Will Europe freeze?

3:35 PM July 18, 2022

Europe is currently facing potentially the worst energy crisis in history. There are many factors which led to the current state of affairs, but the key reason is obvious. Russia, in retaliation for the sanctions imposed after the attack on Ukraine, has already cut off gas supplies to many EU members, and has been gradually reducing gas flows to other countries. For many years, gas was the preferred source of energy in Europe, which was related to its availability and low price. The actions of the Russian lobby, which made Europe dependent on gas transfers, cannot be ruled out either. For this reason, many fear that Europe may freeze during the winter period.

Structure of European gas demand

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Before the war, Russia accounted for approx. 30-40% of gas imported by the European Union. The EU's dependence on this raw material import increased to approximately 80%. This is a lot, but for many years the EU reduced its own production and imported more from Russia due to lower prices. Despite huge objections from transit countries, and also from the United States, Germany decided to build the second branch of the Nord Stream II project, completely neglecting the diversification of supply sources. Gas was not only very cheap, which has increased the competitiveness of German industry over the years, but it is also a relatively low-emission commodity compared to coal. No wonder that gas has become the EU's green agenda favorite 'transitional' energy source.

Now it is worth paying attention to a few numbers. Last year, according to data provided by Eurogaz, consumption in the EU amounted to about 4700 TWh (terawatt hours), i.e. slightly below 500 billion cubic meters. Nearly 20% of this amount is used by Germany, however Italy and until recently the United Kingdom are also major consumers. Gas accounts for 22% of all energy sources in Europe, so it does not appear to be an irreplaceable level. On the other hand, gas is mostly used for heating homes, water and food preparation across Europe, not to mention many industrial sectors where it is currently the only possible source of energy.

What is the current situation?

The share of Russian gas in imports to the European Union has dropped drastically from around 40%, based on data from 2021, to around 20% in the first half of this year. This should not come as a surprise, of course, given that exports to Poland, the Netherlands, Greece, Denmark or even Finland have been halted. Moreover, the transfer to Germany has been reduced by a massive 60%, and many other important contractors, such as Italy, France, Austria and the Czech Republic, are also importing lessfrom Russia. The cut-off of gas supplies is the result of a failure to comply with the payment method imposed by Gazprom, while the reduction of supplies is the result of a political game.

Europe is trying to replace imports from Russia. Huge amounts of liquefied natural gas (LNG) were collected, and imports from other sources, notably Norway, were increased. Europe still has free import capacity when it comes to LNG gas or the ability to import more gas from North Africa or Azerbaijan. Inventories look better than last year and warehouses in Europe are filled in approx. two thirds. Some countries such as Poland or Portugal should be a role model, as the warehouses in these countries are nearly 100% full. Of course, one must also remember that the size of the warehouses is relatively small compared to Germany. In Poland, warehouses are about 6 times smaller than in Germany. Theoretically, the situation is not bad, but unfortunately the immediate prospects are not very optimistic.

Gas inventories in Europe look pretty good given the current period of the year. Warehouses are two thirds full, in line with the 5-year average. Source: Bloomberg

What if Russia turns off the gas tap?

Russia has already significantly reduced gas transfers to Western European countries. Deliveries to Germany were even 60% lower than in the previous years and have now fallen to zero due to the annual maintenance of the pipeline. However, absolutely everyone is afraid that gas transfers from Russia will not be resumed. The earlier reduction in gas transfer was theoretically due to technical problems. Gazprom put pressure on Siemens to repair the turbines required to resume gas transfer. Theoretically, Canada, where one of the turbines was maintained, agreed to send the necessary equipment, but due to sanctions, it is still unknown whether it will reach its destination. We should not be surprised if gas does not flow to Germany via Nord Stream I in August. A small but still positive aspect is that gas is still flowing through the gas pipeline in Ukraine.

Gas transfer to Germany has now dropped to zero. Earlier transfers dropped by roughly 60% due to alleged technical problems. Source: Bloomberg

Should we prepare thick socks?

Unfortunately, this is not a joke. Leaders in many European countries speak of a crisis plan for the winter. Although some solutions seem absurd from the perspective of our daily life, no one is laughing. Politicians in Poland or Germany, advise citizens to collect firewood. Even Deutsche Bank indicated that the Germans would have to use fireplaces to keep themselves warm. The authorities in Poland recommend that houses be insulated before winter, and the authorities from the European Union recommend buying thick socks and sweaters and lowering the temperatures in the houses. In turn, the Greek ambassador to Germany invites all retirees from the North to spend the autumn and winter period on the warm Mediterranean islands. It is really unlikely that people will not have access to gas in their homes during the winter - this is what reserves are built for. On the other hand, we will pay for it with higher bills and through the economic slowdown due to the suspension of activity in many industrial sectors.

Is it really that bad?

Looking at the statistics, the situation is not so bad. In order to replace Russian gas supplies, Europe would have to find around 1600-1700 TWh of additional energy supply. This is roughly the amount of LNG import capacity to Europe. In addition, there is an additional supply of up to 200 TWh via a gas pipeline from North Africa and possible supply from Norway. Unfortunately, however, the LNG gas infrastructure does not allow gas to flow freely in Europe. Spain and the United Kingdom currently have half the regasification capacity. Spain only has permanent contact with France via gas pipelines. Europe also needs to find suppliers who will bring this gas to the continent. The United States is sending quite a lot to Europe right now, but not enough to replace Russia. There is also a need for new contracts on the LNG market, which would direct a part of the gas that has so far flowed to Asia towards Europe. Such matters take time, while Europe could be deprived of the largest fuel supplier overnight. What's more, it is worth noting that Europe's largest lifebuoy also "sinks". Gas supplies from Norway have been sharply reduced as workers in the Norwegian gas and oil sector went on strike due low wages. The situation seems to be under control at the moment, but similar problems cannot be ruled out in the future.

How can Europe deal with the current problems?

Of course, the EU has the option of restarting coal-fired power plants, but these also have limited energy capacity. In this case, it is worth paying attention to the potential significant increase in demand for CO2 emission permits, unless the regulations in this regard are reduced. Most likely, however, demand will be reduced and not only in the industrial sector, but also in terms of heating. It is already recommended in Germany that the temperature in public places in winter should be set at 20 degrees, although some guides show how to deal with everyday functioning at a temperature of about 15-16 degrees. Bloomberg points out that Europe will be able to replace about half of the Russian supply, so the demand response will have to be really strong. All this indicates that not only will it be colder this winter, but our wallets will also lose weight. We should not be surprised if gas prices on the Amsterdam stock exchange jump to the range of EUR 200-250 / MWh, and even the level of EUR 300 / MWh is also possible. Of course, all that has been presented in this article is bearish, but a very realistic scenario. It remains to be hoped that the winter will be mild, and Russia will decide to resume transfer to Germany.

Prices in Europe are hovering near all-time highs, but the suspension of Russian supplies could push them even higher. Theoretically this may push gas prices in the United States higher, which are working on increasing supplies to Europe. Prices in USD per million British heating units. The price on the stock exchange in the Netherlands is currently around EUR 160 per megawatt hour. Source: Bloomberg

Gas prices are also crucial for the euro and the Polish zloty. Price stabilization should benefit European currencies due to the reduced risk of an energy crisis. However, if prices rise above 200 EUR / MWh (above 70 USD / MMBTU) then we may experience weakness in many European currencies.

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