Reducing dependence on Russia’s natural resources

In recent decades Europe has grown dependent on Russia’s rich natural resources, but the withdrawal of that supply now threatens to destabilise the European economy. While the situation remains unpredictable, the eventual outcome will depend on the extent to which Russia withholds gas supplies and the EU’s ability to switch to alternative energy sources.

At the end of July, Russian energy giant Gazprom slashed gas supplies to the EU via its Nord Stream 1 pipeline (which pumps gas from Russia to Germany) to around 20% of normal levels. It blamed maintenance work on two turbines, saying sanctions had created problems. Supplies had already been running well below capacity.[1]

The limits to supply make it more difficult to ensure there is enough stored for the coming winter. Europe needs around 80% of storage capacity to prevent any supply issues in the months ahead. It is currently running at around 65%.[2] Ramping up Liquified Natural Gas (LNG) imports has helped, but the region doesn’t yet have the infrastructure in place to make that a viable alternative.

It is a precarious situation, and some countries are more vulnerable than others. Germany, for example, has lower storage levels than Central and Eastern Europe. Countries with heavy industry, such as Germany and Italy, are also likely to feel the effects of energy supply disruption more acutely. In a worst-case scenario, where Russia cuts off gas supplies completely, we estimate the impact to eurozone GDP could be as much as -2% to -4%.[3]

• Short-term measures: the European Union has asked member states to ration gas supplies. In July, it announced a plan, asking the 27 EU nations to cut their gas consumption by 15% between 1 August 2022 and 31 March 2023.[4] While the reduction is voluntary, it could be made mandatory in the event of a severe shortage
• Long-term measures: Europe has recognised the need to shake off its dependence on rogue states for its energy in order to achieve greater security of supply for the future.
  While the eurozone also imports oil and coal, it is gas that is the real pressure point. Gas is not as easy to replace than other hydrocarbons, and Europe is reliant on gas delivered by specific pipelines. About 40% of imported gas came from Russia in 2021.[5] Eastern Europe’s geographic proximity means that it sources a larger proportion of its gas from Russia. Germany is the biggest concern, given its role as the powerhouse of European economic growth, obtaining around two-thirds of its gas from Russia

The EU’s response has been to roll out a plan, ‘REpowerEU’, with the aim of making Europe independent of Russian energy before 2030. This plan has two main pillars:

• Replacing piped gas from Russia with LNG
• Moving towards renewable energy sources such as wind and solar, as well as renewable gases such as hydrogen and biogas

The latter point draws on the pre-existing ‘fit for 55’ proposals, which aim to reduce net greenhouse gas emissions by at least 55% by 2030​. This includes a reduction in gas of 30% by 2030, plus more obvious targets such as increasing solar and wind capacity, or fitting heat pumps in homes. On 18 May, the European Commission released a more detailed plan, including short, medium and long-term measures to reduce demand, diversify supplies of conventional fuels, future proof infrastructure and accelerate the transition to green energy sources.

In the meantime, Germany has said it will wean itself off Russian gas but adds that it will take until 2024 to end its reliance. The country is moving towards wider adoption of LNG, initially by renting four offshore floating storage and regasification units. For the longer term, it is building onshore capacity too. While these are to be used for LNG, the intention is that they will ultimately be converted for biofuel use.

With the energy mix in flux prices are increasing. This is simply supply and demand: Russia supplies 15% of global gas[6] and sanctions mean many countries are effectively excluding themselves from that supply, while demand remains the same. Prices for gas may fall as alternatives are found, but it’s unlikely to be in the near term and hard to forecast when it may happen. The gas price continues to hit new highs and sits around 10 times its level at the start of 2021.[7]

We believe these developments are likely to prove positive for companies standing to benefit from higher electricity prices, notably companies in the energy and utilities sectors. Clearly, there is a major policy tailwind behind the push for renewables and a range of dedicated renewable power and infrastructure companies should benefit from that over the longer term. More broadly, if these tensions drive a decline in economics growth, then more defensive areas of the equity market such as healthcare would be expected to fare better than their more cyclical counterparts.  

Other areas are more likely to struggle in this environment. Companies in the industrials and materials sector are energy-intensive and look to be in the eye of the storm on energy prices. While industrial energy use is the greatest concern, the consumer is also expected to struggle as household bills rise.

It is a volatile situation for Europe, with very different outcomes for the various scenarios. Policymakers are acting to address the problem, but the solutions won’t have an immediate effect. In the meantime, the threat to the eurozone economy is real and significant.

Sources:

[1] Gazprom: Nord Stream 1 supply to EU to be cut further, BBC News, 25 July 2022.

[2] ASGI/Evelyn Partners Investment Management LLP, Data as at 23 July 2022.

[3] Evelyn Partners.

[4] ‘Russia is blackmailing us’: EU asks member states to ration energy as Putin tightens grip on gas supplies, CNBC, 20 July 2022.

[5] How Europe can cut natural gas imports from Russia significantly within a year, IEA.org, 2 March 2022.

[6] Europe Relies on Russian Gas. A Tough Winter Lies Ahead Amid Fears of a Cut-Off, Time.com, 26 July 2022.

[7] European gas prices soar after Russia deepens supply cuts, Financial Times, 26 July 2022.