Date: 04/18/22
Author: Kent Moors, Ph.D.
As talk intensifies over a significant weaning of European markets from dependence upon Russian energy exports, attention is drawn to the likelihood of such a move. As it happens, I have spent much of the last several weeks working out the logistical and integrated structure for a European movement away from dependence upon Moscow.
Herein is a very brief precis of what I have concluded.
This is not going to be an easy or straightforward proposition. The attempt will be difficult and increase the aggregate cost of the energy secured. Any transition requires that at least six essential considerations be addressed.
The first requires a rather extended conversation. While both crude oil and natural gas figure in the equation, they do not provide the same impact. Much of the current conversation revolves about the gas side of the situation. That is because EU member countries receive about 45 percent of their natural gas annually from Russia, while receiving just 27 percent of their oil.
The EU headquarters in Brussels had been insisting that the Continent would be moving away from Russian sourcing ever since the annexation of Crimea from Ukraine in 2014. But the European reliance on Moscow has increased since then.
To put matters in perspective, and political rhetoric aside, EU countries have paid at least $40 billion to Russia for oil and gas imports since the invasion of Ukraine began on February 24. There are, after all, ongoing contracts in force. The Kremlin has, in fact, been increasing its coffers even as the volume of exports have been under attack from Western sanctions.
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The figures are chaotic. Russia surpassed annual revenue records for oil and gas exports by the end of March year-on-year (yoy). That is despite month-on-month March oil and gas revenue coming in at 38 percent lower than the Russian Ministry of Finance had forecasted back on March 3. Even so, the Kremlin will add $3.2 billion to national reserves for the month from the sales.
The discrepancy is partially explained by the significant spike in global crude oil prices, which has resulted in a massive increase in proceeds from Russian exports even in the face of apparent declining sales along with some appreciable increases of imports by India where refineries have been gobbling up major Russian availability at steep discount.
Brent, the most often used international yardstick set daily in London and against which Russian prices are pegged at discount (due to being sourer, that is, having a higher sulfur content), has surged 41.62 percent year-to-date (YTD) by close on Friday.
On the natural gas side, the increase is even more noticeable. Gas prices remain set by regionally determined trading hubs since, unlike oil, there is not a worldwide gas market. That may be changing (as noted shortly). But for now, the problems in Europe are accentuated well beyond what is being experienced virtually anywhere else. Henry Hub – the benchmark for setting gas prices in the US market via futures contracts in New York – is up 90.84 percent YTD, 46.36 percent for the current rolling month daily average (adding the most recent closing value, deleting the earliest).
However, for Europe, an existing panoply of acute shortages and supply bottlenecks had already been producing historically high prices even before the Russian invasion (see “The Accelerating European Energy Pricing Crisis,” Classified Intelligence Brief,” September 20, 2021). Today, the situation is even more serious with prices well beyond the worst ever experienced.
A concerted reduction in Russian energy imports will intensify the pain. Yet taking the broader view, as matters in geopolitics crystalize, natural gas globally will be a better investment play moving forward than crude oil (where a contraction will occur as soon as the “war premium” plays out).
Despite the record setting year-over-year (yoy) revenues, the wide range of crippling shortages forming throughout the Russian domestic market will have a debilitating effect. The latest estimates by international agencies put the economic contraction at 11.2 percent for 2022. But remember, this is even more debilitating given the rapidly closing Russian market. The government usage of a now (once again) untradable local currency, replete with artificial price levels and internal exchange valuations, will hide even more serious declines.
On the other hand, while gas has been the most focused upon import – with cancelation of the highly contentious Nord Stream II pipeline from Russia to Germany the most visible casualty – it is actually the cutting of oil imports that would do the most immediate damage to the Russian economy. That is because Moscow makes more money on the profit margins from oil sales than natural gas.
Second, a main element in the weaning is continuing an accelerated move into renewable sourcing. These days this is the easy sell, as both wind and solar had been making strides on the Continent well before Putin sent his tanks into Ukraine. Unfortunately, there are a number of factors impeding any pronounced further increase in this approach.
For one thing, the curve has been flattening out for a while now. Early significant rises cannot be expected as systems reach renewable capacity. In addition, even with the availability of additional network elements another spurt could not be maintained as further reliance would require expensive and time-consuming knock-on changes in grid and cross border transmission changes.
Then there is the irritating reality that increasing the portion of renewables in the mix actually requires an increase in the amount of conventional backup sourcing. This is to provide power for those times when the sun doesn’t shine nor the wind blows, as well as for peak periods of electricity demand. This requires more usage of traditional hydrocarbons. While there are fixes for this coming (see last Monday’s “The Arrival of Energy Storage Mandates,” Classified Intelligence Brief, April 11, 2022), the cutting of Russian energy is a shorter-term requirement.
