17.10.22 Expertise

Crisis Instead of a Deal

The Interim Results of the Energy War

Sergey Vakulenko
Independent energy analyst, consultant to a number of Russian and international global oil and gas companies
The energy war between Russia and the West, which was predicted in the spring, is now reaching its peak. While Russia has not yet used all the energy pressure options at its disposal, it is possible to summarise the interim results of the confrontation and draw some preliminary conclusions. First, Europe was able to prepare for the winter without Russian gas, and so far the threat of an energy blockade has not undermined, but rather strengthened, European unity and the functionality of European institutions. Second, the energy crisis will not end this winter but will last several years, during which there will be nothing to replace Russian gas. Third, the energy crisis has spread worldwide and will lead to a severe economic crisis affecting many countries and industries. Fourth, although the costs to Russia of this confrontation have so far looked limited, these will increase over time. Moscow's basic strategic calculations have been proved wrong: the West has chosen a large-scale energy and economic crisis scenario overa political deal with the Kremlin.

The prediction we made in the spring about how an energy confrontation between Russia and Europe might unfold has become a reality — the energy war is now raging.  It thus seems a good time to summarise its interim results: how has each party prepared for the winter season? Four main conclusions can be drawn at this point.

1. Europe Will Survive the Winter, and the Crisis Strengthens European Unity

Russia continues to trade oil and oil products in almost pre-war volumes and at pre-war prices, albeit 20% cheaper than other sellers. The European oil embargo and ban on shipping insurance will come into effect in December, but there are already discussions on exceptions to these measures in cases of sales at below-limit prices. In September, G7's finance ministers noted that a significant reduction in Russian oil exports would raise prices and worsen the global economy. Whether it will be possible to implement price controls is a separate question, which as yet has no answer.During Russian Energy Week in October, both Vladimir Putin and Deputy Prime Minister Novak, who is in charge of the energy sector, asserted several times that Russia would not sell price-capped oil. Oil company representatives confirmed that they were drawing up plans to deal with a sharp decline in oil production.

However, more dramatic events are occurring in the gas market. Russia has consistently reduced gas supplies to Europe using a variety of mechanisms and pretexts for its actions. Some of these even had a certain credibility. Taken together they form a clear picture — confirmed by Vladimir Putin's statements at the Eastern Economic Forum — that this reduction in gas supplies was a response to European sanctions and the supply of weapons to Ukraine. The finale to this scheme was staged on September 26 when three of the four "Nord Stream" pipelines were hit by explosions. This made the quick restoration of supplies via the Baltic route impossible not only for commercial and political but also for physical reasons.

Moreover, the remaining supply volumes are also at risk. Ukraine's "Naftogaz" is threatening "Gazprom" with arbitration for underpayment under their ship-or-pay- contract, according to which "Gazprom" has booked the services of the Ukrainian gas transportation system. However, "Gazprom" has suggested that in this case, "Naftogaz" would likely be under Russian government sanctions, which would make further cooperation between the two companies impossible. Recently, the licence of Netherlands-registered "South Stream Transport", which is the operator of the "TurkStream" pipeline with a total capacity of 32 billion cubic metres per year, was revoked. This also makes the continued operation of this route extremely difficult, if not impossible. As a result, Russia threatens to reduce its energy supplies to the world markets further.

Meanwhile, Europe’s prospects for winter 2022/23 may look slightly better than might have been expected in the spring. Gas storage facilities are almost full — Europe has managed to secure Liquefied Natural Gas (LNG) supplies from nearly all over the world.

The economic cost of these actions has been extremely high. At times gas prices were 15 times higher than the average pre-2019 price.Still, it appears a significant physical shortage of gas can be avoided. Nonetheless, some administrative measures will need to be implemented — from cutting off supplies to industrial enterprises to legislative bans on the temperature of heating.These have already been implemented. In Germany, priority lists for shutting down businesses have been compiled, while in Switzerland, apartment temperatures of over 19 degrees now face criminal prosecution, fines, and imprisonment.

When we speak of winter with a lack of fuel, apocalyptic pictures from the past come to mind — descriptions of Moscow in 1918 in "Doctor Zhivago" or Leningrad in "The Blockade Book", evoke images of frozen cities, burst radiators, and sewers. Perhaps in this context, the coming winter cannot be seen as a crisis, as nothing like this will happen in Europe. At the expense of administrative measures, restrictions on industrial consumers, and very high financial cost, Europe is likely to get through the winter of 2022/23 without significant shocks.

