Whoever has the gas has the power
Kaltchuga, Moscow, October 2021
“Comrade Stalin rightly said that whoever has the oil has the power”, declared Kirov at the XIV Party Congress in December 1925. A hundred years later, little has changed, and comrade Putin is once again deciding how much gas Europe shall receive this winter and at which cost. Once again, Europe fell in this gas trap, as it did in 2009, then again in 2014-15, when Russia repeatedly cut gas supplies to Europe after failing to agree with Ukraine on gas transit terms. History teaches little and Europe once again is ill-prepared and vulnerable.
Low storage levels, soaring gas prices
Europe entered the winter gas season on 1 October with the lowest gas storage levels over a decade (75% full compared to a 2016-2020 average of almost 90%). This will probably edge higher in the next couple of weeks because storage generally starts to fall only towards the end of October/early November with the start of the heating season. But the closer we get to the cold temperatures, the higher the gas prices.
After the TTF briefly traded in excess of €160 /MWh on Oct 6th, gas prices in Europe quickly came off their highs following Putin’s declaration that Russia would be willing to stabilize gas markets, and TTF is now trading around €90 /MWh. These prices are nevertheless still well above the long-term average in European gas market of about €20 /MWh. They also translate in an oil equivalent of around $170 /bbl, more than twice the price at which the Brent is now trading. As a result, power prices have risen almost fivefold in Southern European countries like Italy, Spain and Portugal and have more than tripled in Northern European countries like Germany, the Netherlands, France and the United Kingdom.
Tightness on the European gas market is a consequence of lower supplies of Russian gas these past months, along with a heavy maintenance season in Norway, with recovering demand post-Covid has made things even worse. The LNG market is providing little relief this time because higher demand and higher prices in Asia ensure that spot cargoes are sailing there rather than to Europe.
So far, Russia has been meeting its obligations for delivering gas on the European gas market to customers having signed long-term contracts with Gazprom, but it has not provided much additional supply while markets have been tightening. To the contrary Gazprom, which now controls 50% of gas supplies to Europe, and also a large share of Europe’s distribution and storage infrastructure, stopped selling gas on the spot market in August and cut flows into European storages. This further squeezed the market and pushed European gas prices up to record levels.
No quick fix in the short run
While the market is already tight, high prices also reflect fears over tightness in the months ahead, particularly if we see a colder-than-usual winter. On the other hand, would Europe experience a normal or mild winter, there is potential for a downward correction. But given the amount of uncertainty surrounding weather forecasts, we suspect natural gas prices will remain elevated and volatile until the end of winter.
So is Putin jumping at his chance to use his country’s leverage as an oil & gas superpower. On 6 October, as European TTF prices surged 40% intraday, he offered to help stabilize the market. Indeed, only Russia has the capacity to quickly ramp up gas flows to Europe before the start of Europe’s heating season. But everything has to come with a price. It is obvious from the Hungarian case study that Gazprom will push for the signature of long-term agreements with European clients, thus increasing their reliance on Russian gas. One of Putin’s main goals is of course to obtain a quick approval on commissioning the 55-bcm Nord Stream 2 pipeline, a central piece in his plan to reassert Russia’s coercive influence in Europe. The construction was completed last month and the German regulator, the Bundesnetzagentur, has now four months to certify the pipeline and to comply with EU standards and regulation. If parties speed up the process, the pipeline could be operational before January or February, which are typically the most severe winter months.
Europe’s long-term vulnerability
Europe’s reliance on Russian gas is not only a short-term issue. The green push is making European energy systems more fragile and volatile, hence more reliant on natural gas which, as the cleanest burning of the hydrocarbons, is the fuel of choice to reduce emissions and yet meet energy demands. Germany’s decision to phase out nuclear power by 2023 also increased its reliance on hydrocarbons to generate electricity, in particular natural gas. Europe’s gas demand stands at 604 billion cubic meters (bcm), whereas gas production is only 260 bcm, and declining. So, 344 bcm is sourced in international markets, mostly from Russia, Algeria and Norway, while in recent years there has been a growing share of LNG entering the region.
It is common to say that the EU and Russia are mutually dependent on one another respectively as buyer and supplier of energy. In true, without concerted efforts on the part of the EU states, Russia will have the upper hand in this relationship. Because gas demand is not price elastic, and in absence of alternative to Russian gas it gives Gazprom a strong advantage in fixing prices.
Gazprom long-term bonanza
This is why the future looks bright for Gazprom, but also for Gazprom shareholders, receiving now 50% of net income in dividend payout.
This bonanza looks quite sustainable at least in the coming decade since we see no real alternative to Russian gas. In an effort to reduce its reliance Europe has started to build LNG terminals, but we assume Asian demand will continue to squeeze European LNG supplies. After a pandemic slowdown last year, China’s demand for gas appears to have returned stronger than before (up 16% yoy in 1H21) led by strong power and industrial demand. Natural gas fits into China’s strategies to diversify the coal-dominated energy mix, improve air quality, and pursue low-carbon development. To meet its rising demand, China will call on more imports to bridge the gap between demand and domestic production. The country is already the world’s largest gas consumer and importer. In the first half of 2021 China also overtook Japan as the world’s largest LNG importer.
Oil prices getting a boost
The significant strength that we have seen in the gas market has meant that it is trading at a large premium to oil. TTF gas prices in Europe are trading at an oil equivalent of more than $170 /bbl, well above current oil prices of around $82 /bbl. This should incentivize switching from gas to oil when it comes to power generation. We are already seeing this happen in several countries where there is capacity mainly in Asia where the Asian spot LNG market is trading at an oil equivalent of around $320 /bbl (!). This will boost oil demand for the remainder of the year. As a result, the oil market is looking tighter in the short term, and oil prices shall remain well supported until the end of the year.
This has led us to revise higher our Brent forecast for the final quarter of this year to an average of $75-80 /bbl, up from our previous forecast of $60-80 /bbl. We also assume that if prices trade above $80 /bbl for a sustained period, there is a greater risk of OPEC+ easing its supply cuts.
In 2021, it seems like only OPEC+ are able to increase output, while shale oil and majors have remained on the side. But in 2022, we expect the market will be much more balanced due to the expectation of strong non-OPEC supply growth so that oil prices (Brent) will return to their $60-80 range per bbl.
Other commodities benefitting too
Higher energy prices are also impacting other commodity prices. In Europe, we have seen several industrial players reducing operations due to rising electricity costs. Power rationing in China has seen several metal industries (namely aluminium and steel) forced to curtail operations due to power shortages. Admittedly power rationing goes all the way down the supply chain and thus affects downstream consumers as well. Therefore, it is a bit tricky to fully assess, at least in the short term, if these power issues are overall bullish or bearish for metal markets. But ultimately, the longer this higher energy price environment persists, the more likely it is that we see these higher prices feeding through to higher production costs for other commodities.
Russia is the winner of fall/winter season
Let us not bother with forecasts for the long run here though. It is enough to bet on Russian stocks until the end of this year because the gas and oil rally prices have projected Russia back onto the global stage in its capacity of energy superpower. Investors are getting aware of the huge cash flows pouring into the Russian economy and the super profits of Russian companies. Basically, Russian stocks have now a solid track record for paying at least 50% of their net income of free cash flow, so the average dividend yield of the Russian market is now of 8.1% on a 2022E P/E of 7.7x. It also tells us that despite its outperformance so far in 2021, the Russian market is far from overbought and global investors are still to catch up on this rally.
We therefore believe now is the perfect timing to invest in Russia’s energy powerhouse and get a necessary hedge against Europe’s vulnerability this winter, while enjoying the warmth of a very handsome yield.