Third, for the next 12 to 18 months, more importing of coal will be required, accentuated by a decision to halt all further trade in Russian coal. This is an unfortunate development for the green-based movement that has been successful in cutting coal use but it is inescapable. Most of the new volume will come from North America and as far away as Australia but will cost more. In addition, especially in the case of the US, there is fast approaching an effective export ceiling owing to port and carrier capacities.
Fourth, there will be an increasing reliance on offshore North Sea oil and gas. The massive fifty-year old series of discoveries developed by the UK and Norway has witnessed accelerated production declines at affordable main basins as lifting expenses increase.
These days, however, cost has become less of a factor as Europe moves quicky into assessing more strategically controlled sources of energy. Of course, increasing reliance on the North Sea will further exacerbate the pricing increases that have plagued the Continent for months. On the other hand, this is a matter of security first and cost second. That may open up some leverage in how the North Sea is exploited.
Fifth, an energetic survey of alternative foreign sources has been underway. On its own, Europe cannot meet its energy demand requirements so long as hydrocarbons remain the main component.
The best alternative sources of piped natural gas are emerging as MENA (Middle East North Africa) countries, especially Algeria, the basin developing between Cyprus and Lebanon/Israel, Qatar and offshore Egypt (there will be an additional comment on these two in a moment), and Iraq.
The Iraqi option is one on which I have been spending some intensive analytical time for private clients. The addition from both Iraqi and component Kurdish fields has been on the agenda for some time, utilizing both existing and proposed pipelines across Turkey. And this was before the current European search for new sources.
However, the jury is still out on how much can be added here and how quickly. There may well be some additional volume available from Iran (especially from the huge offshore South Pars fields) also transiting Turkish pipelines. But that is dependent upon a quick renewal of the JCPOA nuclear agreement between the West and Teheran and cannot be realistically factored into our discussion at the moment.
That leaves the sixth, and final wildcard, element: liquified natural gas (LNG). This is looming as the game changer. Involving the cooling of gas to a liquid for transport by tanker, regasification on the receiving end, and then injection into already existing pipeline networks, LNG will transform natural gas into a genuinely global market (rather than a patchwork of regional pricings).
Basic to this energy transition, which is likely to be one of the most important in decades, will be the establishment of hub markets throughout the world that determine the local underpinning of longer-terms contract prices, much as experienced already with crude oil and refined oil products.
This will introduce some exciting investment prospects, a discussion better left for another day.
At the moment, LNG becomes the potentially major new element in the European situation. Already, additional volume has been contracted with offshore Egypt and Algeria, utilizing LNG receiving terminals located in Italy and Spain. Qatar, the world’s leading supplier of LNG (it became the first country to end new pipeline contracts and commit all of its substantial offshore natural gas reserves to LNG shipments), has indicated it could provide more. But it has also acknowledged that it cannot cover the added volume necessary should future Russian trade be cut.
There are new sources emerging in the world, Australia and Papua New Guinea for example. But the main new player here to meet European requirements is the US. Widely acknowledged to move from no LNG in international trade a few years ago to being one of the worldwide leading sources, American exporters are now looked to for the bulk of new consignments.
There are several impediments. For one, there is insufficient available unused export capacity at existing US LNG facilities. A number of additional locations have made application to export but are also in varying stages of development and subject to what remains a slow approval process. Adding Canadian export potential to the mix may help, but most of that LNG tonnage is already committed on long-term contract to the Asian market.
Then there is insufficient receiving capacity in Europe to take up the additional LNG needed. Several new terminals have recently opened and there is the prospect of a creative introduction of LNG/conventional pipeline contract swaps elsewhere in the world allowing for additional consignments moving to the Continent. But this remains a stop gap measure at best.
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The main problem with redirecting LNG trade to Europe involves what that will do to the number one existing and rapidly expanding market – Asia. The genuine prospect of a bidding war would also carry the shroud of rapidly rising prices and localized economic contraction on two continents.
It took several decades to develop the network of Russian energy deliveries to Europe. The move underway to sever that connection cannot be accomplished in short order, even if the misery it will occasion to European end users can be offset. It will require a rapid transformation in how energy is used (especially in transport), overlook standing multi-year delivery contracts in force, and usher in a dramatically altered reading of force majeure.
My initial conclusion is to regard the next 18 to 24 months as a period of progressively new European initiatives, with the attendant dislocation of economies and prospects. But with the Russian invasion likely to become a protracted quagmire, the “New Energy World” may be approaching, nonetheless. Whether it is desired or not.
Two final considerations in what has already been a very long exegesis. First, we may be moving into warmer weather, but this is also the time when Europe needs to replenish gas in storage. Unseasonably high drain offs have taken place to meet unusual weather and political exigencies. That means the need to address energy sufficiency and the increasing cost of arriving there have arrived.
Second, in addition to everything else I have mentioned in this CIB, the other reality hitting Europe is the need for energy demand destruction. The Continent will need to make do with less, an unsettling development in the face of still unknown COVID market aftershocks.
As one of my British colleagues recently noted, “We are already into a second sweater reality.”
Dr. Kent Moors
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
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