Gas and energy problems will be distributed unevenly across Europe. There will be countries that have to make small reductions in consumption and countries that have to change their lifestyle significantly. There will be countries with low domestic reserves dependent on transit through other countries that are in a better, but nonethelessdifficult, situation. In such circumstances, the unity of Europe will be tested. It seems likely that in countries with full storage facilities and transit pipelines, there will be arguments that it is necessary to provide for themselves before allowing gas to their neighbours, and there is no need to limit their consumption if that particular country has enough gas. And the politicians of these countries will face a dilemma as to whether they should fulfil the wishes of their voters or act in the long-term interests of European unity. There will also be countries waiting for an exemplary supply of Russian gas at a low price, hinting to everyone else that their problems could be solved if they were to agree to a unilateral restoration of good relations with Russia.

The E.U. was tested by the economic crisis of 2008-2009. The COVID epidemic has created another crisis in which the E.U.'s stability has been tested. The current situation is the third such test. Despite inevitable tensions, the crisis has instead served to strengthen the E.U., creating additional meaning for its existence. The crisis exposes problem areas: in particular, it has become clear that energy policy and the structure of Europe's energy markets need significant improvement, if not a complete overhaul. In other words, such tests are pushing Europe toward further integration rather than collapse, strengthening pan-European structures to coordinate policies and solve problems, and transforming the European Commission's constituent units from being summary-analytical to organisations with an executive mandate and the resources to go with this.

2. Not a Year-Long Crisis

Nonetheless these problems will not end in one year. We may assume that out of 135 billion cubic metres of Russian pipeline gas supplied to Europe last year, at the very best,20 billion will be exported in 2023, to Serbia, Hungary, and, perhaps, to some other not-too-unfriendly countries. Although, as noted, there is a significant risk that both Ukrainian and Balkan transits will stop, and supplies to Turkey will be halved. The difference of 115 billion cubic metres will be a net decrease in the global gas balance, as these supplies of Russian gas will not be able to go anywhere else. At the same time, we will not see the appearance of any significant new gas sources on the international market until 2024-2025, when the US LNG plants currently under construction will be launched. Therefore, Europe and the world are facing the prospect of a gas shortage for the next two to three years.

The outlook for winter 2023/24 could be even worse. It is very likely that by spring 2023, Europe’s gas reserves will be almost empty(usually, by the end of winter, they are 20-25% full) and, unlike in spring 2022, the north-west of Europe will not receive even small amounts of Russian gas. Of course, by that time, the European economy will have lived with a gas deficit for more than a year, adaptation experience will have been accumulated, and investments in energy saving and alternative energy sources will have started to have an impact. However, this is not a fast process.

The LNG industry has seen a significant upturn in the past few years, with several large projects launched in the US, Canada, and Qatar, and some smaller ones in Mozambique, Congo, and Indonesia (IGU World LNG report 2022). These facilities will mostly be launched after 2025, and 34 million of the estimated 110 million tons of annual LNG volume growth expected from their operation will come from two Russian projects (Novatek's "Arctic LNG 2" and Gazprom's "Baltic LNG"), which are now very much in doubt.

The growth of gas production without the capacity to transport it to the centres of demand (Europe, Japan, and other Asian countries) is practically useless. The discovery and rapid development of a large gas-bearing zone might alter the global gas balance, but only in tandem with the construction of LNG plants or export pipelines. The implementation of such projects takes 7-10 years.

In addition, some of this new gas will need to be used to replace the decline in production from gas fields which are already in operation. For example, the LNG plant in Algeria, with a capacity of 29 million tons, is now running at only 40% capacity, and the plant in Indonesia, with a capacity of 26 million tons — by 50%. LNG production has also decreased in Egypt and Nigeria. According to the Norwegian government's forecasts, gas production in Norway over the coming years will remain stable. This situation will undoubtedly incentivise the launch of new projects and will accelerate those already under construction. On the other hand, even under the current circumstances, the International Energy Agency predicts an increase in demand of 140 billion cubic metres of gas by 2025 (the approximate equivalent of 100 million tons of LNG), mainly in import-dependent Asian countries. 

Following the successful development of shale gas in the U.S., there were many attempts to expand this business in Europe, but by the mid-2010s, they had ceased. Europe's main shale gas basins are northeastern France, central Poland, and Romania. However, the geology there is more complicated than in the United States. In addition, the work, requiring up to 30 thousand tons of water and up to 10 thousand tons of sand per well (hundreds of which must be drilled), is much easier in the sparsely populated areas of Texas and the Dakotas than in Europe, with its narrow roads which pass through populated areas. Land legislation is much more complicated in Europe than inAmerica. Finally, the American shale revolution utilises the vast material base available from the oil and gas industry — a large number of easily accessible heavy drilling rigs and hydraulic fracturing fleets (equipment for hydraulic fracturing, which is the main method of intensifying gas production).This is barely available in Europe. As a result, the development of shale resources in Europe was prohibitively expensive and time-consuming. In the best-case scenario, restarting these projects would take at least several years.

