Lessons and challenges for the European Union in the short and mid term
Context – The relationship between the European Union and natural gas
The European Union had historically relied heavily on Russian natural gas. For many decades, the flows from Yamal-Nenets, an autonomous district in Western Siberia, irrigated most of the eastern and central countries of the continent. In fact, it is fair to say that a large part of the European Union’s industrial competitiveness was tightly linked to access to cheap natural gas from Russia, especially for those energy-intensive sectors such as chemicals, glass, cement, or steel.
Along an intricate pipeline system mostly dated from the Soviet Era which covers thousands of kilometres, Russian giant state-owned Gazprom acquired a quasi-infinite power that allowed it to dictate prices and even blackmail governments for many years.
Surprisingly, very few efforts were made to effectively decouple the European Union from the Russian gas. Brussels ignored several warnings, such as the 2006 and 2009 gas crisis between Gazprom and its Ukrainian counterpart Naftogaz, which left many European countries without gas for several weeks during the winter due to a series of economic disputes. Even in 2014, after the annexation of the Crimean Peninsula to the Russian Federation during the Euromaidan protests, the share of Russian natural gas imports not only did not decrease but also increased, and the share of consumption reached record highs due to the lower domestic production from the Netherlands and the North Sea.
In parallel, very influential people such as former German chancellor Gerhard Schröder, who presided over the board of Russian oil company Rosneft until late May 2022, chaired the shareholder committee of Nord Stream 1 and served as head of the supervisory board of Nord Stream 2, lobbied for many years to increase the ties between Brussels and Moscow at the expense of other energy sources such as the nuclear power.
In 2021 alone, the 27 Member States imported 83% of their natural gas needs, equivalent to 412 billion cubic meters (bcm). Russia was the source of 23.3% of the natural gas entering the European Union, followed by Norway (22.7%), Ukraine (10.2%) and Belarus (8.9%). However, considering that most natural gas entering the bloc from Ukraine and Belarus originally came through Russia, the real dependency on natural gas imports from Russia was higher than 40%, almost twice as much as Norway.
The black swan
Following months of threats, military drills, and massive mobilisations along the Ukrainian border, on February 24th Russia invaded Ukraine.
Shortly after, the gas flows through the Yamal-Europe pipeline -with a maximum capacity of 32 bcm- were halted due to the refusal from the Polish government to purchase them with rubbles. And four months later, following large-scale underwater sabotage, the Nord Stream was fatally damaged.
All of a sudden, two of the main continental natural gas import facilities were out of service. And the bloc’s long-term contracts, mainly signed with Gazprom, turned out impossible to fulfil. This was especially worrying for both Germany and Italy, which together accounted for more than 50% of the European Union’s contracted capacity until 2030.
It also posed a challenge to countries such as Greece, whose industrial giant Mytilineos had signed back in June 2020 for natural gas deliveries until 2030. Other companies from Belarus, Bulgaria, Hungary, Moldova, the Netherlands, Poland, Serbia, Slovenia, Turkey and the UK, with contracts expiring between 2022 and 2024, were equally affected.
Provisional figures for January-November 2022 from the European Commission show Russian pipeline gas imports in the European Union fell by 69 bcm year-on-year, the highest downturn since the collapse of the Soviet Union back in 1991. State-controlled Gazprom, citing Chief Executive Officer Alexei Miller, said its exports outside of ex-Soviet Union countries would reach 100.9 bcm in 2022, a fall of more than 45% from 185.1 bcm in 2021. These numbers include the supplies to China via the Power of Siberia pipeline, which amounted to 15.5 bcm, compared to the 10.39 bcm in 2021.
In 2023, the drop in Russian pipeline gas imports in the European Union will most likely widen even more, given that both the Nord Stream and the Yamal-Europe will not compute at all.
Every cloud has a silver lining
The partial loss of the main source of natural gas imports in the European Union has been traumatic, but it has also enabled the diversification of the piped supply mix towards a more sustainable and resilient one.
Norway has stepped up and has become Europe’s biggest single natural gas supply source. For 2022 as a whole, Norwegian pipeline exports totalled 113 bcm, up by almost 4.5 bcm year on year. These numbers include the United Kingdom market.
The Norwegian Petroleum Directorate (NPD) said on January 9 that production was set to remain flat in 2023 and hit a new peak of 122.5 bcm in 2025.
Denmark is also expected to play a key role in the near future thanks to Tyra natural gas field, the country’s largest, which has been shut down for redevelopment since autumn 2019. French giant TotalEnergies, the operator of the Tyra natural gas field on behalf of DUC -a joint venture with Norwegian Noreco and Danish Nordsøfonden-, expects operations to resume in June 2023.
Once fully operational, it will deliver 2.8 bcm per year, which amounts to 80% of the forecasted country’s gas production. Danish utility Orsted is expected to purchase most of the output and supply the recently inaugurated Baltic Pipe with 1.1 bcm per year until 2028, as part of the contract signed back in 2020 with its Polish counterpart PGNiG.
