The Energy Crisis Is A Crisis Of Change

Some Additional Thoughts On The UK Energy Crisis

Yesterday morning brought an interesting illustration of the current structural imbalances within Europe’s natural gas trading markets. Despite Europe being fearful of an energy shortage, for a moment the spot price of natural gas European natural gas (Dutch TTF market) went negative, as final contract buyers literally ran out of storage capacity to house the natural gas when the contract came due for final delivery.

At one point in the morning, front-month Dutch TTF futures, which serve as a benchmark for northwest Europe, were down over 10% at 101.39 euros a megawatt-hour, having opened at a new four-month low of 100 EUR/MWh.

But what is more remarkable is that the lack of storage availability - similar to what happened in April 2020 when WTI briefly traded as far negative as -$40 - has forced ultra-short term spot prices to collapse as those assigned delivery (without a place to store the gas) were literally paying others to take the gas off their hands!

Two market forces collided to produce this very brief anomaly:

1. EU natural gas storage is more than 93% full—well above the 80% goal sought by the EU earlier this year, and higher than it was this time last year.

   

2. Europe’s massive buying spree of Liquified Natural Gas (LNG) has resulted in a literal armada of LNG tankers cruising near Europe waiting to off-load their cargo into maxed-out LNG regasification plants.

Sixty LNG tankers have been idling or slowly sailing around northwest Europe, the Mediterranean, and the Iberian Peninsula, according to MarineTraffic. One is anchored at the Suez Canal. Eight LNG vessels that came from the U.S. are underway to Spain’s Huelva port.

“The wave of LNG tankers has overwhelmed the ability of the European regasification facilities to unload the cargoes in a timely manner,” said Andrew Lipow, president of Lipow Oil Associates.

Thus while the forecast is still for increased European (and thus UK) demand as winter arrives, right now current supply is bumping up against current storage capacity, pushing the spot prices for natural gas down, and even into negative as the hour-ahead supply exceeded available storage, leaving the suppliers with the bizarre option of literally paying someone to take the gas off their hands!

Yet this odd turn of events does not mean that either Europe’s or the UK’s energy crisis is solved—merely that the major part of the crisis has yet to arrive. This immediately begs the question of how major the crisis will be when that part arrives.

Europe, Like The UK, Is Undergoing A Structural Shift In Gas Demand

As I noted the other day, the UK is undergoing a structural shift energy markets and energy prices:

What the UK is grappling with in 2022 is that simply “reopening” the world’s economies is not enough to return the supply side of the global economy to the status quo ante. The reality is there is likely no going back to the status quo ante, and the world must adjust to new cost regimes, and new relative prices for goods and services.

While it would be a mistake to describe natural gas and energy prices, both in the UK and globally, as “transitory”, they are indicative of an energy economy and a global economy that is very much in transition. The old economic equilibria have been upended, and the global economy overall is still settling and establishing new economic equilibria.

Europe is experiencing this same transition, which has led to massive buying of reserve capacities of natural gas even as Europeans strive to reduce demand so as to increase storage—and both efforts have been successful.

Yet just as October is not November, October weather is not November weather, and neither month has December’s weather. Cooler temperatures are coming, and when they do energy demand will be rising. Based on the current spread between current UK Natural Gas futures contracts (November delivery) and contracts for December through April 2023 delivery, the markets are currently expecting natural gas demand to approximately double by December, and remain there until next spring.

However, the spread also shows us something of the transition taking place. Until early October, the November contract price tracked very closely to the contract prices for December through April, both on the summer rise and the autumn decline—right up until October, when the price for November delivery declined sharply, a reflection of EU natural gas storage capacity nearing saturation (remember, the UK winter energy strategy is to buy gas from Europe). November, being the current contract, reflects the saturated current state of the natural gas markets for both the UK and for Europe.

We can see this because the TTF contracts for November through April 2023 delivery follow the same pattern as the UK contracts, including the October bifurcation where the November contract drops more rapidly than the rest.

Thus, even though current natural gas prices are falling, by December they are expected to rise again, tracking the anticipated increase in demand.

Will Demand Rise?

While the expectation that demand will rise is reasonable, the magnitude of the increase is still very much an unknown. Much depends on how severe the winter will be. Right now, many long-term weather forecasts for the UK are projecting a mild winter:

At the moment most of the data is suggesting a milder than average winter 2022-23.

The seasonal models strongly support the idea of it being milder than average. The precipitation signal is much weaker. The QBO also suggests a lower chance of a cold winter. High levels of solar activity this year may also favour a mild winter.  

