exports to America and Europe, in an effort to isolate Israel.

At this point, we should emphasize that although oil and gas are both principally consumed as primary energy sources, their markets have important differences.

Gas exports require hugely capital-intensive infrastructure, such as pipelines and ultra-secure gas terminals for the ships carrying liquefied gas (LNG) at minus 160°C. There is also the need for regasification facilities and secondary pipelines. By contrast, the export of oil merely requires tankers and refineries close to tanker terminals. As a result, the gas market is dominated by long-term contracts, whereas the oil market is primarily determined by the interaction of spot and futures markets. Because the oil market is deeper, more liquid and has more sophisticated hedging instruments, its prices have largely determined gas prices-at least until recently.

There is a second structural difference: any discretionary reduction in OPEC oil exports immediately affects all importers since OPEC prices are those of the spot market. Besides, a supertanker bound for Rotterdam via the Cape of Good Hope can divert at any point to Singapore if its cargo is claimed at a higher price by Asian refiners. This is impossible for pipelined gas, where the destination is fixed in advance. From a geopolitical perspective, gas can therefore be considered as both a market and a localized weapon. For now, the battlefield is Europe.

The European gas market is experiencing its "1973" moment.

As in 1973, the world economy is in a phase of strong recovery - close to overheating - judging by the rapid rise in inflation. As previously, recovery is driving a strong demand for energy products, this time with an emphasis on natural gas, the preferred option for many countries seeking to reduce their dependence on coal. Additionally, in parallel to the years following 1973, oil producers are drilling at full capacity.

For producers with significant market power, these are ideal circumstances for exercising that power by reducing production. The resulting price surge - as competitors are unable to produce more oil - will more than compensate for a reduction in deliveries.

In 1973, a cartel of oil producers turned off the taps, causing global prices of crude oil to double. In 2021, Russia - which, together with Azerbaijan, supplies 41% of Europe’s gas and 55% of Germany’s - cut its supply by 25%. This will not necessarily be profitable in the short term, since part of the deliveries were previously invoiced at a fixed price. But as contract prices begin to align with market prices, the operation becomes profitable in the medium term.

Another consequence of Russian actions is that the market price of gas in Europe is no longer determined by the price of oil, but rather through its own dynamics.

Another consequence of Russian actions is that the market price of gas in Europe is no longer determined by the price of oil, but rather through its own dynamics: with equivalent energy content, the price of natural gas imported by Germany has increased by 175% since 2019, while the price of oil has only increased by 30%. In Europe, gas has become independent of oil, with undisputable benefits for the dominant producer.

The Russian strategy - kill two birds with one stone.

It is clear that Russia’s strategy is based on the economic fundamentals of strong global demand and a dominant local market position. The increasing price of crude oil ($93/bl on February 4), which remains the primary Russian export, only serves to reinforce Moscow’s economic position.

It is no coincidence that Russian demands for political and military ‘rebalancing’ have coincided with a reduction in exports of a critical energy product in the middle of winter. But it would be a mistake to judge this strategy solely from a geopolitical perspective. It also makes perfect economic sense.

"Why not kill two birds with one stone", they must have thought in Moscow, which will continue to benefit from an exceptionally good economic environment. The question is, for how long?

It is difficult for Europe to avoid blackmail

Russia’s geopolitical as well as economic dominance is an inevitable side-effect result of Europe’s huge dependency on Russian gas. If we restrict ourselves to pipeline deliveries, European producers (Norway, United Kingdom, Netherlands) and Algeria supplied a combined 257 bcm of gas to Europe in 2019, compared to 181 bcm from Russia and Azerbaijan. Therefore, a 10% drop in demand would reduce Russia’s market share from 41% to 34%, a level that might deprive Russia of its dominant position. In fact, most European countries have reduced their fossil gas consumption over the last ten years: between 2010 and 2019 - the last year that can be used as a benchmark unaffected by pandemic conditions - Europe’s consumption fell by 11.2%, with Denmark achieving a 44% drop, and Finland 51%.

