Russian gas embargo will trigger sharp fall in EU GDP, even with rationing and windfall taxes [Gas in Transition]

Europe and China may not have much in common, but one shared situation is that both import most of their energy. In Europe’s case the largest source of those imports for two generations has been Europe’s principal ideological and geographic competitor – Russia. That stable and low-cost supply was briefly interrupted in 2006, when Moscow cut gas flows through the Brotherhood pipeline across Ukraine as a way of reminding Kyiv that it should pay its gas bill. East Europe adjacent to Ukraine shivered for a while, until normal service was resumed. But brief interruptions apart Russia has been a remarkably consistent supplier, at least until this year, without breaking a supply contract, and has provided gas to Europe at very low prices, generally around the level of $0.20/m3.

The 2006 supply cut made Brussels take notice

The European Commission took note of the 2006 lesson and used it as a reason to gather the reins of European energy policy into its centralised hands. An Energy Plan for Europe emerged in April 2007 but changed little in practice. When, two years later, Russia again nudged the gas taps, a new Eastern crisis prompted a new policy – the commission’s 2010 Energy Initiative.

In sum, and cutting through the usual commission verbiage, this contained startling ambitions. One was to decarbonise European energy by 2050, through a (magical) process of “…decoupling economic growth from energy use”. The startling ambition (no less than breaking a well proven link between economic growth and energy demand growth) was probably inspired by two observations. The first is the fact that developed economies experience a peak “oil intensity” after which oil consumption per capita falls as GDP per capita rises. The second is a similar observation for power demand, which also “rolls over” in kwh per capita with growing wealth.

The commission’s energy strategy accepted a long-term role for gas

Both gas and oil “rollover” points are driven by factors which we lack room here to investigate, but the commission appears to have forgotten two important caveats. The first is that demand for energy does indeed “roll-over”, but that it then follows a shallow decline curve in which demand per capita remains high for decades. The second is that total demand is a product of demand per capita and the amount of capita in the economy. If the population keeps increasing, an economy may demand more total energy even as its energy intensity falls.

Those caveats mean that demand for oil and gas fall only very slowly after roll-over (and if populations rise, not at all). With those flat decline curves in mind, the commission did admit that Europe would still need power, and therefore mandated that its “decoupling” objective had to depend on changing the source of power from hydrocarbons to other sources, for choice wind, solar and nuclear.

For ten years the strategy looked like working, mostly

In the decade that followed the commission’s strategy worked surprisingly well. By 2021 both electricity demand and production were running at a flat 2,800 bn kWh/year. The successful part was that 1,800bn kwh was generated by nuclear, wind, solar and hydro, leaving only 440bn kWh to come from coal, and 540bn kWh from gas.

The relative success of the 2010 strategy was hurt by Germany’s unilateral abandonment of nuclear power (triggered by Fukushima). which took German nuclear power production down from 170 bn kwh to about 30 bn kwh. As a result Europe’s gas-to-power demand was one third higher in 2021 than it needed to be.

Gas-to-power needed 100bn m3/yr, but heat and feedstock users need a lot more

The gas-to-power component generated a demand for gas-for-power of around 100bn m3. Europe, accounting for 20% of world GDP, was consuming only 2.5% of world gas production for power. So far so good.

If the share of gas within power production has been a moderate commission success, gas for other uses has not. European non-power gas demand is more than three times as large as gas–to-power demand – at 350bn m3 (the exact level is hard to pin down, in part because statistics sometimes include the UK in European data and in part because demand is partly weather-dependent).

140bn m3 of that demand is used in industry, mostly for heat but also for fertiliser and other chemical feedstock. Both have very limited capacity for fuel switching and even less for efficiency increases. Residential and commercial heat demands about 180bn m3 (also with limited switching capacity). Europe is still addicted to gas in spite of the 2010 plan.

Russia was a minority supplier of gas to the EU, until the commission took steps to shut it down

Before the Ukraine war the EU sourced most of its gas demand from non-Russian sources. Domestic production (not including Norway) was 50bn m3, imports from Norway were about 120bn m3, from North Africa about 50bn m3, 10bn m3 from the UK, and 30bn m3 from LNG  (numbers all rounded). That left 190bn m3 to come from Russia.

