In a previous blog in April this year, we discussed the imminent risk of the energy price shock leading to a potential €1.2 trillion cost to the European economy, equivalent to 7% of GDP. Since then, Russia has weaponized its pipeline gas supplies to Europe and reduced daily exports to 40% of historic levels. With the pivotal Nord Stream 1 pipeline now under maintenance, the world’s eye has turned to 22nd July when flows are scheduled to resume. Energy markets have been spooked by Russia’s actions, such that German power prices nearly doubled to over €350 per megawatt-hour from already unprecedented price levels.

Gas rationing might be required in Europe in the event that imports from Russia are further restricted. To analyse this risk, we have built a detailed quarterly supply and demand model for the European gas market.

We ran scenarios for varying levels of Russian import volumes (40% and 0% of historic volumes) netted against plausible expansion in alternative gas supplies (e.g. LNG) and savings from consumption levels. On the supply side, we don’t see any significant alternative sources that could cushion the blow. Europe already attracts nearly all the freely traded LNG cargoes and we believe Norwegian and North African pipeline supply is reaching its limits. We note an opportunity for the Netherlands to help mitigate the crisis by re-instating supply from its Groningen gas fields. However, it appears for now that the government’s mismanagement of the damage done to local communities by the historic operation of these gas fields, prevents an economically rational decision from being taken.

The solution must thus come from a reduction in demand. Consumption of gas in Europe is split with roughly 40% use for heating of buildings and the remainder divided between power generation and industrial processes like steelmaking. We believe it is politically unpalatable for households to be cut off from gas for heating during the winter season. Our expectation is that governments will launch a broad-based campaign to turn down thermostats, but a 2° Celsius reduction will only save about 20 billion cubic metres (bcm) of gas which will likely not be enough to avert a shortage. We therefore believe that industrial companies will be forced to shut down production.

Imports from Russia are down 60% from normal levels (c. 60bcm versus c. 150bcm p.a.). Should this flow rate be sustained through the summer, we estimate that storage volumes would be sufficient to accommodate a typical spike in winter heating consumption assuming average seasonal temperatures. Unpredictable weather, unexpected disruptions in the LNG market (e.g. the recent fire at the US Freeport terminal) and the degree to which voluntary household thrifting takes place, add variability to a relatively tight storage backdrop, resulting in a slim margin of safety. As a central case, it seems reasonable to assume some rationing by the industrial-sector will be required this winter.

Since the restart of the Russian pipeline is technically complex and could take three years, we think it unlikely that imports will be shut off completely. However, the implications could be quite substantial in such a scenario (i.e. of 0% flow). Europe’s industrial complex consumes c. 6,000 TWh or 25% of the region’s primary energy demand of c. 23,000 TWh. In turn, industry is heavily reliant on gas for 40% of its energy needs or c. 2,500 TWh.

Without any gas imports from Russia, we estimate the demand destruction that would be required from Europe’s industry to be c. 10% this winter but above 50% in Q1 2024. Specific regions like Germany and sectors such as basic metals and chemicals would likely be heavily impacted. We expect a debate about how to spread the shortage among the various European markets receiving Russian gas, as Germany could withhold re-exporting gas that flows through its territory in order to alleviate its domestic shortages. We think it will be most difficult to forecast the second derivative impact on other industries and consumers. The supply chain disruptions witnessed during the last two years should make it sufficiently clear that regions and industries can be very entangled.

The critical question is which of the above two scenarios is more representative of reality. The recent reduction by Russia of gas exports is undeniably escalatory. However, the emergency-like awareness within Europe of the potential economic consequences of current realpolitik in tandem with Russian military advances towards its Eastern Ukrainian objectives also plausibly raises some prospect of a frozen denouement of some form in the coming months. In this scenario, equities appear cheap to us and under-owned by investors. We think quantification of the probabilities of these scenarios risks over-confidence. Our base assumes continuation of the current flow rate, but our perspectives on portfolio risk management are focused on the 0% scenario.

Disclaimer: The views expressed herein are the views of the European Long Only team and not necessarily of Lansdowne Partners (UK) LLP as a whole. The content of this Article has been prepared by the European Long Only team alone and is not, and has not been endorsed or approved by any other person. The article and the information, statements, opinions, interpretations and beliefs contained in it are those of the European Long Only team and are provided in good faith, but no representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the contents of the Article, and no person shall be entitled to place any reliance on the Article or its contents. This Article is not intended to be, nor should it be construed as, investment, financial, tax or legal advice, or a recommendation to buy, sell or hold any security or other investment or pursue any investment strategy. Neither this letter nor any of its contents constitutes an inducement, offer or solicitation to purchase or sell any securities.