AccuWeather is anticipating near normal winter conditions with occasional bursts of colder weather.

This winter, the forecast calls for temperatures generally near normal, with cold bursts that can coincide with periods of snowy weather. 

The overall pattern this winter in cities such as Dublin and Edinburgh will favor fewer snow days than in typical years. However, any cold and unsettled periods that may grip the region this year could have substantial repercussions given the state of energy demand and costs associated with heating homes. 

“There can be stretches of mild weather with near-normal temperatures," Roys said. "However, an outbreak of colder weather can settle across the region for a period of two to three weeks."  

This is also the broad assessment of RealWeather.

At the moment the signals are pointing towards a La Niña based Autumn and winter. A La Niña Autumn and Winter would lead to an unsettled and cooler Autumn with areas of low pressure moving in off the Atlantic to affect the United Kingdom.

The winter period, or at least the start of winter 2022-2023 would more than likely bring much colder weather compared to El Niño years. Whilst winters generally get off to a colder start during a La Niña year, we would then normally go on to see a milder second half of winter or a mixed (seasonal reversal) which can be seen on the below graphics from the Metoffice.

A mild winter means lower energy demand—which translates into a slower draw on available stored reserves, and thus less storage capacity to accommodate December-April natural gas deliveries, pushing price down as a result.

In other words, so long as the current weather outlook holds, the December-April contract prices will continue to decline (although potentially at a slower rate), and thus result in a final contract price that is higher than the current November contract, but not by the 2x margin some have been anticipating, but instead by a significantly lower margin, perhaps as low as 150% of current contract.

If the winter outlook worsens, the December-April contract prices will likely rise significantly above the 2x margin over the November contract. The key word here is “if”.

Still, just like the negative WTI print in April 2020 was an historic outlier, so don't expect today's negative "next hour" gas print to become a frequent occurrence, especially since the more conventional (one month, etc) European winter prices remain very high amid continued uncertainty over the fate of European gas, because while the winter of 2022 may avoid the worst case scenario (which again will depend on just how cold the coming winter will be), it is the winter of 2023 where all bets are off.

Smaller Shift Than The Narrative Suggested

Another reason the energy crisis might turn out to be smaller than anticipated in the UK even as the winter months unfold is the reality that British imports of Russian natural gas—the supply that has been disrupted—were far from the dominant import volume. In 2021. that honor went to Norway, with Qatar coming in a distant second, the US an even more distant third, and Russia in fourth place providing less than 10% of UK natural gas imports in 2021.

While the loss of 10% of available supply is a significant market shock under any circumstances, it leads to a far smaller disruption and a quicker rebalancing at a new equilibrium than a 20% or 40% loss of supply.

The transition and rebalancing of UK natural gas equilibrium prices after the loss of Russian natural gas, while a significant event, was never as large nor as apocalyptic as was claimed in the corporate media.

The “Invisible Hand” At Work

In reality, what we are seeing both in the UK and the EU natural gas markets is a classic demonstration of Adam Smith’s “invisible hand”, the process by which markets achieve equilibrium irrespective of government and regulatory agency actions¹.

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can, both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

While natural gas prices soared during the summer months, after Vladimir Putin largely cut off Europe from Russian natural gas, time has allowed the European polities and the European markets to adapt—to shifting demand as well as shifting supply.

It is worth noting that the EU in March sought to mandate that member nations fill 90% of their gas storage capacity by November 1, as the realities of Putin’s invasion of Ukraine and the economic discomfitures of sanctions against Russia became clear.

To build up a supply buffer for the next winter, Brussels will require EU countries to fill storage facilities at least 90% by Nov. 1 each year, with intermediate targets applying in the months before.

"In the current geopolitical context, further supply disruptions of gas can no longer be excluded. This could severely harm citizens and the economy of the Union," said the draft proposal, seen by Reuters, which will need approval from EU countries and the European Parliament.

Countries will be responsible for meeting the targets, and can use options like obliging suppliers to put minimum volumes into storage, tasking transmission system operators with buying strategic gas stocks, and providing financial incentives to do so.

After some negotiation, an EU-wide regulation was finalized in May that set out a broad goal of achieving at least 80% storage capacity utilization by November 1, with the actual target being at least 85%.

Because the level of gas storage in each EU country varies widely, ensuring fairness was a major concern during the negotiations.

