Europe Didn’t Escape An Energy Crisis Just Yet

So far, an energy crisis has been somewhat averted in Europe. But policy and political risk remain. Oil bulls shouldn’t have a hard time forecasting energy prices to rise, thanks in part to the EU.

Such policy risk, led by the price cap for Russian oil, “could trigger significant and abrupt changes of the broader market environment, which could impact the orderly functioning of markets, and ultimately financial stability,” a Bloomberg article stated on Jan. 22. The price cap (known as the market correction mechanism) goes into effect on Feb. 15.

For now, Brent crude oil, the price most quoted for European oil markets, has been in steady decline since Dec. 30. As has the all-important Dutch natural gas market.

Robin Brooks, the chief economist for the Institute of International Finance, noted on Jan. 26 that falling prices are a mixed signal for Europe. There is still an “energy shock”, if not a crisis, Brooks wrote on his Twitter page. Electricity prices are higher in some countries, led by Germany, the heart of the European economy.

Electricity prices remain elevated for Europe versus a year ago, even if commodity prices have been in decline. Some companies have closed factories. Dow Chemical is laying off over 2,000 workers, citing energy costs as one reason, as Bloomberg reported last week.

The European Union has fairly successfully cut off Russian oil and gas from its energy matrix, though some gas is still piped in through Turkish Stream and as liquified natural gas (LNG). Some Russian crude is coming in through transshipments. To replace them, new energy alliances with Qatar, Egypt, Azerbaijan (natural gas) and the United States have come to the fore. At least one comes with added political risk.

Russia Out. Who’s In?

The U.S. has replaced some Russian natural gas supply with liquified natural gas, or LNG. This requires LNG ports, which Europe needs more but has enough to turn the U.S. into its main LNG supplier. The U.S. became the world’s largest LNG exporter, thanks to Europe, in the first quarter of 2022, according to the Energy Information Administration.

LNG prices are higher than piped natural gas, but don’t come with the political risk or the bad look of dealing with Russia at the moment. Those higher prices were overlooked by the EU in 2022 due to necessity and desperation. But, a Reuters column by Gavin Maguire published on December 20 notes that this year, the EU will have a greater focus on costs – and cost cutting, in particular. Such a move “may bring into stark relief how Europe continues to depend on imported energy supplies,” Maguire wrote.

Knowing this, the EU has had to look elsewhere for cheap, piped gas.

Russian gas exports used to be about 40% of the total amount of gas imported by European countries and 60% for Germany’s imported gas supply. Over the last 20 years, the EU has increased its purchases of Russian gas by 150%, according to industry estimates.

When sanctions against Russia began because of the Ukraine war, Europe was quick to sanction Russian oil and gas. Russia returned the favor by making it even harder for Europe to receive the important fossil fuel. Europe has had no choice but look elsewhere, even as it relied on Russian and Polish coal, despite its dirty polluting image – an unsavory for Europe’s establishment. It allowed the Saudi’s to export their oil to Europe while replacing local demand with Russian crude.

Azerbaijan became a solution for natural gas last summer. The country already supplies oil and gas to Austria, Bulgaria, Germany, Greece, Italy, Spain, Ireland, Portugal, Romania, Croatia and the Czech Republic. In 2022, the volume of Azerbaijani gas supplies to the EU reached 12 billion cubic meters, and it will double imports of natural gas by 2027, the EU has stated.

Azerbaijan has already “saved Italy from de-industrialization,” Matteo Villa, head of the Institute for International Political Studies DataLab, reportedly told an Azeri newspaper, highlighting the value of the two-year old Trans-Adriatic Pipeline. This pipeline connects to the Trans-Anatolian Natural Gas Pipeline (TANAP) that connects to the South Caucasus Pipeline in Azerbaijan.

Azerbaijan’s natural gas won’t be enough to make up for Europe’s supply constraints.

Russia has the world’s largest proven gas reserves, with 37.4 trillion cubic meters (tcm). Azerbaijan has 2.5 tcm. Neighboring Turkmenistan has 13.6 tcm (according to some sources 19 tcm). And there is another 2.3 tcm in Kazakhstan. But Turkmen and Kazakh gas would need to go to Europe via Azerbaijan through a Trans-Caspian Interconnector Pipeline. The problem is that the pipeline does not exist, except on paper.

Europe will have to pay for diversification. It comes with a different set of supply risks. Another war is one of them.

EU Energy Security Not Secure Yet

There are two major threats to Azeri gas supply to the West: Russia and Iran.

According to U.S. government media sources, Russia has sent ex-CEO of investment bank Troika Dialog, Forbes-listed billionaire

Ruben Vardanyan, to become the defacto face of The Kremlin in Azerbaijan’s – Nagorno-Karabakh. He was crowned “state minister” of the region, known as “Artsakh” to separatist Armenians, lacking any international recognition, and patrolled by Russian military units. He lives there. Most of the area was reclaimed by Azerbaijan in the fall of 2020. Despite his close ties to the Kremlin, he has managed to escape Western sanctions.

