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The war in Ukraine and its impact on energy
Robert Lind
Craig Beacock
March 10, 2022
From a financial perspective, the February 24 Russian invasion took markets utterly by surprise. The global economy — already reeling from high inflation — suddenly faced dire new threats, including a severe energy shortage, a growing refugee crisis and the potential for a protracted war in eastern Europe. The following takes a closer look at the impact of the war on energy with perspectives from two Capitals Express Investments investment professionals.
Sanctions pose a dilemma for EU policymakers
Robert Lind, European economist
This week, the U.S. announced expanded economic sanctions against Russia, banning imports of oil and gas, and the U.K. quickly followed suit, banning Russian oil. But the European Union, which counts on Russia for a significantly larger portion of its energy supply, has not moved as forcefully, vowing only to cut its gas imports by two thirds within a year.
A full energy embargo on Russia would be extremely painful for the major European economies, especially Germany and Italy and smaller countries in central and eastern Europe that depend on Russian gas imports. In the short term, the EU should be able to cope with offsetting imports of liquified natural gas. But the bigger challenge will come during the summer when gas is being stockpiled for winter. Higher prices will make it even harder.
Analysis by the European Central Bank (ECB) and others show that a significant reduction in gas supply would have substantial negative effects on the euro zone’s GDP. For instance, the ECB estimates a 10% reduction would reduce euro zone GDP by around three quarters of a percentage point. Given that Russian imports account for around 40% of EU gas supply, an energy embargo could depress GDP by 3% to 4% relative to the pre-war baseline.
International sanctions are mounting against Russia
Sources: Capitals Express Investments, Council of the European Union, U.K. Foreign, Commonwealth and Development Office, U.S. Department of the Treasury, U.S. State Department. As of March 7, 2022. Note: SWIFT is the Society for Worldwide Interbank Financial Telecommunication, which runs a messaging and payment system used by more than 11,000 financial institutions. “Golden passports" refer to residence permits that can be made available to foreign nationals and their immediate family via certain citizenship-by-investment programs.
Unsurprisingly, the EU is wary of implementing sanctions that could have such a damaging impact on its economy. But if the recent spike in oil and gas prices continues or is protracted, the European economy will suffer a negative supply shock even if there is no embargo. Alongside steep energy prices, we are seeing higher prices for other commodities related to the global food supply chain. Prices are also rising sharply for fertilizer and building materials. At the same time, in the absence of an embargo, higher energy prices will boost Russia’s export earnings, mitigating the effects of the economic and financial sanctions.
In the light of extreme uncertainty, I expect the ECB to avoid giving a clear signal that it will end its asset purchases. It will also have to closely monitor the inflationary shock this conflict brings. There is a growing risk of stagflation in Europe, which is a bigger challenge. Central banks would want to monitor any signs of inflation expectations so they don’t fall behind. I think they will continue to signal a removal of monetary accommodation, but at a much more cautious pace.
Gas is more challenging than oil for Europe’s economy
Craig Beacock, equity investment analyst
There’s an important distinction between oil and gas that seems likely to impact Europe and could ripple through the global economy, given the region’s standing as a major manufacturing and industrial base for automobiles, airplanes and chemicals. Oil is easier to supply and ship around the world when regions experience supply disruptions. Natural gas, on the other hand, is much less fungible. It is far more difficult to transport, whether through pipelines or LNG liquefaction infrastructure. So, if Russian supply is curtailed and Europe faces major shortages, it would be challenging to secure replacement supplies. This would certainly be a blow to Germany, which is a large user of gas for power generation.
In the commodities market, oil and gas prices have reacted very differently. While oil prices usually dominate headlines, the spike in gas prices has been more staggering. For example, European natural gas prices recently skyrocketed, trading at the equivalent of about US$100 per million cubic feet of gas. That’s roughly equivalent to US$600 for a barrel of oil. This underscores the disparity in how these commodities are transported around the world.
Energy prices spike amid Russia-Ukraine conflict
Source: Refinitiv Datastream. As of 3/4/22.
I expect CEOs of oil companies and others in the industry to play a role in alleviating this crisis. In the U.S., I anticipate production to grow to 500,000 to one million barrels a day. Trading prices have recently climbed to nearly US$140 a barrel. I don’t think oil producers want prices at this level because it creates volatility and destroys demand. In my view, most oil stocks are priced for the commodity to trade in the range of US$60 to US$70 a barrel.
I do not expect this to significantly derail the world’s shift to green energy, but I do think it shows how the policy lines around energy security and sustainability could change, especially in Europe. Going forward, I expect policymakers will put a much greater emphasis on balancing the environmental side of things with the social ramifications of what could happen if they do not shore up energy security and insure they have the right supplies from the right partners.
Prior to the invasion of Ukraine, equity markets had been signaling to oil companies a preference for dividends and buybacks and less investment in pumping oil — partly because many such projects over the past decade had poor returns on capital. Oil companies have ample cash flow, and if capital expenditures are increased, they should have sufficient funds to provide both dividends and share buybacks.
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