Some observations on the natural gas crisis

The sky rocketing natural gas prices have convulsed Europe. The blame game has pointed to a multitude of factors like increased demand, China's coal crisis forcing up its own gas imports, supply chain disruptions due to the pandemic, bungling on storage, domestic stockpile shortages in Russia, Russia trying to use the opportunity to gain approvals for Nordstream 2, unusual weather patterns, natural disasters, closures of generation capacity, and unfettered price competition at the downstream supply side. The crisis is also being posited as the first crisis of the energy transition, with the risk of slowing down the transition. 

This post will discuss two aspects of the energy transition - the decline in capital investments in the natural gas sector and the increasing reliance on short-term contracts. Both these trends in the context of a rising share of renewables pose serious threats to grid stability and reliable supply. 

Ariel Cohen writes in Forbes pointing to these two aspects,

The concerns of many energy experts (this author included) about Europe’s hasty transition away from traditional baseload powers sources (gas, coal, and nuclear) to intermittent renewable generation. Europe’s master plan for carbon neutrality has pushed the member states away from long-term purchase agreements and towards short-term pricing, making the crisis even more costly to energy utilities and other consumers who are now seeking alternative fuel sources...

As the EU sought to decarbonize their energy infrastructure, Brussels failed to establish a reliable baseline capacity for electricity generation. Today, without the ample nuclear, coal, and gas power stations, Europe would be a dark and cold place indeed. Moreover, they lack sources of energy for low renewable periods like the “windless summer” of this past year in the UK. Low wind speeds and cloud cover are becoming more unpredictable as climate change progresses, and the lack of baseload generation has resulted in the current crisis... Germany, despite all rationality, will decommissioned nearly all its reactors next year, while betting on wind and solar... Depending on Russia to fill the energy supply gap is a risky proposition. But perhaps even more short-sighted is Europe’s unwillingness to partner with the United States beyond short-term contracts. Refusal to engage in long-term purchase agreements has led Europe to fall behind Asia as America’s top destination for LNG... The main lesson is: one cannot will energy transformation into reality without building ample, reliable and economically viable baseline generation capacity.

The FT has a long read which highlights some of the problems with the energy transition,

The transition to cleaner energy such as wind and solar has had the effect of pushing up demand for gas — often viewed by the industry as a medium-term “bridging fuel” between the eras of hydrocarbons and renewables. But the long-term target of creating net zero economies in the UK and Europe has also sapped investors’ willingness to put money into developing supplies of a fossil fuel they believe could be largely obsolete in 30 years. Meanwhile, Europe’s domestic gas supplies, run low by decades of rapid development, have declined by 30 per cent in the past decade.

Adding to the problems from energy transition is the volatility associated with natural gas demand, 

The world’s oil consumption remains relatively stable throughout the year with only small fluctuations between the seasons. Gas demand, however, is far stronger each winter owing to its role in domestic heating. While there is a baseload of gas demand all year from electricity generation and industry, such as fertiliser and steel producers, the winter peaks can be far higher across the northern hemisphere. About 40 per cent of total gas consumption in the UK goes directly to heating homes, largely condensed into a period of five-six months. The industry manages these cycles in various ways. The chief one is storage — pumping gas underground during the low-demand summer months that can then be called on when the weather turns cold. The other is access to swing supplies that can rise or reduce as needed. One of the big problems the UK and Europe faces, however, is that the main sources of these supplies are not working as they once did, creating the conditions for more volatile gas prices.

European swing supplies, mainly its largest gasfield, Groningen in Netherlands, and storage facilities, like in UK (Rough storage facility off the east coast of England), have been shut down. 

The accompanying trend is the push for spot market purchases. For long natural gas supplies were governed by long-term contracts involving point-to-point pipelines. The rapid growth of the LNG market, with its liquefaction and regassification terminals, have not only integrated the global natural gas market but also led to the emergence of a rapidly growing short-term spot market similar to that for oil. An extended period of low natural gas prices lulled many market participants into the belief that the greater global natural gas market integration has resulted in a low price regime. 

In fact, in recent times, the EU has sought to shift away from long-term contracts linked to oil prices with Russia too. But with prices rising, "Gazprom has done little to help Europe refill, declining to ship additional supplies via Ukraine beyond what had been secured under long-term contracts."

