Energy Monitor: Balancing on geopolitical territory

by: Hans van Cleef

140307-Energy-Monitor-Mar.pdf ()
  • ·Spot gas price higher due to Ukraine conflict, future prices untouched so far
  • ·‘Stranded assets’ due to implementation of carbon reduction targets…
  • … should stimulate further investments in energy transition

European gas price supported by Ukraine / Russia conflict

In the past few days, European gas prices found support as a result of the increased tensions between Ukraine and Russia. Spot prices in Europe (TTF, NBP) rose by 7%. Future prices, however, remained relatively stable. This indicates that the conflict is mainly impacting sentiment. There seems to be no fear that it will turn into a long-term conflict which could potentially hurt gas deliveries from Russia to Europe for a longer period of time. Inventories are relatively high due to the mild winter and many professional market participants are buying their oil and gas on the future markets. The impact on the economy of Western Europe will therefore remain limited for the moment. Also, consumers will not feel the conflict financially, unless fuel prices start to rise due to increased oil prices.

Only if Russia reduces its oil and/or gas exports – as it did during the last conflict between Russia and Ukraine in 2009 – or if Europe imposes sanctions on Russia, will it have a bigger visible effect on oil and gas future prices. Russia’s trustworthiness as a trading partner would be hurt again, which could also lend support to energy prices. After the last conflict in 2009, Europe took measures to become less dependent on Russian energy. Examples include the building of LNG terminals, increased investment in renewable energy and more imports from other countries (such as UK, Norway, US). Many of these initiatives are costly and will take many years to complete and are not enough to lift the dependency on Russian energy completely. Furthermore, the construction of the Nord Stream pipeline (from Russia through the Baltic Sea to Germany, bypassing Ukraine) was finalized. Therefore, a gas delivery conflict between Russia and Ukraine will have less of an impact on European gas imports than it had in 2009.

Russia is heavily dependent on oil and gas exports

Energy is crucial to the Russian economy (50% of tax revenues, 70% of export revenues). Specific investments in the energy sector are needed too, as Russia faces serious challenges which must be dealt with. These challenges relate not only to the production of energy, but also to changes in the way it relates to customers and energy dependency. From a production perspective, overdue maintenance and the lack of technological developments resulting from low competition have led to inefficient and old-fashioned energy production methods. In the past, these were sufficient, but now large investments are needed to keep production high and customers satisfied. Russia is trying hard to increase these foreign investments, but it will be tough. For more information on the Russian economy and its energy sector, please see our recent report entitled “Russia Watch: An energy-driven Olympic giant”.

‘Stranded Assets’ on your balance sheet

Increasing media attention is focusing on the possible effects of ‘stranded assets’. Here we want to explain what this phenomenon is, and what the effects could be. ‘Stranded assets’ are those assets – in this case oil companies’ oil and gas reserves –, which are on the balance sheet, but may possibly not be used due to changes in legislation. To meet the climate change target of a maximum temperature rise of 2 degrees Celsius, only a certain amount of fossil fuels can be used. According to the International Energy Agency (IEA – World Energy Outlook 2013), a stable level of current global energy consumption would lead to an average rise in temperatures of 3.6 degrees Celsius. According to the IEA, about two-thirds of the current fossil energy reserves should be kept underground to meet these international targets.

Recent media attention has focused on the reported assets on the balance sheets of several large independent oil and gas companies. However, the six largest independent energy companies together hold only 3% of global oil reserves and 4% of global gas reserves. This makes us think of the reported – and possibly also stranded – reserves which are held by the far larger national oil and gas companies. Also, the energy-consuming industries, especially the metallurgical industry, could be stranded with many supplies which cannot be processed due to tougher legislation on carbon emissions. National oil and gas companies control the bulk of global proven oil and gas reserves. Companies such as Saudi Aramco (Saudi Arabia), Gazprom (Russia), Petrobras (Brazil) and Petronas (Malaysia) report large proven reserves of oil and gas. As soon as these assets seem to lose value, oil and gas companies will try to do their utmost to secure this value, taking new technological carbon demands into account. Furthermore, these countries/companies are investing large amounts of money to find and, if cost-effective, exploit new reserves. The question often heard is whether these large investments are needed if current reserves may even be too large to be used completely as a result of tougher legislation on carbon emissions.

Big steps needed to reduce the use of fossil fuel

The IEA also indicates that, despite the fact that renewable energy is taking a bigger share of the energy mix, fossil fuels will remain crucial. In fact, due to ongoing rising demand for energy from emerging markets (especially China and India), the use of fossil fuels such as oil and coal will even increase. This will happen even despite the fact that fossil fuel demand is set to decrease somewhat in the Western world as a result of energy efficiency and a larger share of renewable energy in electricity. However, to make real progress in reducing fossil fuels, some big steps must still be taken. To name a few: 1) More support for energy efficiency, for instance through insulation in homes/offices; 2) Making the Emissions Trading System (ETS) work properly. That would lead to a significant reduction in carbon emissions and would match the economic need for green energy with the social need; 3) Investing in technological development, for instance to make large-scale storage of solar and wind energy possible. Another possibility is to increase the performance of solar energy (currently around 20%); 4) European, or even better, a globally aligned energy policy with national interests being subservient.

However, this cannot be realized in a short period of time. Therefore, focusing on reducing carbon emissions by shifting to less polluting fossil fuels seems a priority. Gas is the best alternative, with carbon emission being two-thirds lower than for coal. Nevertheless, an efficient ETS mechanism is still needed. Last week, the European Parliament approved an initial plan to create scarcity. The aim was that carbon emission prices would trade at higher levels and the European Parliament would gain some time to create a better long-term policy. These initial measures did indeed lead to higher prices, but for now these measures are by far insufficient to bring about an actual transition from the use of coal to the use of gas.

Transition of the energy market

Our base scenario includes lower oil and gas prices in Europe over the coming years. For the US, we do see a moderate rise in gas prices as a result of economic growth, but here too gas prices will remain below historical averages. These forecasts are based on several arguments. There is enough oil production, and oil production capacity, to meet the rise in demand. The overproduction as reported by the IEA will largely remain intact (figure 4). Furthermore, we expect that US yields as well as the US dollar will rise, partly as a result of the Fed’s tapering measures. As a result, commodities will become less attractive as an investment. ‘Stranded assets’ therefore seem to be a phenomenon which may have an impact on energy prices in the medium term, but not in the near term. Nevertheless, current new legislation will certainly have an effect on the future. So, where ‘stranded assets’ may prove to be less valuable in the future than assumed at this point in time, it is good to keep a close eye on these kinds of developments. It is another signal that the global energy market is in a major transition phase. During this transition, there should be a good balance between stimulation of, and investment in, both fossil energy sources and renewable energy. Politics and legislation will play a crucial role in this respect.