In February this year, in spite of the hole that would be left by losing that 190bn m3 the commission, encouraged by US and UK authorities, took unilateral action to reduce Russian imports. Its first step was a decision to prevent the commissioning of the Nord Stream 2 pipeline – an objective long cherished by Washington and one that cut a possible 55bn m3 out of the import mix.

A Commission embargo, not a Russian one

The months that followed have seen a dramatic distortion of the narrative around that decision, with the present situation characterised universally as “Russia weaponising gas supplies.” That is an untrue description. Moscow has constantly restated its willingness to supply all the gas that Nord Stream 2 can carry, and has stated its willingness to supply any quantity of gas required by Europe (so long as it can receive un-sanctioned payments), and has honoured its existing contracts to the letter.

At first Nord Stream 1 continued to run at nearly full capacity (55bn m3/yr). As part of its sanctions strategy the commission worked to obstruct Nord Stream 1 imports by sanctioning the delivery of gas turbine units being maintained in a Siemens plant in Canada. While that sanction was eventually lifted, Moscow has cited subsequent difficulties in getting other turbines serviced. Most recently Moscow cited a set of turbine oil leaks as a reason for stopping the pumping of gas into Nord Stream 1.

This last step is suspect. It may indeed be the case that some turbine oil leaks are preventing operations, but it is at least possible that Moscow is creating excuses to restrict Nord Stream 1 supplies to put pressure on Europe, and to hint of possible future actual Russian embargoes in future.

Other routes have also been embargoed by Brussels

Sanctioning of the two Nord Streams left three potential pipeline routes by which Russian gas could reach the EU – the Yamal pipeline capable of bringing 33bn m3/yr across Belarus and Poland, various pipelines across Ukraine capable of delivering some 80bn m3/yr, and Turkstream, with a capacity of around 30bn m3/yr.

The commission, again working under Washington’s prompting, froze Russian state currency reserves in Western banks at the start of the war. Unable to receive unsanctioned currency payments for gas Moscow mandated payment in rubles via Gazprombank. The Commission’s response was to sanction ruble transactions with Gazprom. As extant gas contracts wound down flows through Poland stopped in April, and flows through Ukraine dwindled to about 12bn m3/yr by the summer, in part because Kyiv shut down part of the pipeline network citing (probably imaginary) problems at the Sokhranivka station in the Luhansk region. The residual amount of gas transiting through Ukraine almost exactly balances gas consumed in Hungary, which has rejected the Commission’s sanctions regime anyway.

Turkstream is the only unobstructed import line

Flows through Turkstream have also continued, perhaps because the commission is willing to turn a blind eye to the ruble transactions Turkey undertakes to feed the pipeline, and partly because Europe badly needs that 30bn m3.

The commission’s suite of sanctions has reduced Russian imports from 190bn m3  to around 42bn m3/yr.

The shut-downs and sanctioned capacity have between them cut 150bn m3/yr of flows from Russia to Europe, and precipitated a major crisis in the EU (more on that in a moment).

The commission is trying to fix the problem it has created

The commission has reacted by adopting two short-term fixes. The first is to seek a 15% reduction in gas use by EU member states. With various exclusions in place and allowing for higher energy demand in winter, what the commission’s request means is a reduction in annualised gas use of around 50bn m3/yr. The most likely route to a reduction that large will be for member states to cut gas-to-power demand by allowing electricity prices to rise sharply while mandating reductions in power usage by non-industrial users.

In Germany that means high profile limitations on the use of heat and light in public buildings and community facilities (cold showers and unheated swimming pools have drawn the most attention). Switzerland has mandated a temperature cap on domestic heating, enforced by swingeing fines for non-compliance (those won’t be necessary – there are few populations more compliant with regulations than the Swiss). The Eiffel Tower’s lights will be dimmed. More diktats are sure to follow.

