With the Russian and Ukrainian armies engaged in exhausting trench warfare, Europe is about to enter its second winter without Russian gas. Exactly a year ago, on the threshold of a colder-than-expected season, concerns revolved around costs and energy security. A looming energy crisis was considered one of the main uncertainties for the value of European stocks. With an extra year to absorb the shock of the war in Ukraine, has the situation changed? And what are the risks for the economy and investments in Europe?
Cutting the supply
For over a decade, Russian gas pipelines have been the primary source of imported gas for Europe. Football enthusiasts will remember Gazprom’s logo, the leading Russian energy company, appearing at the beginning of every Champions League match. A sponsorship of high symbolic value, almost reminding millions of Europeans who kept the stadium lights on across the Old Continent. Before the invasion of Ukraine, the percentage of Russian gas varied between 40% and 50% of total imports. In Europe’s energy mix, gas generates around 20% of the generated electricity, but the percentage rises to 32% when only considering domestic use.
Following the invasion of Ukraine, the supply of gas from Russia has become a serious political and economic issue. To replace Moscow’s supply, European countries have, on one hand, reduced gas demand and, on the other, sought alternative sources of supply. The approach has borne fruit.
Let’s start with the reduction in gas demand for energy generation, which decreased by 17% in the second quarter of 2023 compared to the average of the 2019-2021 period. According to Bruegel, this outcome was achieved by implementing energy efficiency measures, focusing on alternative energy sources, and also benefiting from last year’s ‘warm’ winter. The decrease in demand made it easier to move away from Russian supplies but wasn’t the core of the European strategy.
Within the context of declining imports, those from Russia were significantly reduced, though not entirely eliminated. In the second quarter of 2023, Russia accounted for only 14.6% of the European Union’s natural gas imports. In just the past year, the quantity of gas imported from Russia has more than halved, standing at 2.5 million tons compared to 5.1 million in the same period in 2022.
The fact that Europe continues to finance the Russian government adds a dimension of complexity to the conflict (and according to many, it’s also one of the reasons why there will eventually be efforts to find a solution that at least partially accommodates Russia’s demands). However, looking at the data, it seems that Europe is disentangling itself from Russia’s energy ‘blackmail’, securing its own supply chain.
Where do we get the gas from?
However, the shift in Europe’s energy geography hasn’t been painless and has come with considerable costs. The gap created by replacing Russian gas has been partially filled by a decrease in demand and partly through the use of gas from other sources. Particularly notable has been the growth of liquefied natural gas (LNG), which has and will continue to play an increasingly strategic role in the energy plans of European countries.
The primary source of liquefied gas supply is the United States. Gas imports from the United States peaked, surpassing 60 billion cubic metres last year—an exponential growth considering that supply from the US was practically irrelevant just a few years ago. The issue is that these types of supplies are more volatile and more expensive than those delivered via land. To be transported by ship, the gas must be stored at -160 degrees and transformed into liquid. The complexity of the transportation process gives significant pricing power to companies involved in gas transport. As a result, American LNG is sold in Europe at a price up to four times higher than in the United States. Furthermore, the market for this commodity, not being tied to infrastructures, is subject to speculative activities and price fluctuations that can be caused by issues seemingly disconnected in the supply chain. Just last month, news of a strike by workers on a gas project in Australia triggered a surge of over 40% in future contract prices (price related to the Dutch Title Transfer Facility (TTF) hub, a benchmark for gas prices).
Further complicating the situation is the conflict in the Middle East, which could bring additional volatility to the commodities market. To safeguard itself, Europe has accumulated record reserves. By the end of summer, gas storage facilities were at 90% capacity, two months ahead of the plan outlined by the EU. This prevents the risk of an energy crisis, meaning a situation where the continent would be forced to shut off its supply. An analysis by Bruegel estimates that even in the event of a complete halt in imports from Russia and an exceptionally cold winter, the continent would still have about 20% of its reserves intact by 2024.
