European gas crisis – the new normal

It is hard to imagine that natural gas was once an unwanted fuel. “What is worse than finding a dry hole? A gas discovery!” – early oil explorers reportedly quipped. Even today, around 142 billion cubic meters (bcm) of natural gas (or 4 percent of world consumption) is flared globally. But Europe is facing a harsh gas crisis. Compared to a year ago, the market price for gas has increased by 600 percent this September.

It would be simplistic to attribute the current situation to a single factor. On the contrary, there are many reasons for the increase, though the political angle has attracted the most media attention. Furthermore, only some of these forces have emerged during the Covid-19 pandemic. Others have been much longer in the making.

The crisis will eventually be resolved, but its ramifications will go well beyond Europe and gas markets.

Before diving into the analysis of the current situation, it is worth highlighting some basic features of gas markets.

Unlike oil, which is traded in global markets, gas largely remains a regional business. While 74 percent of the oil produced is traded interregionally, for gas that share is only 24 percent, 48 percent through pipelines and the rest as liquified natural gas (LNG). Most of the resource is sold under long-term contracts, where the price is pegged to the price of other fuels, mainly oil – so-called oil-indexed contracts. These contracts provide for the delivery of an annual volume at a gas price adjusted to the price of oil on a given date.

Traditionally, pipeline gas has been traded under long-term contracts given the peculiarity of pipeline transport. When a producer and a consumer are connected by a single pipeline, they form a bilateral monopoly; markets do not determine the price. However, as LNG is traded across regions and between multiple partners, it increasingly follows spot pricing, which changes daily based on supply and demand, becoming less tied to oil prices.

Gas markets are further segmented into three main regions, namely Asia, North America and Europe; each of these markets has different institutional features, pricing and infrastructure. In the past, they operated mostly independently from each other. But thanks to LNG, these hitherto distinct areas are becoming increasingly interconnected following a general increase in global export capacity and the emergence of new suppliers, for example, the United States and Australia. Eventually, the ongoing commoditization of LNG may give birth to a truly global gas market, resembling today’s crude oil market. LNG grew from nearly 27 percent of interregional gas trade in 2000 to 52 percent today.

Broadly speaking, the Northern American market is the most liberalized, especially in the U.S., where prices and volumes are determined on the spot by demand and supply. Asia relies more on long-term contracts. Northwestern Europe relies on virtually 100 percent market-based spot pricing, but this percentage declines east and south of the continent.

Traditional pipeline exporters like Russia’s state-backed monopoly company Gazprom have long favored the old mechanism of long-term oil-indexed contracts. However, in recent years (when prices were low), Gazprom had to adjust its pricing strategy to safeguard its most important and lucrative market following pressure from the European Commission for competitive pricing. Accordingly, the Russian gas giant started to sell some of its gas under more flexible terms, including spot pricing.

When economies shut down to contain the coronavirus, gas demand faltered. Regional gas prices subsequently collapsed to historic lows. As a result, exporters curtailed their supplies. Almost 100 U.S. cargoes destined for international markets were canceled amid dramatic oversupply at the height of the 2020 lockdowns, further dampening forecasts. As one study by the Oxford Institute for Energy Studies stated, “Even before the coronavirus pandemic, natural gas prices were projected to remain low for several years into the 2020s and the consequent recession will extend this period.”

However, it was only a question of time before such forecasts were discredited.

As economies gradually emerged from lockdowns, prices started to rise, and markets recovered swiftly. Spot prices began to climb in the summer of 2020, amid supply outages and a disruptive hurricane season in the U.S. Unusually cold temperatures and a tightening shipping market then pushed prices to their six-year high in December. A supply crunch ensued in the spot market, and in the first two weeks of 2021, the Northeast Asian spot price doubled.

The rise in prices in Asia attracted LNG that was hitherto sailing to other markets, affecting prices in the latter locations as well. For instance, in June 2021, Asian and European spot prices were five times the prices recorded 12 months ago, and U.S. prices had doubled in the same period.

Few took note of the unusually high prices in Europe during the summer season. Typically, price spikes occur during winter when gas demand is higher. In August, for instance, European gas prices reached their highest levels in 10 years, and even surpassed the previous record price reached on March 1, 2018, during the famous “Beast from the East” cold wave.

