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Understanding Europe's energy crisis

Sara Silano  |  08 Nov 2021Text size  Decrease  Increase  |  
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Increased natural gas demand in Europe has sent prices soaring and spilled over to the global liquid natural gas market as European buyers compete with Asian buyers for supplies.

Allen Good, equity strategist at Morningstar, said that prices are likely to remain elevated through winter, although perhaps not at today's lofty levels if the weather is milder than expected.

However, he won't rule out future spikes saying the energy transition will likely be uneven, opening the door for more supply/demand imbalances.

Investors are wondering whether it is time to bet on the energy sector. But before deciding what to do, it’s wise to understand how we got there. The issues behind Europe's high prices are varied.

The energy transition

High European natural gas prices are a result of the energy transition. An ongoing multi-year shift to renewable power generation, combined with coal plant closures, left the continent already dependent on natural gas for 20% of power generation in 2020. That demand increased in 2021 when low wind speeds across the continent weighed on wind turbine utilisation rates.

The European Union also made some modifications to its Emissions Trading Scheme in 2021, the mechanism used to achieve its emissions targets, to reduce the supply of allowances as the EU stepped up its emission reduction target in 2030. These actions produced an increase in the relative price of coal power generation.

Natural gas power generation in the EU has been increasing even as renewable share grows owing to coal plant closures

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Natural gas power generation in the EU has been increasing even as renewable share grows owing to coal plant closures

Covid-19 and geopolitical issues

On the supply side, Europe exited the 2020-21 winter with low natural gas inventory levels owing to severe winter weather. Rebuilding inventory levels has been difficult. Volumes were reduced because the coronavirus pandemic lowered the availability of capital and people for maintenance activities during the lockdown.

Russia, which supplies about 40% of Europe's gas imports, has been meeting long-term contract commitments but has not provided incremental volumes. Also, Russian gas production is increasingly coming from fields in eastern Siberia, where pipelines are built to carry gas to China, not Europe.

Other geopolitical issues are related to the NordStream 2 project, which has drawn criticism because it would mean greater dependence for Berlin on Moscow, and the tensions between Russia and Ukraine.

Finally, this year Europe has been outbid by Asian buyers for liquid natural gas supplies from the United States. In short, Europe is short on natural gas supply.

Long-term implication

Morningstar's Good say high prices have already been flowing through to equity prices for better or worse, depending on how the company is exposed.

However, from a valuation perspective, his concerns lie with the long-term implications.
"Given the current situation is in large part due to the energy transition, which will be ongoing for decades, we expect similar dislocations in supply and demand for electricity, and thus natural gas, leaving those firms long well-positioned," he says.

"Even assuming a rapid adoption of renewables, natural gas demand will be around for a long time.

"Paradoxically, as reliance on renewables grows, the ‘importance’ of natural gas is also likely to grow. In this case, we don't define ‘importance’ as absolute volume, but rather its availability to supplement renewables quickly in time of need."

Is there a problem with renewables?

The most important issue with renewable energy is intermittency and the inability (as of now) to store it to deploy at a later time during demand spikes or supply shortages, such as during sweltering summers or low wind speed periods.

For example, with current technologies, it is not easy to store wind energy, but the situation would change in the future, as there are companies and research centres working to find a solution.

The problem is further exacerbated as more coal and nuclear power plants are retired, leaving natural gas as the only option. In the absence of cheap renewables storage, natural gas will become the fallback in times of need.

Who benefits from this scenario?

According to Good, all natural gas producers should benefit from high prices, but it's likely those with flexibility in the liquid natural gas market who are best positioned to capitalise.

“The current situation in a way validates the European integrated oils' strategies," he says.

"They plan to invest in liquid natural gas and capitalise on gas demand with their portfolio models while leveraging their trading organisations across all commodities, particularly liquid natural gas and electricity."

European integrated oil firms plan the most growth in liquid natural gas markets as it is a key pillar of their energy transition strategy

European integrated oil firms plan the most growth in liquid natural gas markets as it is a key pillar of their energy transition strategy

Australian ETFs most exposed to the energy sector

Funds exposed to oil and gas companies have performed strongly this year thanks to soaring prices.

ETFs Most Exposed to Oil and Gas Companies

Source: Morningstar

is Editorial Manager for Morningstar Italy.

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