Europe's fuel disaster: what does it imply for traders? – Schroders

August 17, 2022 By admin

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Europe faces excessive fuel costs and potential shortages as provide from Russia dwindles. We ask our funding consultants what this implies for firms, the power transition, and the eurozone economic system.
16/08/2022
Europe faces excessive fuel costs and potential shortages as provide from Russia dwindles. We ask our funding consultants what this implies for firms, the power transition, and the eurozone economic system.
16/08/2022
Emma Stevenson
Equities Correspondent
Europe’s precarious fuel provide state of affairs has been a major focus for markets ever since Russia’s invasion of Ukraine on the finish of February.
The European Union (EU) and others had been fast to use sanctions to Russian oil. Nonetheless, fuel is a extra sophisticated matter given the reliance of main European economies – most notably Germany – on pure fuel from Russia.
The state of affairs turned much more essential when a serious provide pipeline – Nord Stream 1 – was closed for upkeep in July. Whereas the pipeline has now come again onstream, fuel is being provided at a lowered quantity.
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Fuel demand is decrease in the summertime, however this lowered provide places in jeopardy the EU’s purpose of filling fuel storage websites to 80% capability in November this 12 months, and to 90% in 2023.
We requested our funding consultants what this implies for Europe’s economies and markets.    
“Europe is going through an 18-24 month interval of very excessive fuel and electrical energy costs”, stated Mark Lacey, Head of World Useful resource Equities. “Europe has turn out to be and can stay the premium marketplace for fuel over this era, with costs above these in Asia or the US. This premium will final till we begin to see significant new volumes come onstream from 2024/25”.
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Excessive costs will be tackled through two strategies: a discount in demand or a rise in provide. European international locations are taking steps to deal with the demand facet.
Azad Zangana, Senior European Economist and Strategist, stated: “EU member states lately agreed to a voluntary 15% discount within the consumption of fuel, however this might turn out to be necessary if provide continues to be disrupted.
“Whereas power inflation fell again from 42% year-on-year (y/y) to 39.7% y/y within the newest studying, we anticipate additional worth will increase to maintain power and headline inflation elevated within the second half of this 12 months, which in flip will cut back the spending energy of households.”
The excessive costs could in themselves trigger demand to drop as customers restrict their fuel consumption.
Mark Lacey stated: “Following a worth improve of round 400% year-on-year, it’s inevitable that some aspect of demand is destroyed. Fuel demand in Europe will seemingly fall round 10% in 2022. Even at decrease costs, it’s unlikely to develop considerably in 2023 given the chance of recession”.
The desk under signifies how fuel demand is anticipated to fall this 12 months in most components of Europe.
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Nations within the EU have very completely different profiles when it comes to the quantity of fuel beforehand provided by Russia.
Environmental Economist Irene Lauro stated: “The EU imports 90% of its fuel consumption, with Russia offering round 45% of these imports in 2021. Austria and Poland imported greater than 80% of fuel from Russia in 2021, Germany greater than 50%, whereas for France and Spain the share was lower than 8%.”
Some international locations have different choices to fuel piped from Russia. Nations such because the UK and Spain have important LNG (liquified pure fuel) capability, that means they’ll obtain imported LNG cargoes. Italy has lately signed a collection of fuel offers with Algeria.
Nonetheless, there isn’t at all times the infrastructure in place (regasification crops to show the LNG again into fuel, or the pipelines) to produce this fuel to central components of Europe the place it’s most urgently wanted.  
The chart under highlights how renewables will be a part of the reply to the fuel scarcity. The chart reveals the common annual proportion of electrical energy era depending on Russian pure fuel in blue, whereas inexperienced represents projected renewables progress within the interval 2021-23.
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Irene Lauro stated: “Germany and Italy closely depend on Russia when it comes to absolute electrical energy era. Nonetheless, based mostly on IEA’s wind and photo voltaic expectations for the following two years, and given present insurance policies, the potential for renewables to cut back dependency in Germany is considerably increased than in Italy.
“In the meantime, France and the Netherlands’ reliance on Russian fuel is comparatively low, with a major potential for renewables to displace Russian fuel.”
Germany’s reliance on the Nord Stream 1 pipeline, and lack of different choices, means it’s the main economic system most liable to fuel shortages. Earlier this 12 months, the German authorities unveiled a three-step plan for fuel rationing that would see provide lowered to trade with the intention to guarantee availability for households and demanding establishments like hospitals.
Beneath such a situation, energy-intensive sectors similar to metals manufacturing and chemical substances could be probably the most affected within the brief time period.
Arianna Fox, European Equities Analyst, stated: “The chemical substances trade is one that’s immediately uncovered to fuel scarcity threat given how energy-intensive it’s and the way a lot of the trade is concentrated in Germany. The federal government may introduce rationing however there are nonetheless many questions as to how this might play out.
“For instance, would all industries face the identical degree of rationing? It could be the case that the federal government would attempt to shield industries similar to meals & beverage manufacturing, or healthcare firms. If that’s the case, then different industries like chemical substances must shoulder a bigger burden, hitting their manufacturing more durable.
“The difficulty is that chemical substances are utilized in so many merchandise and processes. In the end, each trade would really feel the affect of lowered provide or increased costs for chemical substances. Companies may attempt to import the chemical substances they want from exterior of Europe however provide chains are nonetheless disrupted submit Covid, and there’s no assure that crops exterior Europe have spare capability.”
After all, rationing just isn’t at the moment in place, however monetary markets hate uncertainty. Share costs of European chemical substances firms have fallen sharply in consequence.
Arianna Fox stated: “Some chemical substances firms could doubtlessly seem like enticing investments, given how far shares have already fallen, particularly if the ‘worst case situation’ of a shut-off of Russian fuel doesn’t transpire.”
