Ukraine and the energy market

The highly unstable situation in Ukraine has already had major impact on the world energy market. ONS Guest Writer and Visiting Professor at King’s College, London, Nick Butler gives us a fresh analysis on the connection between the conflict in Ukraine and the energy market.

The short-term implications of the Russian attack on Ukraine are already clear.

  •  Oil prices have risen to their highest level in 7 years.
  •  Natural gas prices, already pushed higher during 2021 by the imbalance of supply against surging post Covid demand rose by almost 10 per cent in a single day.
  • Russia and its current leadership are if anything at least as dependent on continuing oil and gas exports as the importing countries in Europe.

So far, the higher prices reflect fears of what might happen rather than any actual disruption of physical supplies caused by the invasion. Speculation is fuelled by concerns that the gas lines through Ukraine which provide around 15 per cent of Europe’s daily gas needs could be disrupted by conflict or sabotage. Uncertainty about the outcome of the invasion and the possibility of a long tit for tat battle of sanctions and reprisals adds fuel to the possibility of a lasting breakdown in the well-established energy trade between Russia and its western neighbours.

Who will fill the gap?
Some of these fears about ever rising prices are probably overstated. The international markets in oil and gas are strong and capable of replacing any immediate shortfall relatively quickly. Russian Ministers may say that Europeans could find their gas prices doubling over the next few weeks, but such comments will simply stimulate suppliers from elsewhere to see an opportunity to fill the gap. Short of a complete breakdown in trade there is sufficient available supply to ensure that any new price spike will be temporary.

A complete breakdown in trade is still unlikely. It is hard to imagine Russia deliberately cutting itself off from crucial sources of revenue. Oil and gas have underpinned President Putin’s Government throughout his 23 years in power. That power depends critically on the provision of resources to the key elements of the Russian state. Any major loss of revenue would rapidly weaken Mr Putin’s authority. Russia and its current leadership are if anything at least as dependent on continuing oil and gas exports as the importing countries in Europe. This balance of interests suggests that however strong the rhetoric the bulk of energy trade will be allowed to continue.

The more substantive implications of what is happening are likely to flow from the longer-term changes in energy policy and the geography of the market which the invasion will provoke and accelerate.

First, Russian dominance of the European gas market has clearly passed it peak.
The tolerance of Russia as a secure trading partner has been replaced as the crisis has escalated by a determination to diversify supplies. This begins in Germany and has the open support of the new German Vice Chancellor Robert Habeck. Mr Habeck has supported the role of natural gas as a transition fuel but has also expressed the need to ensure a degree of security of supply which reliance on Russia cannot provide. The Green Party has been stronger in questioning the need for Nord Stream 2, the new gas pipeline from northern Russia to Germany than the Social Democrats. The Russian military attack on Ukraine has reinforced the logic behind their doubts. With declining gas consumption and a new push to build renewables led by on and offshore wind power, the new line may simply stand empty. Alternative supplies are readily available, not least in the form of LNG from the shale wells of the United States and from undeveloped resources around the Mediterranean and the Caspian.

Under German leadership and with strong support from many countries in Eastern Europe the Russian action is likely to reinforce the European Commission’s plans to move away from fossil fuels. Mr Putin has provided a new element of logic behind the goal of decarbonisation which in some countries could even now lead to a resurgence of interest in nuclear power as a new generation of small modular reactors becomes available.

The second key impact will be on Russia’s reputation as a safe place for investment, not least for the energy sector itself.
Russia holds huge reserves of oil and gas and needs western technology to develop several of the more complex projects. International companies including Shell, Exxon, Total and BP have all managed to work effectively and profitably in Russia over the last two decades. They will hope that the current crisis will pass without affecting their investments, but the risks of a continuing conflict and the actions of a leader now regarded by Western governments as unstable and irrational will make it difficult for any company board to justify further major capital spending.

“As ever energy and politics are inseparable”

Thirdly there is the question of Russia’s own response to the situation.
The decline of the European gas market is well known, and Nord Stream 2 has been pushed as part of a strategy to secure the Russian share of a shrinking market. Over recent years Russia has therefore turned its attention eastwards with a series of new deals to sell gas to China and other parts of Asia. The current crisis can only reinforce this approach even if the shift gives China and others an even greater power to control the volumes involved and the prices to be paid. Seen from Beijing Russia will now be regarded as a forced seller.

Each of these factors reinforces trends already evident before Russian tanks moved into Ukraine. They reflect the changing geography of the energy market and in Europe at least the determination to decarbonise. But there is one wild card which could yet transform the situation in unexpected ways.

Mr Putin’s actions in ordering the military attack on Ukraine are likely to cause more problems for Russia itself than for any other country except Ukraine. The logic for the attack is hard to pin down, and the gains of taking over a hostile nation of over 40 million people are elusive to say the least. The memory of the disastrous Russian attempt to annex Afghanistan seems to have been lost.

The possibility, which may seem remote as Russian tanks roll towards Kiev, is that Mr Putin may have overreached. Few leaders stay in power for more than 20 years and in any society, even a dictatorship, there is always pressure for change. The open display of Russian military might be no doubt satisfying in the very short term but if victory creates a new environment of isolation the events of the last week could mark the beginning of the end for the Putin presidency. For a country dependent on oil and gas revenue the implications of what has happened could blow back against Mr Putin.

As ever energy and politics are inseparable.