Among large gas consumers, the exception is Germany, whose usage increased by 0.7% between 2010 and 2019.

Among large gas consumers, the exception is Germany, whose usage increased by 0.7% between 2010 and 2019. Natural gas is now used for 25% of its primary energy needs, with an even greater (albeit decreasing) dependence in the Netherlands (38%) and Italy (39%) and much lower dependence in France (16%). In most cases, reduced dependence on gas is the result of CO₂ reduction policies rather than strategies of political independence, though the latter may have somewhat guided Finland and the Baltic states, whose geographical proximity to Russia has inevitably influenced their strategic decision-making.

The fact that Germany has gone against the grain is a direct result of its energy policy: using gas instead of coal to reduce emissions, while concurrently closing nuclear production units in favor of renewable - but intermittent - energy sources, all of which inevitably results in a greater need for gas turbines.

It is a strategy that is becoming increasingly difficult to justify, leading former IFO President Hans-Werner Sinn to comment that "viewed in [a] global, twenty-first-century context, Germany has become the wrong-way driver on the Autobahn." Perhaps Mr. Sinn was being polite in refraining from mentioning Belgium’s journey down the same road.

However, the agenda of the new governing coalition means it is unlikely that Germany will reverse its decision to close the remaining nuclear power plants, despite their high performance. Germany’s dependence on Russian gas will therefore only continue to increase.

Did someone say sanctions?

With regards to the current crisis, the potential sanctions outlined by Ursula von der Leyen, President of the European Commission, in her interview with Handelsblatt and Les Echos on February 4 are not entirely convincing. In a world where 85% of Russian pipeline exports go to Europe, the latter would usually represent the dominant buyer - what economists call a ‘monopsony’ - which it could use to put pressure on its supplier. But this only applies if the buyer is a singular entity prepared to follow a united strategy. Germany’s dependence on Russian gas means that this cannot be the case.

Ursula von der Leyen is evidently aware of this when she suggests that the EU is seeking to diversify supplies. She emphasizes that the number of LNG gas terminals has risen significantly, and "imagines" a situation where EU gas purchases could be centralized. On the path from imagination to realism, it is Japan that has taken the lead: Koichi Hagiuda, Minister of Foreign Trade, has said that his country will ensure it is supplied with LNG this winter, prior to any consideration of "what it could do to help the international community" in the event of open conflict in Ukraine.

The potential sanctions outlined by Ursula von der Leyen, President of the European Commission, [...] are not entirely convincing.

Other potential sanctions include embargoes on advanced technologies that Russia needs to import (partially to satisfy its military ambitions) and the possibility of blocking Russia from the SWIFT international payment clearing system. These are more credible threats than those of stopping NordSteam2, which would be wholly incompatible with the reality of German energy needs. The effectiveness of these strategies, however, is limited. Russia can simply turn to China for its technological imports, which may be less sophisticated but still do an effective job - at the potential cost of political compromise.

As for the exclusion from SWIFT, the effects may be minimal for oil and gas exports, which remain Russia’s primary source of income. Slower settlements would not prevent continued exporting, and Russia’s huge foreign exchange reserves mean it has no liquidity problems. On the other hand, there would be significant issues for European companies trading with Russia. Under these conditions, it is difficult to imagine that all the banks involved in SWIFT, a Belgian company chaired by a Pakistani and managed by a Spaniard, would willingly accept the exclusion of Russia, for the sake of American policy.

That leaves the sanctions directed against some of those in Vladimir Putin’s entourage or even towards the President of the Russian Federation himself-via his nominees. Their effectiveness, however, is not a subject for economic analysis.

Ultimately, the best long-term economic strategy for resisting Russia is reducing Europe’s dependence on gas. Let’s not forget that half the world’s natural gas reserves are held between Russia (20%), Iran (17%) and Qatar (13%). By reducing gas consumption, the EU would lower CO2 emissions while, at the same time, protecting itself against political pressure from regimes that remain openly hostile to its values.

Copyright: Odd ANDERSEN / AFP