So the world will face a significant gas shortage at least until 2025. The projects to be launched after 2025 will reduce this deficit but will not create an abundance: they were developed to deal with increased demand, not to compensate for the loss of Russian gas. Projects urgently launched in 2022-2023 will not have a significant impact on the market until 2028-2030. Moreover, despite the dramatic change in attitudes towards investment in conventional energy, investors remain very wary of the long-term profitability of new projects in the upcoming energy transition. Most likely, they will demand gas purchase guarantees, ship-or-pay agreements, and other assurances, but this will only mean shifting the risk of owning a stranded asset to someone else, most likely European governments.

Many people are currently focused on declining stock exchanges, inflation, and rising utility bills. But beyond that, a solvency crisis for energy companies is spreading across Europe, comparable in severity to the 2008 financial crisis. In most European countries, companies supplying electricity and gas must charge customers a fixed annual rate;but they buy gas and electricity on the open market with volatile prices. The depth of the derivatives market, which would offset the gap between the fixed and fluctuating prices, is insufficient. As a result, these companies usually have a significant open position, and the risk is covered by the reserve included in the price for buyers. This might work under normal market conditions but not in situations like that since February 2022 (even going back to summer 2021). Several European energy companies are now on the brink of insolvency (for example, "Uniper" in Germany, a regional utility provider across Europe), and governments are being forced to set aside tens of billions of euros in reserve funds to save them.

Thus, the crisis and tension in the energy markets caused by the loss of Russian gas will last for several years and become most acute over the next two years.

3. The European and World Economies Are Facing a Severe Crisis

The gas crisis is not only a European phenomenon. The European gas crisis has become global through the LNG trading mechanism: gas prices have risen in all countries. Some of them, such as Pakistan and Bangladesh, can now not afford gas and as a result face regular power cuts.

The current situation is reminiscent of the oil crisis of 1973 when the Arab states reduced oil production and cut off oil supplies to five Western countries in response to their support of Israel. The oil embargo lasted about four months; the reduction in supply reached nearly 4% of world trade, leading to a fourfold increase in prices and a years-long economic crisis. All the indicators of the 1973 crisis have already been exceeded, both in the share of gas supply reductions and in the share of price increases.

The 1973 oil embargo surprised the world; since then, steps for saving energy and building strategic oil reserves have been taken. When the discussion of an oil and gas embargo for Russia began, one of the arguments in its favour was that the global economy today is much more prepared for such shocks. And indeed, in the first few months, nothing particularly severe happened. But what long-term consequences can be expected?

Let's compare the current situation with 1973. Development of the North Sea oil field began in the late 1960s (the famous Brent field was discovered in 1971, and by 1973, its platforms had been built, in 1976, it produced its first oil). The Soviet development of Western Siberia also began in the 1960s (the first fields were discovered in 1960-1961, Samotlor in 1965). At the same time, the conversion of oil-fired power plants to gas began. In 1970, there were 90 nuclear power reactors in the world. By 1980, this number had increased to 253, and their total capacity had grown from 16 GW to 135 GW.

 The oil and gas industry is now in deep decline, investment in it has fallen by half since 2014, first as a result of the price shock and then under the pressure of public opinion.There is a belief that energy transition will happen soon and that even existing oil and gas production capacity is a "stranded" investment that will be shut down before the resource base has been exhausted. Nuclear power development was practically halted after the Chornobyl disaster and the Fukushima accident in 2010, with power units built in the 1970s being decommissioned throughout the 2010s. The impressive growth of solar and wind power generation in Germany since around 2000, which provided about 100 TWh of electricity in the first half of 2022, largely compensated for this decline in nuclear power production (from 90 TWh in the first half of 2006 to 17 TWh in the first half of 2022).

All this indicates that the loss of Russian gas in the coming years will lead to a crisis in the global economy. For European economies, this means a considerable increase in gas and electricity prices, including (due to the pricing features of energy markets) in countries with a minimal share of gas generation, such as France. There is a possibility that governments may abandon market principles and impose regulations on prices, but they will remain high. For households, this would mean that monthly payments would increase by hundreds of euros,possibly reaching as high as 1,000 euros. With the average household budget in "wealthy Europe" around 2,500 euros per month, losing such a significant share of it would drastically reduce people's purchasing power, economic security, and willingness to spend money. These kinds of shocks usually lead to recession.