Two additional developments signaled a tight market ahead.

First, a wave of intense cold in Europe at the start of 2021 meant that gas was withdrawn from storage more quickly. As a result, Europe went into the summer season with much less gas stored than usual. Gas storage plays an important role in balancing markets during winter because they are used as a buffer at times of high demand (mainly for heating) and tight supply. Low gas storage makes markets more nervous. Storage sites had to be topped up significantly over the summer months to ensure enough gas would be available for the coming winter, resulting in upward pressure on spot prices.

Second, total imports into Europe were lower in the summer of this year compared to the same period in 2020, when most countries went into lockdown. That is, Europe was supplied with less gas while economies were opening up than during the strict lockdowns of 2020.

The main reason for this development is that Europe was not able to attract LNG cargoes sailing to Asia – typically the market where LNG fetches a premium. There was also additional demand for air conditioning because of hot summer weather as well as unplanned outages and scheduled maintenance at several nuclear facilities in key importers such as South Korea. In parallel, several Asian countries are ramping up their efforts to switch from coal to gas. China especially is aiming to increase its gas usage, partly for environmental reasons like Beijing’s Blue Sky policy. Also, China placed a ban on imports of coal from Australia to China after the diplomatic dispute between the two countries.

Europe also saw a decline in pipeline gas imports from Russia. This can be attributed to several factors: one is technical, as a fire at one of Russia’s production facilities (Novy Urengoy) limited export capacity on the Yamal-Europe pipeline (via Poland to Germany).

The other two factors are speculative but cannot be ruled out. Russia could be strategically limiting supplies to increase spot prices, thereby setting a floor for gas prices in winter. Second, Moscow could be hoping to gain support from Europe for the completion of the U.S.-sanctioned Nord Stream 2 pipeline.

The pipeline would be one of the cheapest transport routes for Gazprom to bring Russian gas to Europe but is a politically divisive project as it increases Russia’s grip over the European market and allows it to bypass Ukraine.

There could be another reason for Russia’s stance. Recently, Russian officials made statements discrediting spot pricing while showcasing the crucial benefit of long-term oil-indexed contracts for safeguarding the security of supply and limiting exposure to market volatility. Gazprom repeatedly said that it met all its contractual obligations.

“Currently, the European spot market shows a high price volatility and is disorienting both buyers and sellers, (this) brings risks of destabilizing the entire regional economy. … The European spot market only reflects the current state of demand and supply but is not the pricing tool which provides a long-term balance,” the head of Gazprom Export Elena Burmistrova said.

In reality, even long-term contracts can be broken. Spot LNG has made this possible; some desperate buyers bid higher prices to compensate for any legal penalties and get hold of the gas.

Meanwhile, Russian President Vladimir Putin did not miss the opportunity to display the crucial role his country plays in stabilizing European gas markets, indicating his willingness to send more gas to the continent to ease pressure on the economy. He also brushed aside accusations of market manipulation. “Let’s think through possibly increasing supply in the market, only we need to do it carefully. … This speculative craze doesn’t do us any good.”

Whether Russia delivers on its promises or not, it is unlikely to reverse a trend long in the making. Spot gas pricing is here to stay – the genie is already out of the bottle.

Meanwhile, the good news for those affected by the high prices is that markets will correct themselves in the end. In Asia, signs of demand destruction are increasing in response to higher prices, thereby easing the pressure.

Part of this is a call to use alternatives to natural gas. This may not be great news from a climate perspective, as the most obvious substitute is coal in power generation.

A recent statement made by China’s Premier Li Keqiang about the energy situation in the country largely revolves around old “king” coal – renewable energy was barely mentioned. Even the United Kingdom, which only a year ago praised its achievement of going coal free in power generation, had to refire its coal power plants to avoid blackouts as renewable energy could not compensate for a shortage in gas supplies.

The implications of the current crisis go well beyond gas prices. The transition toward a greener energy system may be affected: high costs and charges could provoke a backlash against carbon-cutting initiatives.

Policymakers should have been better prepared for this dilemma. For the energy transition to accelerate, fossil fuels need to become more expensive to encourage substitution. But if a cheaper, greener, alternative is not readily available (for example, wind generation capacity in Europe was too low to compensate this year), nations will resort to other means to avoid a major energy meltdown.