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Europe unprepared for hard winter without Ukraine gas

Oil markets
By Paul Hodges on 30-Jul-2014

Russia gas Jul14There is an alarming naivety about Western policymakers’ response to events in the Ukraine.  They have simply chosen not to recognise that Russia’s strategic objectives are no longer about building links with Europe, but are instead about creating a Eurasian Economic Union (EEU).

Thus they assume that Russia will always put its economic interests ahead of its political objectives.  And they ignore the fact that any reduction in Russian gas supplies would increase world prices, perhaps by quite a lot – thus mitigating any volume loss.

Yet as the Asian Times reported from April’s St Petersburg International Economic Forum:

“In St Petersburg, from session to session and in selected conversations, what I saw were some crucial building blocks of the Chinese New Silk Road(s), whose ultimate aim is to unite, via trade and commerce, no less than China, Russia and Germany.”

The Times went on to suggest the EEU has 3 core elements, none focused on links with the EU or NATO:

  • For Asia, China wants a Free Trade Area of Asia-Pacific based on its position as ASEAN’s largest trading partner
  • For Europe, the aim is to create the most important commercial route in the world by extending the railway between Chengdu in Sichuan and Lodz in Poland to Duisburg in Germany
  • China also wants a new Asian security cooperation architecture to include Russia and Iran – and exclude the US

The St Petersburg event also highlighted the critical importance of the Crimea.  Its potential energy resources are vast.  And now it is under Russian control, China is stepping up to finance its development.

As the chart from the Financial Times shows, Russia supplies around a third of European gas demand.  Half of this volume comes through the Ukraine, which itself is highly dependent on Russian supplies.

The assumption in Western circles is that Russia would never want to disrupt this flow, due to the loss of revenue involved.  But this is a myopic view, which assumes that economic interests will dominate Russia’s thinking.  In fact, as the Eurasian concept demonstrates, the focus is increasingly eastwards towards China – where it has now completed a $400bn deal for future gas supplies.

China’s planned volume at 38bn cubic metres is relatively small, slightly less than Ukraine’s 45bcm consumption.  And the gas involved will come from new developments in the East of Russia.  But it highlights the direction of travel.

And history shows that gas supplies have been cut off before in 2006 and 2009, due to earlier disputes with Ukraine.  Whilst Russia cut supplies to Ukraine last month due to the continuing dispute over unpaid bills.

So companies and investors cannot simply sit back and assume everything will be alright on the day.  This is particularly true about the potential timing of any cutbacks – past shortages occurred in the middle of freezing weather, not in the summertime.  As the FT warns:

Ukraine and Europe are devising contingency plans for this winter – including caps on consumption by households and businesses – (but) implementation in such a short period will be challenging, say analysts”.

The real solution would be for Europe to develop a sensible energy policy that focused on major increases in energy efficiency, and thereby reduced today’s current dependence on Russian gas.  But that would also mean having a serious conversation with voters about the balance of risks with fracking.  As the blog noted back in May:

  • Its very easy to worry about possible risks from fracking when your home is warm, and the transport system is working normally
  • But its too late to worry about alternative sources in the winter, if your major source of supply has just been cut off

Gas and oil prices would almost certainly go up, and by a large amount, if markets start to worry that Europe could be held hostage over energy supplies later this year.

The key issue is that current oil prices of $100/bbl are entirely artificial, and the creation of the central banks:

  • They are not related to the growing supply surpluses around the world
  • Nor do they relate to the real potential for temporary supply disruption through the Ukraine in the winter

The former could take prices down to $50/bbl, and the latter could increase them to $200/bbl.

Developing a contingency plan for both possible outcomes would seem a prudent policy today.