However, this belief flies against the long history of price volatility with commodity prices in general. Given this, spot market reliance leaves buyers exposed to rapid demand spurts, like that now from Asian countries who are substituting away from coal towards gas. Also, when prices go up, LNG cargoes go towards those willing to pay top dollar, as the Chinese and East Asian countries are doing now to Qatari gas. 

The combined effect of these two, coupled with the stigma associated with fossil fuels and the buzz around renewables, have meant that domestic investments in natural gas infrastructure - exploration, extraction, storage etc - have declined sharply across the developed countries.

The rapidly increasing share of renewables and the simultaneous phasing out down of coal raises the question of grid stability. The only substitute for coal to serve as baseload generation is natural gas. This means that the demand for natural gas, even if mostly for baseload generation, will continue to rise for the foreseeable future even in the developed economies. This means that governments and society have to accept the reality of natural gas based generation and attract investments into the sector instead of scaring them away. Under-investment in natural gas generation at a time of rapidly increasing share of renewables is extremely short-sighted and will only create the conditions for gird breakdowns. Perversely, it could end up lowering public support for the energy transition and substitution with coal-based generation. 

These generation plants come with 25-30 year lifecycles. Given the variable fuel cost pass-throughs in utility contracts with consumers, this naturally calls for long-term contracts to hedge for short-term price volatility. It's often argued that a 10 year user requirement is best served with a 70-30 break-up between long-term and short-term contracts, and a 20 year requirement with a 80-20 break-up. In any case, the dominance of long-term contracts in any fuel sourcing contract is obvious. It would be short-sighted to ignore the long and rich history of commodity price volatility and get locked-up in a regime dominated by short-term contracts. 

Finally, on the Russia angle, I struggle to understand the reactions within mainstream media on Nordstream 2. The pipeline to pump 55 bcm of gas directly to Germany through a pipe under the Baltic Sea has been under construction for years. Irrespective of whether the gas comes through Nordstream 2 or the pipeline through Ukraine, Europe's dependence on Russia for natural gas supplies is a stark reality - just as that of US and Europe on Gulf oil was for decades. It's alternative option is LNG imports, which are more expensive and can only partially replace the Russian supplies.

Further, instead of saying no at the outset, the German government had gone along with the project for nearly a decade, including providing several permissions. Now holding up its approval may be just as repugnant as the alleged Russian attempts to starve Europe off gas supplies. Finally, the Russian intent to bypass Ukraine and deliver gas directly through Nordstream 2 is easily understandable given the geo-political significance following the 2014 Russian annexation of Crimea. Protecting Ukraine's interests is perhaps best served by other means than linking it with Nordstream 2.

Update 1 (08.01.2022)

Merryn Somerset Webb attributes the ongoing natural gas price rises in Europe to a decarbonisation shock,

The Bank of America reckons that the average European household spent about €1,200 on electricity and gas in 2020, a number that, based on current wholesale prices, will rise to €1,850 by the end of 2022 — up 55 per cent. Next year is unlikely to be much better. Energy prices will keep on rising. Why? Because too many governments have jumped the gun on renewables — thinking that we can phase out fossil fuels in favour of deeply unreliable renewable energy significantly faster than we actually can — if indeed we ever can. This is a decarbonisation shock — which one fund manager tells me could even end up causing as much pain as the Opec-driven oil shocks of the 1970s...

It is, say analysts at JPMorgan, a simple matter of supply and demand — as ever . . .  There has been a collapse in investment in oil and gas production — capital spending on new projects is 75 per cent down from its peak. But at the same time global demand for thermal energy sources as a whole has “barely declined” — and the demand for oil just keeps rising. JPM expects global oil demand to grow by 3.5m barrels per day in 2022, ending the year both slightly above 2019 levels and at a record high. There will be a new record high in 2023 — there are a lot of record highs in today’s column — more unwanted inflation I’m afraid. JPMorgan’s various research teams forecast oil prices in 2022 to range from $80 to $125 a barrel. The world’s efforts to energy transition are obviously well intentioned. But good intentions often come at an unexpectedly high price.