Demand constriction can take 50bn m3/yr out of import needs

If the consumption reduction plan works it would reduce EU power demand by about one tenth 250bn kwh – and its gas demand by 50bn m3. Not so hard, one would think – power has always been cheap and its use more or less careless, meaning that mandated changes to consumption patterns and efficiencies plus widespread voluntary self-rationing should be able to deliver the required reductions with only moderate pain.

Power price rises work, both by driving efficiencies and by cutting GDP growth

The second part of the commission strategy was to allow power and gas prices to rise sharply. The idea was that (marginally) increased prices would impose efficiency measures across Europe without the need for new regulation. Reductions would not just flow from efficiencies. GDP growth is in part a function of cheap energy. Spiking power costs would reduce Europe’s already weak propensity to grow GDP, and might even tip Europe into a recession. As GDP stagnates or falls it will take power demand with it. Each 1% fall in GDP cuts gas-to-power demand by around 4bn m3/yr.

The commission has openly accepted that its Russia sanctions would inflict some mild GDP pain on Europe. In private it may even be celebrating GDP constraint as a significant step towards its “Fit for 55” grand plan (cutting CO2 emissions from Europe by 55% by 2030) and as another step in its ultimate plan to be carbon neutral by 2050.

Green campaigners may even welcome GDP pain

Some members of EU governments will like recession too. The Green members of Germany’s coalition probably value cuts in CO2 emissions above the pain of a recession. Since the Commission is not elected and its revenue is not explicitly linked to GDP the political and economic pain of recession is not its concern. Member state governments may disagree, but from the commission’s perspective governments come and go – the commission is eternal. The embargo strategy includes one aspect which is highly popular with elected governments – the ability to blame Putin for all the pain that is following.

Demand constraint can only go so far. The other answer is buy buy buy

The demand slump caused by the commission’s Russian embargo should reduce Europe’s 150bn m3/yr gas import gap by at least 50bn m3 and likely by as much as 60-70bn m3. That still leaves a gap that might be as high as 80bn m3/yr, higher over the coming winter months. The commission’s solution to that gap has been to buy as much LNG as can be found, at more or less any price required to secure spot cargoes.

At the time of writing Europe’s LNG import terminals (and a couple of chartered FSRUs) have a theoretical capacity of some 170bn m3 – 14bn m3/month. If the LNG cargoes can be found the import gap could be comfortably filled even allowing for capacity outages and some geographic mismatches. The Commission’s energy challenge is now therefore finding uncommitted LNG cargoes.

The EU needs about 15% of global LNG supply, spiking to 25%

World LNG production is, in the short term, a fixed quantity. At the start of this year total capacity was around 600bn m3. Historically Europe has bought 5% of that. The commission’s strategy now needs 13% of it, more over the winter months, and even more if it wants to fill gas storage to help with demand peaks this winter.

In consequence Europe has maximised purchases from the US and Qatar, reaching 14bn m3/month this summer, about 25% of world production. The only way to secure that market share has been to pay wildly high prices.

EU demand has sent LNG prices up by around seven to ten times

LNG, which used to leave the US at about $0.30/m3  is now selling in Europe at $2/m3, and has touched $3/m3 over the year. The commission abandoned long term gas contracts several years ago (when contractual gas was more expensive than spot gas), so pipeline gas is tracking LNG prices. So desperate is Europe for LNG cargoes that it has even held its nose and bought 5.5bn m3 of Sakhalin LNG resold (at a considerable profit) by China.

Rising prices serve the commission’s demand reduction strategy, but these levels have sparked a new crisis

The commission was happy to see gas and power prices rising marginally, but rises of seven to ten times are another class of problem. Marginal gas prices, working through grid power price pools, set the price of power at unprecedented and uneconomic levels. The commission briefly flirted with a poorly defined form of buyers’ union designed to cap gas prices, before realising that a 13% share of the global purchase market is too small to make a “buyers’ price cap” anything other than a way of not buying any gas at all. One has to wonder at the level of technical and market knowledge brought to Ursula von der Leyen’s desk by her Brussels civil service team.

Margin structures are on the point of collapse across much of European industry

European industrial gas users have built their businesses on margin structures in which heat costs in the region of $0.03/kWh. At that price low-margin large-scale industrial industries (metals, glass, paper, concrete, cement, fertiliser, plastics, rubbers, polymers) might spend 5% of sales on heat, within a margin structure that generates a pre-tax profit of 10% of sales.

