The Russia-Ukraine War: Implications for international energy markets
In addition to its disheartening humanitarian implications, the Russia-Ukraine conflict has put European and global energy markets on high alert. A potential disruption to Russian oil and natural gas exports could lead to severe natural gas and power shortages in Europe and could send global oil prices north of $200 per barrel. This is a rapidly evolving situation. Low probability, high consequence events that we never thought possible just a few weeks ago are now distinct possibilities, generating tremendous anxiety and volatility in international energy markets. While we don’t know what is going to happen next, we will try to explain the current situation as best we can: How did we get here? Where are we now? What could happen next? And what does all of this mean for energy markets and policy in both the short- and long-term?
How did we get here?
Europe’s dependence on Russian energy is a well-known vulnerability dating back to the Soviet era. Europe was reminded of this vulnerability during the 2009 Russia-Ukraine gas dispute when Russian gas supplies moving to Europe through Ukraine were cut off for nearly two weeks in the middle of winter, and again during Russia’s invasion of Crimea in 2014. And as of 2020, Russian gas accounted for more than one-third of EU-27’s gas supply, a statistic that has gone up since 2014, and Russian oil accounted for approximately 20% of Europe’s oil consumption.
In short, Europe’s push for renewable energy and gas at the expense of coal and nuclear, combined with low development of domestic gas resources, has increased its dependence on Russian natural gas. These policies have left Europe more vulnerable to Russian natural gas disruptions. Europe’s current situation highlights the importance of making energy security a critical component of long-term decarbonization policy and underscores the potential dangers of moving too fast in the energy transition.
Where are we now?
Russia began slowing its gas supply to Europe beginning in summer 2021 and, prior to the invasion, export flows on Russia’s main pipelines to Europe were down approximately 40% from the first half of 2021. Although Russia’s Gazprom continued to supply volumes to its contract customers, it throttled back sales in the spot market, pushing Europe’s gas inventories to historic lows for the start of the winter and driving spot gas prices in Europe to record levels.
As of early March, Gazprom continues to meet its contractual obligations, including contractual nominations and contractual “ship or pay” volumes through Ukraine. Russian gas pipeline volumes have ramped up post-invasion as contract customers have increased nominations to maximum contract levels in response to surging spot prices.
As with gas exports, Russian oil continues to flow but uncertainty surrounding the potential for future sanctions and higher freight rates for loading at Russian ports are keeping many spot market buyers away. The U.S. announced a ban on Russian oil imports on March 8—a move that will have limited impact on markets given that Russian imports are not a major component of U.S. supply. It is unclear whether European countries more dependent on Russian oil will follow suit.
What could happen next?
As the conflict in Ukraine intensifies, the possibility of a disruption to Russian energy exports grows more distinct, which is something neither side would want. A disruption of Russian energy exports would trigger severe shortages in European and global energy markets and a severe financial crisis in Russia.
Russia, for its part, has strong financial, legal, and reputational incentives to continue supplying oil and gas to its European customers. The oil and gas sector contributed nearly 40% of Russia’s federal budget revenue in 2019 and accounts for more than half of Russia’s exports. Purposefully cutting off this income stream would cause extreme financial harm to Russia and long-term reputational impact to its energy trade with Europe. Assuming no escalation in the standoff between Russia and Europe, one would expect Russia to maintain supply for its own economic benefit, particularly given the soaring energy prices caused by the conflict Russia itself created.
For European energy markets, the impacts of a Russian gas disruption would be devastating. Europe’s LNG import capacity—concentrated primarily in coastal western Europe—is already operating at record utilization rates and pipeline constraints limit the volume that could be transferred from coastal terminals to markets further east. With a shortage of gas, energy-intensive industries would grind to a halt and power cuts would be needed to prevent a collapse of the grid. Even some household gas use for home heating may need to be curbed to bring supply and demand into balance. The situation would be akin to the February 2021 Texas Freeze event but on a continent-wide scale.
A more limited scenario involving suspension of gas flows through just Ukraine—due either to purposeful shutoff or unintended damage from war—would be more manageable in the short-term. Russian gas piped through Ukraine is currently running at around 3 Bcf/d and with the end of winter nearing, downstream consumers may be able to maintain supply from storage and Russia may be able to increase shipments on other pipelines that don’t traverse Ukraine. Already volatile energy prices, however, would escalate further.