Moving to the East, Azerbaijan has taken decisive steps to become a trustworthy partner for the European Union. In the first eight months of 2022, gas imports from the former Soviet republic rose by 50% year-over-year, and on July 18, European Commission President Ursula von der Leyen and Commissioner for Energy Kadri Simson met with Azeri President Ilham Aliyev and Energy Minister Parviz Shahbazo in Baku, where a new Memorandum of Understanding in the field of energy was signed.
Azerbaijan shipped almost 12 bcm for the full year 2022 to the European Union, significantly more than the 8.1 bcm from 2021. Following the July accords, there is a commitment to double the capacity of the Southern Gas Corridor -which goes through 7 countries- to deliver at least 20 bcm to the European Union annually by 2027.
Last but not least, the North of Africa has paved the way to consolidate itself as a strategic ally in the eyes of Brussels, although regional disputes threaten its competitiveness for years to come.
Algeria for instance exported 36.5 bcm of piped natural gas in 2022, down 7.6% year-over-year. Despite ramping up supplies to its core customer Italy to a 12-year high, it was not enough to compensate for the slump caused by the shuttering of the Maghreb–Europe Gas pipeline across Morocco on its way to Spain, which in 2020 alone shipped more than 6 bcm.
In July last year, state-owned Sonatrach announced a sizeable new gas discovery at its biggest gas field that it said could add around 3.65 bcm to annual production starting from November. But other major new additions will not arrive until 2024. During 2022 Sonatrach signed agreements with Italy and Slovenia to supply 9 bcm and 300 million cubic meters (mcm) of natural gas, respectively, through the Transmed-Enrico Matei and Medgaz pipelines.
In parallel, Libya exported roughly 2.5 bcm of natural gas to Italy through the Green Stream pipeline in 2022, far from the 3.23 bcm in 2021 and 4.46 bcm in 2020. This facility, which connects Sicily to the gas fields in southwest Libya, has an export capacity of up to 11 bcm per year, fourfold the current volumes.
Libya’s natural gas exports are being squeezed by rising domestic gas demand and stagnating production after years of under-financing in exploration and production.
In addition, several interconnectors were commissioned ahead of the 2022-23 heating season, further facilitating internal natural gas flows, and enhancing market resilience.
A natural gas carrier Armada to the rescue of the European Union
The great shift has come through the liquefied natural gas (LNG) revolution, whose demand experienced a massive surge in 2022 all across Europe. The 27 Member States imported 101 million tons (mt) of LNG last year, equivalent to 137 bcm. That implies a 58% increase from 2021 figures and almost matches the approximately 140 bcm of piped natural gas received from Russia that same year.
For the first time ever, the European Union as a whole became the largest LNG importer in the world, overpassing both Japan and China. This trend is likely to acute even more in the next years, as Europe adds more regasification capacity. On the other hand, both Japan and South Korea have released plans to increasingly depend on nuclear power to the detriment of LNG.
The United States (US) consolidated as the main supplier of LNG to the European Union and the United Kingdom, shipping 44% of the total inflows. Such numbers outshine the 27% market share it reached back in 2021.
Qatar was the second source of supply covering 18% of deliveries, and to the surprise of many, Russia completed the podium serving an impressive 15% of demand, slightly lower than 2021 percentages but 13.5% higher in absolute terms.
The massive surge in LNG demand from Europe has given way to a race for supplies with Asia. More than 90% of the long-term contracts signed in 2022 for LNG export were recorded in North America, mostly in the United States.
European energy companies such as Shell, Equinor, RWE or Engie signed 10 sale and purchase agreements for up to 24.4 bcm of US LNG last year, whose length varies from 15 to 20 years. That’s twice the amount registered in 2021 and equals almost one-third of the 33 agreements signed since 2011. All those agreements are linked to export terminals under construction which are expected to start delivering LNG between 2024 and 2027.
The same applies to Qatar, which tied the US as the world’s main LNG supplier with 81.2 mt in 2022. There’s barely any spare capacity to export until 2025, when the expansions of the North Field East and South will add 32 and 16 mt per year, respectively.
European utilities such as TotalEnergies and Eni have acquired minority stakes in these expansions to alleviate the growing appetite for LNG in their home countries.
Germany has also reacted, and in November it signed a long-term agreement to purchase up to 2 mt of LNG a year from state-owned Qatar Energy and ConocoPhillips. Deliveries are expected to start in 2026, and the deal will last at least 15 years. Such amounts of LNG equate to about 6% of the volumes of Russian natural gas Germany imported back in 2021.
All in all, the European Union is taking decisive steps to disconnect from Russian energy dependency, but it will still take several months until most of the long-term supplies materialise.
Paradoxically, the only big LNG project expected to start operations in 2023 is the Russian Arctic 2 terminal located in the Yamal Peninsula and operated by Novatek. The first train is due to be launched in late 2023, and once fully operational it will have a production capacity of almost 20mt per year.
Contrary to the pipeline gas exports to the European Union, which will continue to drop in 2023, Russian LNG could ultimately see the opposite trend and play a decisive role to ease the energy crunch.