These are hard times for industries with high energy or gas costs.. These include metallurgy, metalworking, chemical production, glass production and processing, cement production, building materials, and nitrogen fertilisers. All of these industries have dramatically reduced their competitiveness in Europe. They will only be able to retain their competitiveness in the area of specialised goods with unique properties (which is how the Japanese steel industry has survived thus far).

Their total collapse is probably not to be expected, but restructuring, optimisation and reduction are almost inevitable. The owners are faced with a difficult choice — to close for good, to wait out the crisis for a couple of years, or to start reforming and restructuring production (in particular, relocating it to countries with cheap gas that do not have access to foreign markets). In any case, these industries are expected to see a significant decrease in production and employment in the near future.

It’s also important to remember that technically production is a relatively small sector of the economy: about 15% in the E.U. overall, while services account for about 65%. Modern industrial organisation involves a large share of outsourcing, such as I.T., finance, accounting, development work, etc., which are often considered services in statistics. In other words, a significant amount of services are, in fact, a part of manufacturing companies' activities and are thus entirely dependent on their condition. 

In addition to the energy crisis, the world may face a food crisis. Natural gas is the primary raw material for nitrogen fertiliser production, 12% of which is made in Europe. Almost all of these factories are currently closed. India and Indonesia, the world's 4th and 5th largest nitrogen fertiliser producers, are LNG importers, and its cost affects their production costs. Since 2021, world prices for nitrogen fertilisers have increased fivefold. This rise has led to a decline in fertiliser use, which means lower crop yields and a decrease in the food supply.

All this increases the prospect of a deep recession, caused not by cyclical but fundamental factors (however, it appears also to be time for a cyclical recession). Both of these expected shortages (energy and food) are highly pro-inflationary. The traditional mechanism for fighting inflation is to raise the lending rate, while recession prevention would require lowering it. The current recession is not a slowdown from an "overheated" economy but a result of structural shocks. The energy crisis caused by the war and sanctions overlaps with the problem of the 2020-2021 monetary overhang, when governments, responding to the COVID-19 crisis, poured hundreds of billions of dollars and euros worth of subsidies into their economies.

Many of these economic trends also occurred in the 1970s, and gave rise to stagflation. The 1970s were quite a difficult time for developed economies. It was the end of an era of postwar economic growth known as the Wirtschaftswunder (Trente Glorieuses, Milagro español, and Miracolo economico italiano). The sociopolitical sphere seemed to have calmed after the turbulent 1960s, but at the same time, the 1970s saw an upsurge in terrorism — the RAF in Germany and the "Red Brigades" in Italy. As we now know, many extremist movements in Europe were financed by the USSR.

It is political instability that the current Russian government is most likely counting on by launching an energy war. Russia's modus operandi in its relations with the democratic world raises fears that support for extremists could once again become attractive to Russian politicians. Yet, unlike in the 1970s, even with all the possible scepticism of Western countries' institutions and structures, Russia, unlike the USSR, is unlikely to serve as an attractive model for an alternative path of development, even for the most naive citizens.

All these shocks will require a major transformation of production chains. Much of the capital and production capacity created based on the old price structure and energy balance is now redundant and needs to be replaced. Substantial funds from the budgets of energy-importing countries and their citizens flow to Qatar, the U.S., Norway, and Australia, slowing economic growth in donor countries and not actually helping the recipient countries, whose economies may not be able to process the sudden influx of wealth. Overall, we are talking about a crisis that may be heavier, deeper, and longer-lasting than even the crisis of 2008-2009.

4. The Kremlin's Strategic Calculations Have Turned Out to Be Wrong

In the short term, the situation looks relatively good for Russia — a reduction in gas supplies is offset by price growth. Although a complete cessation of gas supplies and loss of gas revenues for the "Rossiya" Corporation would be unpleasant, it wouldnot be catastrophic as oil is several times more profitable. In terms of figures, export supplies make up roughly a quarter of "Gazprom's" portfolio. Their loss would mean a significant, but not fundamental, change in its operation. Of course, on the domestic market, gas is sold at prices several times lower than exports, but these fully cover the cost of extraction. "Gazprom" still has a portfolio of loans, but to pay them off the company can buy foreign currency from other exporters on the domestic market.

In addition, it will be necessary to finance the construction of infrastructure for the "Great Turn to the East", but "Gazprom" seems to be counting on the government's support to do this. Given that mining, smelting, and pipe production for the new pipeline are mostly domestic Russian industries, if these were to end, the state would have to support citizens, factories, and the cities where they are based. Thus, the incremental costs of this infrastructure construction may be much higher when seen from the treasury's perspective.

