As the summer comes to a close, oil traders should start paying close attention to the European energy situation. Even though most of the concern is with natural gas availability and price, the oil market could be impacted in atypical ways if the crisis intensifies this winter.
Background
In their push to cut carbon emissions, many European countries switched to burning natural gas instead of coal. Some countries, like Germany, simultaneously cut nuclear power generation by decommissioning successful nuclear power plants and increased their reliance on natural gas even more. Russia provided them with a convenient and cheap source of natural gas.
By 2019, 40% of Europe’s natural gas consumption was fulfilled by Russian gas. Everything seemed to be working adequately until Russia invaded Ukraine and western Europe and the U.S. imposed sanctions on Russia in response. Since then, European countries have been desperately trying to decrease their dependence on natural gas in general and on Russian natural gas, in particular.
Overview of Current Situation
The price of electricity has risen astronomically across Europe. This is due to a combination of factors, but the most significant component is that the price of natural gas has more than quadrupled. Summer heatwaves have also meant high demand and less electricity from wind power installations because the wind hasn’t been blowing.
Since the end of July, Russia has also reduced the amount of natural gas it typically sends through the Nord Stream pipeline to Germany, to 20% of its typical capacity. Russia blamed the cut on technical matters, but Germany claims it is a political move. The decline has also impacted electricity prices in other European countries that receive Russian natural gas or electricity through Germany.
At the same time, the European Union is pressing members to reduce their energy consumption now so that natural gas can be stockpiled for winter. As of the beginning of August, Europe’s natural gas reserves were 71% full, which is short of the 80% target the EU hopes to reach by November.
Germany’s gas storage facilities are 75% full. But even if Germany fills all of its natural gas storage facilities, it will only have about 1/5th of the natural gas it typically consumes, or about 2.5 months of heating, industrial and electricity demand. This is why German energy regulators are pushing the country to reduce energy consumption by 20%, and why utilities are desperately looking to lock in LNG cargoes from overseas suppliers for the winter months. They have been somewhat successful in the latter effort.
A Look Ahead
Germany and Italy will be the hardest hit if Russia completely shuts off natural gas flows or there just isn’t enough gas to meet demand. The German government has committed to provide residential heating, so German industry will be hit hard by natural gas shortages this winter even with energy rationing in place now.
German industry would not have natural gas to make steel and other products and people would not be able to heat their homes. Germany would be plunged into a recession, and other European economies that rely on German industry and products would similarly be hurt. We don’t have a good sense of which businesses and industries would be the first to lose access to power because German regulators are still trying to figure out what manufacturing is considered “systemically relevant” for critical industries (this may bring recollections of discussion of which businesses were “essential” in 2020).
Barring an increase in the flow of natural gas from Russia, the German economy is going to suffer. Already, high energy prices are hurting Germany’s economy. Shortages will only hasten a recession.
How oil markets could be impacted
An economic downturn in Germany would likely cascade through other European countries. Mass layoffs and industrial slowdowns across Europe would cause a drop in oil demand. However, if oil prices come down far enough, we could see more power plants switching to burning oil—assuming they can afford the carbon offsets required by the EU—thus buoying oil demand. Traders should not assume that a recession brought on by this energy crisis will necessarily resemble the market reaction of prior energy crises. Energy prices and energy usage have broken with historic patterns (both in the U.S. and Europe) due to over-reliance on natural gas, and, as a result, oil demand may not drop as much as expected during a typical recession.