This can be illustrated by the ongoing bet to substantially increase the LNG import capacity in the European Union and the United Kingdom. It had remained relatively stable in the last 10 years, but now it is expected to expand by 34% by 2024 compared with 2021 figures. And most of these new additions will be located in northern Europe.
Across the next two years, new additions will provide 192.6 mcm per day of extra import capacity or some 70 bcm per year. Considering that neither the US nor Qatar are expected to significantly boost their production, Russia will most likely fill part of this gap.
This also implies that a substantial amount of the natural gas imported by Europe will continue to be purchased at the spot market. In 2022, due to the aggressive 0-Covid policy implemented in China, LNG consumption in the country sharply reduced from 2021 figures, which allowed the 27 Member States to have access to a buoyant offer. But as Beijing pivots towards the opening and starts coexisting with the virus, the consumption is expected to rebound, which will ultimately tighten the access to LNG.
The particular case of the United Kingdom
Despite having one of the lowest natural gas storage capacities compared to its European peers, the United Kingdom has sorted out the energy crisis with mastery. The best way to contextualise this headline is the fact that for the first time on record, the United Kingdom flipped to being a net power exporter to continental Europe last year.
In 2022, both the national flagship Shell and chemical giant INEOS signed two separate LNG agreements with its US counterparts, and in parallel Shell stamped the biggest long-term LNG contract of the year with Mexico Pacific Limited LLC for a 20-year 2.6 mt supply starting from 2026.
Also in December, both the British and the US governments ratified their energy alliance which intends to ensure at least 9-10 bcm of American LNG over 2023. Such quantities were already fulfilled in 2022.
The gradual reopening of the Rough natural gas storage facility by Centrica will also boost the country’s storage capacity by 50%, up to almost 15 days of consumption equivalent.
Nevertheless, it’s fair to say that political uncertainties, especially relative to windfall taxes in the North Sea basin, could end up endangering its energy security.
Conclusions about the European Union natural gas situation
The wide-scale disruptions in the natural gas flow from Russia to the European Union following the invasion of Ukraine, especially through Gazprom’s pipelines, have been partially offset thanks to other pipes from friendly countries, but regional disputes and political uncertainties pose a threat to the current status quo.
The LNG revolution is here to stay. More and more demand is expected to pile up in the coming years, and countries must be ready not only with an improved regasification capacity but also with better interconnections among countries which will ultimately strengthen the continental power grid.
The energy crisis has also showcased that more investment and efforts are needed to secure energy supplies. Just a minority of the future LNG supplies are tied to long-term agreements, which implies a higher dependency on the spot market. In spite of Japanese and South Korean intentions to gradually reduce their dependence on LNG, other Asian nations are expected to ramp up imports, from India to the Philippines or Vietnam, offsetting the potential surplus.
The mild weather and the demand destruction, especially acute in both the industrial and power sectors across 2022, have contributed to minimising a potential natural gas shortage in the European Union. Nonetheless, such variables have only given us more time to get adapted. The inherent challenges remain the same and are far from fixed, especially over the next two years, in which very little new liquefied capacity will be added to the market.
How should we think about this situation from an investor perspective?
As we can see, Europe is short of natural gas and its policies are not helping to rely on itself to tackle this problem. However, as always that there is a problem, an opportunity emerges tied to it. And certainly, several industries in the natural gas sector are getting benefited of the situation.
The most evident is the LNG shipping segment. Europe’s demand for LNG carriers has considerably increased. And the world is short of LNGCs, boosting its rates. Shipping companies are reacting by ordering new LNGCs, and the LNGC order book is exceeding 50% of the current fleet. However, it takes several years to build new vessels. In fact, the shipyards are fully booked until 2027. So rates probably remain higher than usual for the coming years. In the last 20 months, several companies in this segment have been taken private (Teekay LNG, Hoëgh, Gaslog,..), but there are still interesting names such as Flex or Coolco.
Another industry that hugely benefited from this transition is LNG infrastructure, which is in high demand. Both liquefaction and regasification terminals are both needed to ship the LNG from one place to another. In the liquefaction part, we see Cheniere (the US’s biggest LNG exporter) as the biggest winner. Nevertheless, companies providing liquefaction services offshore like New Fortress Energy and Golar have also beneficiating from it. We think that companies operating in West Africa will profit the most due to the closeness to Europe.
Last but not least, European natural gas producers should be on this list, as the natural gas they produce avoids the transportation cost (so it is cleaner and cheaper), but it is not the case. The Windfall taxes settled in Europe and the UK in 2022 have made companies and investors flee the old continent. Despite that, we like Kistos because of the management and Vermilion due to its diversification.
Main Author: Aleix Amoros (@aleix_amoros)
Note: Every week we publish investment thesis, macroeconomic articles and comment the market situation in the recently launched blog section. You can follow us to receive an email each Sunday with the publications of the week.
Note 2: We are organising an investment thesis competition aiming to find talent in the community & move this project to its next stage. Send us your thesis before 19th February!