The impact of a loss of Russian oil exports—which account for about 5% of global oil demand—would extend well beyond Europe, creating a global oil shortage. Russian oil exports cannot be replaced in the short-term. Commercial suppliers would maximize exports to the extent possible and governments would release barrels from strategic reserves, but both these activities are already underway, face logistical bottlenecks, and could not be maintained indefinitely. Although European buyers, who purchase more than half of Russia’s oil exports, would experience the brunt of supply impacts, global oil prices would likely be pushed above $200 per barrel as buyers compete for limited supply alternatives on the spot market.
What does this mean for energy markets?
The current situation is causing extreme volatility in European gas and power markets, and global oil and LNG markets. European gas prices, which were already trading at $29 per MMBtu—a 1.7 multiple to crude oil—prior to the invasion have since surged to more than $70 per MMBtu (as of March 7)—the oil equivalent of $420 per barrel. European gas prices are setting the price for LNG spot cargoes, pushing up costs for buyers around the world. Global crude oil prices are on their wildest ride since 2008, jumping from under $80 per barrel at the beginning of the year to more than $123 per barrel as of March 7. Energy consumers around the world will be harmed by this escalation, especially gas and power consumers in Europe, including energy-intensive industries such as steel and fertilizer manufacturing, and consumers of petroleum products around the globe. In the U.S., gasoline pump prices have already risen to a national average of more than $4.17 per gallon with further escalation expected in the coming weeks as price impacts cascade down the supply chain.
But the current crisis is also producing opportunities for energy sellers, including those selling gas into the European market at prices tied entirely or partially to European hub prices and those selling spot shipments of LNG anywhere in the world, especially U.S. LNG exporters who expanded export capacity this winter and have managed to shift export cargoes initially going to Asia to markets in Europe. For a sense of the opportunity, U.S. LNG exporters are buying feedgas in the U.S. Gulf Coast at less than $5/MMbtu and selling it in Europe where prices currently exceed $70/MMbtu. Power producers in Europe that use other fuels—nuclear, coal, wind, and solar—will also see a windfall as gas-fired power sets the marginal power price, especially during peak periods. Oil producers and refiners will also benefit on the heels of surging crude oil prices and widening refinery crack spreads (the difference between refined product and crude prices).
What does this mean long-term?
Even if the Russia-Ukraine war concludes without a major disruption to energy supply, the psychological impact of instability and political risk will remain baked into European and global energy prices for the foreseeable future. This lasting risk premium will provide a higher floor for energy producers around the world, making investments in new oil and gas production and export facilities more attractive, particularly in the United States where the industry is already beginning to shake off the demand-side uncertainties caused by the COVID-19 pandemic.
On the policy front, in the mid- to long-term, Europe will likely accelerate its development of renewable energy resources and LNG import capability. There will be enthusiasm for increased LNG trade on both sides of the Atlantic, and new export facilities in the U.S. will be more likely to get the green light. New U.S. LNG exports will increase demand for U.S. gas, however, supply is also likely to increase as higher prices prompt more drilling—both gas-directed drilling and associated gas production from oil drilling. This will keep U.S. natural gas price increases in check. While there will be renewed interest in developing European gas, geology and environmental opposition may continue to limit the upside.
As Europe works to diversify its gas supply, Russia will in turn work to diversify its gas customers. Russia announced it will be moving forward on design work for a new pipeline to deliver natural gas to China through Siberia and Mongolia. The construction of an interconnector pipeline between Russia’s eastbound and westbound pipeline systems could allow Russia to divert to China at least some of the gas from its western Yamal fields that currently supply Europe. To protect itself, Russia may turn to a yuan-based alternative to the Western-controlled SWIFT cross-border payment system, such as China’s Cross-border Interbank Payment System (CIPS).
Beyond the obvious lessons surrounding dependence on Russian energy, the current crisis may force policymakers in Europe (and across the developed world) to consider the risks of transitioning to renewable energy too quickly. Retiring reliable energy sources, such as nuclear and coal, is risky, especially if it means becoming more dependent on energy imports from unreliable suppliers. The current crisis highlights the importance of considering the short- and mid-term energy security implications of long-term decarbonization policies.