If industrial heat rises in price by a factor of ten then margin structures collapse. Heat that used to cost 5% of sales now costs 50% of sales. Selling prices don’t change (we are talking about globally traded commodities) so a 10% pre-tax margin can become a 40% pre-tax loss overnight. In short, large swathes of European industry are on the point of becoming structurally unprofitable. German business media is currently focused on reports of forthcoming (and indeed already-arrived) industrial plant shutdowns. The commission’s energy price strategy is blowing up in a spectacular way.

Primary industry collapse will take secondary industry with it

It’s not just heavy industry that is vulnerable. Most secondary manufacturing depends on the metals, plastics, glass, papers, rubbers and polymers made by primary industry to make, package and distribute their own products. The construction industry (about 10% of GDP) depends on concrete, cement, structural steel, plate glass and a whole suite of plastics for its daily inputs. The supply chain story is the same wherever one looks.

The commission plans emergency action, but numbers are thin on the ground

This week the commission announced a plan to impose windfall taxes on the profits of non-gas power producers (profits created by the working of national pricing pools), and to recycle those taxes back to companies and consumers in the form of subsidies. That is potentially one way of returning energy costs to something approaching a pre-war level.

Reports focus on an amount of around €150bn ($150bn), a number whose foundations are not a matter of public record. Europe generates around 200bn kWh/month from non-gas sources. If we assume that this tranche of generation would normally sell into power pools at around €0.10/kWh, and that the gas price spike is increasing the pool price to around €0.25/kWh (based on $2/m3 or $55/mn Btu), then the excess profit washing around pool generators would be in the region of €30bn Euros/month. Is the commission's tax plan based on a five-month time scale? Possibly. We also don’t know yet whether the commission plans to remove all of that profit spike, or just the normal “corporation tax” percentage. We have yet to see any details. Spot prices can spike 40% above $55, which would make the tax inflow even higher.

Whatever amounts the tax-and-redistribute plan comes to, it will be a massive transfer of spending power (and therefore power) to the commission, whose total budget this year is just €12bn/month. This might be an example of a civil service applying that old tested maxim – “never let a good crisis go to waste”.

The tax-and-subsidies plan is unlikely to be perfectly efficient, and will demolish the EU’s historic trade surplus

Redirection of windfall taxes may be a good idea but is unlikely to allocate benefits exactly in parallel with the pain, which means that the disastrous effects of the commission’s Russian energy embargo are still likely to appear painfully visible in GDP outturns. Extremist economic forecasters are citing coming annual falls in EU GDP of 4%, 5% and more. Alongside GDP falls (whether large or small) Europe’s trade balance has already swung from a generation of surpluses to a substantial deficit. 100bn m3 of imported LNG at $2/m3, passes $200bn/yr to Qatar and a handful of (very happy) US LNG producers. More cash is flowing out to Norway and North African gas exporters. 2022’s EU trade deficit is likely to be shockingly high. That will hit the euro, which is showing signs of anticipation as it trades down to (and now below) parity with the US dollar.

As consumer consumption and industrial output fall, European government tax revenues will fall too. Meanwhile Germany has committed to spend some $50bn on subsidising energy for consumers (the UK has committed £120bn, all to be borrowed). Consumer subsidies may shore up voter support but they will switch off pricing signals that would have forced demand reduction, while doing nothing to fix the collapsing margin structures of energy-using businesses. EU member deficits will balloon.

The crisis is an entirely self-inflicted blow

The crisis that is about to land is one entirely of the commission’s own making. The commission’s decarbonising ambitions and its flawed ideas of how to punish Russia for its invasion of Ukraine have combined to set Europe’s industrial economy up for a large and painful fall. The commission’s energy strategy looks like being the largest collective act of economic self-harm since Mao Tse Tung’s Great Leap Forward in 1958. However, since the commission shares one feature with chairman Mao’s administration – it is not elected – it can plough on regardless. It shows every sign of doing exactly that.