Eventually, it was agreed that EU countries should fill underground storage on their territory to at least 80% of their capacity before next winter and 90% in the following years.

However, several exceptions were made for Cyprus, Ireland and Malta, meaning that the actual EU capacity would only reach 75%, a parliamentary source told EURACTIV. This is well below the 90% storage considered necessary in the event of a supply shock this winter.

Because of this, a new paragraph was added to the legislation, allowing EU countries to adopt higher filling targets so the EU could reach a collective storage level of 85% in 2022.

While the EU set gas storage targets, the EU did not set market prices or dictate gas buying behavior. Still, because of the targets, EU energy producers during the summer months bid up the price of natural gas as they strove to meet (and would ultimately exceed) storage targets despite the disruption and effective loss of Russian supplies of natural gas. Having exceeded the storage targets, the drop-off in natural gas demand is now exerting downward pressure on natural gas prices, both for the current contract for delivery as well as future contracts.

Thus market adaptation therefore occurred not just to the changing nature of natural gas supply in Europe, but also to the changing regulatory structure. The storage requirement regulation effectively shifted some winter demand for natural gas forward into the summer months, forcing prices up. Achieving storage targets effectively stopped that shift, thus forcing prices back down. The annual nature of the storage requirement suggests this forward shifting of winter demand will likely be a recurring yearly pattern.

The adaptation process is ongoing, however, and should not be presumed to be at all complete. Even before the summer spike in natural gas prices, the general upward trend in prices has been a constraint on several European industries, with heavy industries such as aluminum smelting being faced with severe production restrictions due to higher energy costs.

Cutbacks and curtailments to Europe’s aluminum capacity began in October last year as power prices started surging. Since the end of 2021, cuts have been announced at smelters in Spain, Slovakia, Romania, the Netherlands, Slovenia, Montenegro, Norway, and a number of smelters in Germany, Standard Chartered noted. Over the past week, a 50% production cut was announced at the Neuss smelter in Germany and a 22% cut at Europe’s largest smelter in Dunkerque in France.  

Despite the capacity cuts, aluminum prices are falling, reaching a 17-month low this week after hitting a record high in March this year at the start of the Russian invasion of Ukraine. This, according to Standard Chartered, is a reflection of the mounting fears of recession and a recovery in Chinese aluminum production, which is largely offsetting capacity cuts in Europe.

Rising natural gas prices are also impacting fertilizer production, which is heavily dependent on natural gas as a feedstock.

The fertilizer industry is also suffering from natural gas prices 15 times the pre-crisis level, 10 times more than U.S. prices, and well above the prices in Asia, the Fertilizers Europe group says.  

Soaring natural gas prices are pushing electricity prices higher, and they are also hurting producers of ammonia, a key ingredient in fertilizers because natural gas is the primary feedstock for ammonia production. Globally, 98% of ammonia plants around the world use fossil fuels as a feedstock, primarily natural gas, 72%, and coal, 22%, according to the EIA. 

Fertilizer production—and therefore fertilizer costs—directly impact agricultural output, and thus are a factor in food price inflation as well as food insecurity.

Yet it must be noted that Europe’s relative rise in energy costs—and thus input costs to industries such as aluminum smelting and fertilizer production—predate the disruption of Russian supplies, as I noted in my previous article. This crisis is not a Russian-induced crisis, although Russia’s invasion of Ukraine has certainly exacerbated it.

The Crisis Is Change

As I stated in my previous article, the UK’s energy crisis—as well as that in the EU—is a crisis of change. It is not merely that there is a sudden shortage of energy supply. The fundamental balance between energy supply and energy demand has shifted post-2020 (which is to say post-pandemic and post-lockdown). The old balance is gone, and is unlikely to return.

Both the UK and the EU are going to see their economies evolve and change dramatically in the next few years as they come to grips with the shifting dynamics of energy supply and demand on the continent. In the short term, this is driving both price inflation and economic contraction.

What it will drive in the longer term is as yet unknown. Industrial and broad economic change are the future of Europe, the future of the UK, and, ultimately the future of the entire world. While pundits and prognosticators will insist otherwise, in large measure the trajectory of that change is not merely unknown but unknowable. We know change is coming. We do not know what that change will ultimately be.

1. Smith, A. “Of Restraints upon the Importation from Foreign Countries, of Such Goods as Can Be Produced at Home.” An Inquiry Into the Nature and Causes of the Wealth of Nations, London : Printed for W. Strahan and T. Cadell, 1775, p. 183. Project Gutenburg e-Text