Vardanyan allegedly seized gold, copper and molybdenum mines belonging to Azerbaijan, so there is some dispute there, according to EU Today, a London-based news site covering the region. Vardanyan claims that Azerbaijan is “laying siege” to this disputed border area, populated by Armenians, who are being protected by the Russian military. Vardanyan has said that Azerbaijan is planning a “genocide” of 120,000 Armenians, which at this point is already greater than the population living in Karabakh.

Janusz Bugajski, a senior fellow at the Jamestown Foundation, wrote in an op-ed in The Hill on Jan. 27 that, “Vardanyan’s attempts to destabilize and manipulate with fictitious numbers repeat the tactics used by Putin, who exaggerated the numbers of the Russian population, before annexing Crimea, Donbas, and other regions in Eastern Ukraine.”

Analysts see the Azeri-Armenian border crisis as a potential powder keg. The worst-case scenario is for that war to resume in earnest and for the Azeri gas lines to face the possibility of supply disruptions.

In the past, some members of the European Parliament have called for sanctions against Azerbaijan because of the war, but not since around 2014. In December, a lone Congressman, Republican Representative Michael Garcia (CA-27), called for sanctions. California is home to a large Armenian community.

There is no indication of any actions to go after Azerbaijan at this time.

For Europe energy security, Karabakh and Russian interests in Armenia are potential “kill switches” for reliable Azeri natural gas.

Iranian Risks Escalating

The other risk is Iran, a perennial threat.

Tehran has its own problems with Azerbaijan. First, Iran also does not like Azerbaijan’s close diplomatic ties with Israel, a country it does not recognize has a right to exist.

Furthermore, the proposed Zangezur corridor, a transit route that would connect Azerbaijan and Turkey would intercept land connecting Iran and Armenia. Iran hates this idea, according to analysis by Jamestown Foundation published in the fall.

Zangezur is Azeri President Ilham Aliyev’s top priority. It would build new highways and rail, not pipelines, and the EU would love it, having just signed an agreement with them in hopes of making them a reliable, long-term supplier of fossil fuels.

Last week, the Iranian Revolutionary Guard published a video warning to Azerbaijan – a clip with children in military outfits standing at the border with Iranian flags. The AP reported a fatal shooting of a security guard inside the Azerbaijan embassy in Iran on Friday and wounding two embassy personnel. Azerbaijan President Aliyev closed the embassy and called the assault a “terrorist attack.” Iran immediately fired the police chief on duty, a step seen as insufficient by Baku.

Will a war-weary market make a move based on this potential hot-button issue for European energy supply? It’s worth a look.

Meanwhile…

Oil Bulls Be Ready

Oil and gas bulls have to love European energy politics.

The worst-case scenarios for Europe have not panned out this winter yet, but that is thanks to energy rationing, a warm winter and lower natural gas prices. Some countries are better off than others.

Over the last three and six months, the FTSE Europe exchange-traded fund is up 25% and 13%, respectively, beating the S&P 500. All of this is due to the winter worries abating on Wall Street. Europe is in the money.

American LNG, Russian coal, transshipments of Russian crude, and Azeri gas have all improved European sentiment. They have avoided what looked like a disaster.

But Europe is not out of the woods yet. The European Union’s new ban on imports of Russia-refined petroleum products, along with the price cap, all start in a few days. Far from the European drama, China is re-opening. Both of these changes can be good for oil investors.

Here’s Goldman’s take:

The biggest caveat will be European demand, the ongoing risks associated with new energy deals and Europe’s continued push for a post-fossil fuels economy at all costs.

Should risks to the Azeri supply occur, the European Commission said it would suspend the price cap rule, as Oil Price.com noted on Jan. 23.

“The Commission stands ready to suspend ex-ante the activation of the mechanism, if an analysis from European Central Bank, European Securities and Markets Authority and ACER (EU energy regulation group) shows that the risks outweigh the benefits,” EU Energy Commissioner Kadri Simson said.

In the meantime, the Azerbaijan-Armenia crisis is a concern for supply security in the EU. Brussels could step into a more prominent mediation role between the two countries. Beyond that, Europe will still have to look elsewhere for fossil fuels. The U.S., Qatar, Algeria, Azerbaijan, Norway, Nigeria and, in the future Mozambique offshore LNG, remain Europe’s best diversification strategy. As China reopens, competition for supply will increase, and prices for oil and gas should rise.

The biggest caveat for oil prices will be Europe’s economy, the ongoing risks associated with new energy deals, and its push for a post-fossil fuels economy. Europe’s stock market has looked like a growth story. Business activity has picked up, based on latest PMI readings. For the outlook to keep improving, portfolio investors and companies will be paying attention to Ukraine. And whether or not Europe’s energy supply chain remains drama free (and low cost) for the factories and office towers of the EU.