This data provides reassurance that Europe has managed to secure its energy reserves. This is good news regarding the price of European stocks because the risk of an energy crisis is undoubtedly less significant than it was on the brink of the 2022 winter when uncertainty held back the performance of this asset class, which continues to have appealing valuations.
The effects of persistently high energy costs for businesses and households remain to be evaluated (with billing costs still lagging behind the reduced import costs). Taking a longer-term perspective, one could argue that the crisis triggered by Russia has accelerated Europe’s transition towards energy security and independence (seen in the strong growth of alternative energies). This could bring definite benefits to the economy of the continent.
Measures taken by European countries
But how are the major European countries responding to the crisis? While waiting for substantial investments in renewable energy to take effect, Italy is looking towards Africa and the Middle East, hoping to become a hub for natural gas arrivals. Investments have already been initiated to increase gas processing and storage capacity. The goal outlined in what the government has termed the ‘Mattei Plan’ is to transform Italy into a hub in the centre of the Mediterranean for supplies coming from Africa and the Middle East. Alongside this medium-term strategy is also the control of consumption (implemented through various administrative and public actions). The containment plan implemented by the Draghi government was a success: in Italy, in 2022, consumption decreased by 9.8% compared to 2021. Specifically, between September 2022 and February 2023, gas demand dropped by 20% compared to the same period in the previous three years (exceeding the targets set by the government).
Before the war in Ukraine, Germany sourced up to half of its gas through pipelines from Russia. To replace the shortfall, Berlin increased gas imports through pipelines from the Netherlands and Norway, and developed three new LNG import terminals, with new terminals under construction to increase reception capacities.
Shortly after the invasion, the largest European economy rapidly formulated an emergency plan. The plan outlined that the country’s extensive gas storage facilities—the largest in Europe—should be at 65% capacity by August, 80% by October, and 90% by November.
Germany also implemented energy efficiency measures. The goal is to reduce gas usage by 20%. Regulations affect both private consumption and businesses. Companies with high energy consumption are required to implement small-scale efficiency measures with a payback period of fewer than three years. These measures don’t have long-term consequences but have already started to yield results: Germany used nearly 15% less natural gas last year, aided by a relatively mild winter.
Similarly, Poland, like Italy and Germany, heavily reliant on Russia for most of its gas imports, is focusing on increasing its liquefied gas storage capacity.
France historically has been less dependent on gas due to extensive nuclear energy consumption, satisfying 40% of the national demand. Additionally, Paris sourced only 17% of its gas from Russia before the war.
To increase energy security in a volatile context, the French government has implemented measures to reduce the country’s energy consumption by 10% compared to 2019 by next year, and by 40% by 2030. A new LNG storage facility is under construction in Normandy. The United Kingdom and Spain, less directly involved in the situation in Ukraine, have nonetheless had to grapple with rising energy costs.
Focus on portfolios
Giorgio Broggi, a Quantitative Analyst in Moneyfarm’s Asset Allocation team, noted: “Overall, the situation is much less frightening than last year when we even tactically reduced exposure to European stocks due to risks associated with the energy crisis. Reserves are full, and European countries seem much more prepared to withstand even negative scenarios such as a complete cut-off of the Russian natural gas supply, which nevertheless remains an extreme case.
“It remains very difficult to predict where the price of key energy commodities will go in the coming months, although we believe there are two main reasons to maintain exposure (even higher than in the past) in portfolios. On the one hand, it provides protection against potential deteriorations in the situation in Ukraine and a potential escalation of the conflict between Hamas and Israel. On the other hand, it continues to provide enormous diversification benefits, maintaining high defences in market conditions similar to those of 2022. In other words, if new (although unlikely) waves of inflation were to hit the markets, affecting both stocks and bonds, we believe that, in line with history, the commodities sector could perform well.”
*Capital at risk. Tax treatment depends on your individual circumstances and may be subject to change in the future.