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Why Europe fears a gas crunch even before winter demand begins

Natural gas prices in the UK and continental Europe have soared to record highs because of tight supplies ahead of winter, raising fears of a severe economic hit to industry and weather-induced shortages.

Day-ahead prices in the UK jumped by 7 per cent on Tuesday to more than £1.65 per therm, almost treble their level the start of the year, and an increase of 70 per cent since early August alone. That is also stoking record electricity prices, as gas is key for power generation.

But what has driven the gas crunch before winter heating demand starts in earnest and how will it affect households?

What is driving supply fears?

Concerns about tight supplies started with a prolonged cold winter that drained natural gas storage. Normally this would be refilled over the summer when demand for heating largely evaporates.

But storage filling has not happened at the pace traders would have liked in 2021. Russia has been sending less gas to Europe, for reasons fiercely debated in the industry. These range from Russia’s need to refill its own storage to suspicions that it is trying to pressure European governments, including Germany, to approve the start-up of the highly controversial Nord Stream 2 gas pipeline.

Europe has also been phasing out coal plants in recent years, limiting the opportunity to switch fuels when prices rise. Record carbon prices have also made fuel swaps less attractive because coal emits more carbon dioxide when burnt.

The UK and parts of continental Europe are more reliant on wind turbines for electricity generation, but remarkably still weather in recent weeks has slashed wind’s contribution to the grid. That has largely been backfilled by natural gas, boosting demand for the fuel.

“The power market’s exposure to gas prices has increased,” said James Huckstepp at S&P Global Platts Analytics.

Who pays the bill?

Everyone, eventually. But natural gas bill increases are not always as immediately apparent to consumers as the rise in pump prices when oil soars.

Large industrial users will experience higher energy costs quickly, although many will have hedged their expected consumption in advance to lock in prices.

Many households will be shielded initially, as many are on fixed tariffs — particularly in the UK. But regulator Ofgem has already raised the so-called price cap in August by more than 12 per cent to account for the strength in wholesale prices. That is despite wholesale costs only making up about 40 per cent of an average utility bill.

Normally gas storage would be replenished in the summer, but this has not happened as traders had expected © REUTERS

If gas prices in the UK remain at similar levels or higher than today throughout the winter, Ofgem will have little choice but to raise the price cap on energy bills again — potentially by an even larger amount.

In Spain, where more households are exposed to variable rather than fixed tariffs, the government this week announced plans to claw back “excess profits” of about €3bn from utilities. Madrid said it would put these funds towards reducing bills, while cutting €1.4bn in consumer taxes on electricity until the end of the year.

How exposed is the UK?

The UK is arguably more exposed than the rest of Europe. The country has won plaudits for its sharp reduction in emissions over the past decade — but this was achieved by boosting renewables capacity and supplanting coal with natural gas, particularly during periods of low wind speeds.

The UK also in effect operates a “just-in-time” approach to gas supplies. While it has more domestic production than countries in the EU, it also has far less storage capacity.

The UK government says the country has diverse sources of supply. But it concedes that this means it has to compete in the global market for imports, particularly for cargoes of liquefied natural gas (LNG).

Demand for LNG is increasingly strong in Asia, prompting competition for cargoes. While pipeline supplies from Norway to the UK and the rest of Europe are seen as reliable, the UK is also increasingly reliant on exports from EU pipelines linked to Russia.

Some are concerned that after Brexit, European might prioritise their own supplies over UK needs in a pinch. “We’re effectively at the end of the pipe — not just physically but politically as well,” said Niall Trimble of the Energy Contract Company, a consultancy.

“It’s far from inconceivable that we could have a problem in the event of a very cold winter.”

Will prices just keep rising?

Not necessarily. A number of things could dampen the rally.

The most important point is the weather. A mild winter in the northern hemisphere would go a long way to calming the market. A pick-up in wind generation would also help, reducing the amount of gas being directed to electricity generation.

Traders are also watching for Germany’s approval of the Nord Stream 2 pipeline from Russia. While some doubt how much additional gas that would bring into Europe this year, there are concerns that a delay to starting up the line could exacerbate the situation.

Gazprom, Russia’s state-run monopoly pipeline exporter, has met all its long-term contracts. But it has not made additional supplies available via Ukraine, which Nord Stream 2 is designed to bypass.

S&P Global Platts Analytics has identified one avenue for easing tightness in gas markets: switching from gas to oil or other hydrocarbon liquids, where feasible, either in manufacturing processes or power plants that are capable of burning oil. But this would be worse for the environment.

Gas-to-oil switching “started earlier in Asia due to the [LNG price] premium and less stringent emissions regulation”, said Huckstepp at S&P Global Platts. “But it is now also being seen in Europe.”

Long-term risks

A few years ago, gas was seen as a ‘bridge’ fuel between fossil fuels and renewable energy. But it has increasingly come under fire from activists and investors alike.

The industry argues that this is wrong-headed and has restricted new supplies that could actually help cut emissions by replacing coal, which produces about twice as much CO2 when burnt. But observers also note that there is not yet anywhere near enough renewable capacity, even in countries such as the UK, to keep the lights on without gas as part of the energy mix.

“That’s the tragedy right now of the supply of gas being restrained by being lumped in with coal and oil by climate activists,” said Andy Calitz, a former Royal Dutch Shell executive who is secretary-general of the International Gas Union.

“The outcome will be that the climate curve is slower to turn, if you don’t have enough gas to replace coal”, he said. “If this continues, the consequences will be felt in either unaffordable prices for energy or in energy insecurity in the forms of lack of availability.”

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