Geopolitical tensions are now well and truly back at the forefront of investors’ minds as Russia threatens to cut all gas to Europe.
We knew Putin had a powerful card to play if he felt cornered by the West. Now the proposal from the G7, led by the US, to cap the price paid for Russian oil has triggered Putin to play that card. Russia has cut off all gas flow through the Nord Stream 1 pipeline, resulting in supply to Europe now falling below critical levels.
If Europe follows through on its additional proposal to cap the price of Russian gas, we expect all other Russian pipeline routes to be cut off.
Europe can’t have its cake and eat it too.
At the same time, higher demand for LNG from Japan, Korea and China to build their own storage in advance of winter is affecting Europe’s ability to plug this ever-growing gap in energy supply.
Consequently, European energy prices have ratcheted up. At around €500/MWh, German baseload power is 10x its historical norm. The European Commission has wasted no time proposing a maximum €180/MWh revenue cap on all non-gas power generation, which covers about 80% of power gen in Europe.
This proposal will see revenue earned by non-gas power generators above the cap clawed-back by the government and distributed to support consumers, and gas generators may see a temporary levy on surplus profits. Policy makers estimate this could amount to around €140b in support to consumers and it provides greater certainty to generators around the ambiguity of a “windfall tax”. The plan also includes a proposed mandatory 5% reduction in peak electricity demand. The European Parliament is expected to finalise the proposal by the end of the month.
Supply and demand for energy in Europe remains very delicately balanced through winter 2022 – peak annual consumption – meaning adverse winter weather could have an outsized impact on energy availability.
We don’t think it’s all doom and gloom though:
· Gas storage levels in Europe have been building in advance of winter. Member states have reduced demand in line with the European Commission’s directive to get to 90% storage fill by November e.g. Germany gas storage facilities are at over 80% capacity.
· Alternative fuel sources are being sought e.g. fuel oil, and
· Rising energy prices have led to incremental demand destruction as non-profitable, low value add industries shutter capacity e.g. nitrogen fertiliser, aluminum.
As Europe fills the void of Russian gas, it will come with a price tag. We estimate 2 – 4% of GDP.
Given the extent to which the weather remains a key yet unpredictable variable, the range of outcomes is wide. On a 12 – 18-month view, Europe is building additional regasification
terminals to increase LNG imports to feed the gas between member states, as well as using alternative energy sources were possible.
Exposure to European stocks may feel uncomfortable. But at 12x forward earnings the market is already pricing in a tough scenario around energy. Our European exposure is focused on multinationals – leading franchises that generate revenue and profits globally and aren’t dependent on just the European economy.