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And certainly, it might be that the much-feared cut-off of all Russian provide doesn’t materialise.
Mark Lacey stated: “We expect {that a} continuation of pipeline flows (albeit at lowered ranges) is extra seemingly than an entire cut-off. A cut-off would see Russia lose all its political and financial leverage over Europe. Additionally, the misplaced revenues from fuel gross sales have to be having a major affect on the nation’s export revenues.”
It might even be that households are requested to shoulder extra of the burden, which might assist to guard the company sector. Germany has unveiled plans for a levy on fuel that might have an effect on households too.
The excessive fuel costs are simply one in all a number of components that would weigh on financial exercise. German GDP progress was zero in Q2, albeit Q1 progress was revised increased.
Azad Zangana stated: “We proceed to anticipate affordable progress for southern EU member states, which haven’t loved a full tourism season since 2019.
“Nonetheless, it’s clear from Germany’s efficiency that world capital funding has slowed in response to rising rates of interest and issues over progress. China’s draconian lockdowns haven’t helped issues both. With the heavy reliance on Russian fuel to think about as properly, it seems that the northern member states are notably weak going into the following two to a few quarters.”
The potential of a broader financial slowdown, or recession, additional complicates the choices of firms such because the chemical substances producers who could also be compelled to chop their manufacturing volumes as a consequence of lack of fuel.
Arianna Fox stated: “Sometimes, firms going through quantity declines attempt to shield earnings by elevating costs. However that’s tough for chemical substances corporations within the present surroundings the place clients have already endured worth hikes. As a substitute, demand could also be prone to fall.”
Demand for fuel just isn’t solely excessive in Europe, however world wide. Nations are searching for to shut down polluting coal crops and transfer to pure fuel as an interim step in the direction of lowering their greenhouse fuel emissions. This implies Europe is at the moment competing with international locations similar to India and China for LNG, with cargoes going to those that pays the very best costs.
One other drawback is that there’s restricted new LNG provide coming to the market over the following two years.
Mark Lacey stated: “The primary purpose for this lack of provide is because of under-investment in upstream fuel tasks and undertaking deferrals. That is largely due to the Covid-19 pandemic, in addition to beforehand low regional fuel costs.
“Nonetheless, past the following 24 months, Europe begins to have some different choices for provide of fuel. That’s once we’ll begin to see the ramp-up of recent provide from the US and Qatar.”
That stated, even when new LNG provide turns into accessible, fuel costs are unlikely to return all the way down to their earlier ranges given the rising demand from different areas and for fuel as a transition gasoline.
Mark Lacey stated: “European (and Asian) fuel costs have clear draw back threat from present ranges, however once they do ‘normalise’, they’re prone to retrace to the next base degree. For instance, slightly than $5 – $10/mcf long run pricing, $12 – $18/Mcf pricing could also be extra wise.”
This might have long-term implications for energy-intensive sectors like chemical substances, even as soon as the present disaster is over. They’d nonetheless face increased prices than they’d beforehand been used to, impacting their profitability.
Arianna Fox stated: “This might trigger a longer-term structural shift that would cut back the competitiveness of chemical substances firms producing in Europe. Chemical substances firms could search to shift manufacturing to international locations the place the price of fuel is cheaper.”
Within the medium to long run, a transparent winner from the fuel disaster is prone to be the renewable power sector. The necessity to curb dangerous emissions and to cut back reliance on Russian fossil gasoline imports go hand in hand.
Renewable power tasks like wind or photo voltaic farms is probably not on the spot options to the issue, however they’re lots faster to rise up and working than a nuclear energy station, for instance.
Increased energy costs are additionally feeding into long-term contract costs for energy, that means funding returns on such tasks now look extra enticing.
Mark Lacey stated: “Energy buy agreements (PPAs) have been rising steadily from €40/Mwh in March 2021 to simply beneath €100/Mwh in June 2022.
“This has a direct affect on renewable undertaking returns, with builders noting that some undertaking inside charges of return (a measure used to estimate profitability) have elevated from 5-6% two years in the past, to nearer to 11-12% now.”
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In Could this 12 months, the EU unveiled its “RePowerEU” plan which is designed to part out dependency on Russian fuel and guarantee a extra diversified provide of energy from decrease emission sources. This summer season’s disaster and the low fuel volumes coming from Russia heighten the necessity for that phase-out to speed up. In the end, it will convey costs down and make the EU extra self-sufficient when it comes to energy era.
Nevertheless it is probably not an easy journey in the direction of renewables. For instance, measures to cushion the fuel worth affect on shoppers could have unintended penalties.
Economist Irene Lauro stated: “Governments are offering measures to defend weak households from rising power costs through subsidies, scrapping surcharges or capping electrical energy costs.
“Subsidising power consumption is essential to assist shoppers with the price of dwelling disaster within the brief run. However it may possibly have some drawbacks, not directly incentivising the usage of fossil gasoline power and making the required change from soiled to cleaner applied sciences much more costly in the long term.”
Nonetheless, within the close to time period, there’s a clear winner that emerges from the present disaster: US fuel producers. The upper fuel costs make it economically viable to recuperate US fuel than would have been attainable with fuel costs at $3.00/Mcf.
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Mark Lacey stated: “Extra importantly, round two-thirds of the overall US fuel useful resource base is in Texas, Pennsylvania, West Virginia and Oklahoma. All of those markets have transportable entry to worldwide markets and are conveniently positioned to export fuel to Europe at a pretty worth of round $8.90/Mcf.
“That is additionally prone to enhance long-term US fuel costs. Moderately than retracing again all the way down to their home value of round $3.00/Mcf, we predict it makes extra sense for costs to commerce round $5.00-$6.00/Mcf. Clearly, this will increase the attractiveness of US fuel firms to traders.”
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