However, in the medium and long term, the negative consequences for Russia look much more severe. In the best-case scenario, European gas revenues will be partially compensated by revenues from Yamal gas sales to China, which will require the construction of the "Power of Siberia 2" pipeline. Still, it may be possible to redirect between a third and half (at best) of the gas flowing to Europe there. According to an optimistic forecast, it will take five years to build the pipeline, but it seems more likely that the construction will take 7-10 years. As a monopsonist trading partner, China will be more demanding than Europe, leading to relatively low gas prices. The situation is less dire in the oil sector: Russia maintains a larger share of sales with more diversified markets and has a stronger negotiating position. This is despite the pressure from the United States and its partners restrictions on the Russian oil trade. Yet even here, the losses will still be significant.

Most importantly, the consequences of this energy trade reversal cannot be considered independently from the consequences of Russia's overall "great isolation" due to the war in Ukraine. These effects will be determined not only by the reduction of foreign exchange earnings from energy exports, but also by the significant isolation of the financial sector, the exclusion (to a large extent) from the international division of labour, and the difficulty in accessing the benefits of scientific and technological development available to other countries. The potential scale of long-term losses from sanctions can be observed in the example of Iran, which, even 43 years after the 1979 revolution, has not regained its pre-revolutionary per capita income (taking into account inflation).

In present-day Russia, it is thought that nothing will surprise Russians after the crises of 1991, 1998, 2008, and 2014, and that Russia knows how to recover from crises quickly and move on. But Russia has overcome previous crises along with, and as part of, the rest of the world, but now it finds itself in isolation. An isolation which is not only passive, but also often active. It remains to be seen how the Russian economy will be able to cope with this challenge, but the main forecasts are, unfortunately, very pessimistic.

Perhaps most importantly, Moscow has yet to turn Europe's energy dependence into leverage to achieve its political goals.

Before World War I, popular theories suggested that wars between the great powers were no longer possible because their economies had become too interdependent and so war would be too destructive for all sides. One hypothesis underlying Russia’s strategic plan for the Russian-Ukrainian war apparently suggested that trade with Russia, primarily in the energy sector, brought substantial economic benefits to Europe, which the West was unlikely to give up to protect the territorial integrity of Ukraine and its independence from Russian influence. This theory appears to have been correct when it comes to economic benefits but proved false regarding the West's willingness to sacrifice its economic well-being in confrontation with Russia.

Let's consider the situation according to the rules of game theory: this puts forward that it is not the potential of the players' actions that matter,but rather how other players evaluate the probability of their opponent’s various moves and their consequences. Player A can try to prevent player B's movement by announcing a threat — his next move, which incurs costs for A, but even higher costs for B. If B makes his move, despite this threat, then in this game, the implementation of the threat may no longer make sense for A. On the other hand, player B makes a move, assessing the probability of revenge from A. In this case, the player's actions and willingness to retaliate, despite the costs to themselves, may be important not only for the current game but also how seriously their threats will be taken in the following rounds and with other players.

The Kremlin's calculations were based on the fact that, to date, rejecting Russian energy supplies has been seen as a trigger for a large-scale economic crisis, which the West would try to avoid by all means possible. At the same time, the power that energy has, as a form of leverage, will weaken over time. As previously mentioned, by 2025 this threat will have greatly reduced thanks to significant new volumes of LNG on the market and the accumulation of energy transition components: wind turbines, solar panels, energy storage systems, and industrial and domestic energy supply systems, where electricity and hydrogen replace natural gas. So it makes sense to try to convert market power into political dividends right now.

Today we can say that this strategic calculation most likely was wrong. If, before February, the Kremlin, hinting at its ability to inflict unspeakable damage on the enemy, raised the stakes expecting the other side to"fold", now it has found itself in a "call" situation where it is forced to demonstrate its actual strength of its hand. However, when trying to implement the threat, its position was not as advantageous as expected, both militarily and economically. As a result, many of the Kremlin's fears — the potential threats and risks it saw in the medium term, in particular the reduction of its influence on the energy markets, have become a reality in recent months. . It is unlikely that the Kremlin is ready to accept this situation, and perhaps it will try to take desperate measures to reverse this situation (mobilisation is one of them). For now, however, it is a game of defending from "a difficult position", as chess players say.

Nonetheless, this scenario is quite pricey for Europe as well. On top of the costs already incurred by Europeans in the fight against the COVID-19 pandemic, the costs of the energy war could have severe socio-economic and political consequences. These include changes to the industrial landscape and the fall of the old political establishment.