By Andrew Wetzlel, CFA®, Managing Director of Sustainable Investing
It is becoming abundantly clear that in many ways the world is changing. Russia’s war with Ukraine is bringing what recently seemed like fraying alliances firmly back together and is potentially creating clearer separation between spheres of economic power centered around democratic and authoritarian leadership. Within global markets, the shifting world order has been most obvious in energy markets as major developed countries reassess the fundamentals of energy security and attempt to accelerate the shift to energy independence, both centered on a transition away from Russian oil and gas. This dynamic is most pressing in Europe, a region structurally short of primary energy sources and highly dependent on Russian oil and gas.
Some background data from the annual BP statistical review of world energy is helpful to set the stage. Europe, as most broadly defined including all countries in the region, holds just 1% of global oil reserves and 2% of global natural gas reserves, though the region was responsible for 4% of global oil production and 6% of global natural gas production in 2020. Europe is working with mature resources that are in decline, with regional production over the last ten years down 3% annually for oil and down 2.5% annually for natural gas. On the demand side of the equation, Europe is responsible for 14% of global primary energy consumption, a level that has declined 0.2% annually over ten years as energy efficiency gains have offset economic growth. In 2020, about 60% of Europe’s primary energy needs were met by oil and natural gas. About 80% of Europe’s oil consumption and 60% of natural gas consumption were met by imports, with 40% of oil and 60% of gas imports from Russia.
To be clear, Europe’s import-dependent energy position is not new news and pressure to accelerate change predates the Russia/Ukraine war. As the chart below shows, benchmark European natural gas prices began to accelerate to the upside as the region started to emerge from COVID-related restrictions a year ago. Forty percent higher residential energy bills in Spain led to protests in the streets last September. European leaders have
enacted a host of measures designed to push toward an energy-independent net-zero future, including a decarbonization strategy in 2019 called EU Green Deal; a financing framework for environmentally sustainable activities in 2020 called the EU Taxonomy on Sustainable Finance; and in 2021, the Fit for 55 package covering legislative reforms needed to hit green deal targets.
The Russian war against Ukraine has put Europe in a very precarious position. European leaders have enacted increasingly impactful rounds of sanctions, though have hesitated to completely cut off Russian energy. Olaf Scholz, the German Chancellor, warned that an embargo would wreak havoc on the economy and risk social unrest. Despite short-term tensions, the European Commission (EC) recently announced an energy-independence proposal called REPowerEU, covering increased non-Russian liquified natural gas (LNG) imports and green hydrogen production, as well as an accelerated shift away from fossil fuels by increasing renewables and electrification, and boosting energy efficiency efforts. The EC outlined the potential to reduce Russian imports by 2/3 within a year. The EU Green Deal and other frameworks set a pathway that will now be expanded and accelerated.
With Europe actively working to shift away from Russian energy as rapidly as physical infrastructure will allow, gas, oil, and other commodity prices are likely to remain elevated for some time. As European leaders attempt to balance availability, affordability, and the path to net zero, there will be winners and losers in Europe and in other markets. High natural gas prices should drive investment in US LNG export capacity and regassification infrastructure in Europe, benefitting energy producers and other companies in the energy and industrial sectors. Higher energy prices will lead to rising input costs for manufacturers in Europe and elsewhere, potentially weighing on margins. Higher traditional power prices make alternatives, which are already economically competitive, increasingly profitable. Even higher-cost fuels like green hydrogen are currently competitive, something that was not expected before 2030. Elevated oil and product prices should accelerate the shift from internal combustion to battery electric consumer vehicles and hydrogen fuel-cell-heavy transportation.
In the near-term, the developed world will pay more for traditional energy sources, potentially exacerbating inflation and leading to higher levels of oil and gas development to bridge the gap and keep the heat and lights on. The long-term consequences of this structural energy shift are profound. Higher prices send a powerful signal that will lead to an acceleration of growth in renewable energy, battery storage, energy efficiency, electrification, and other pathways to decarbonization. These trends and many others inform our security-level and broader asset allocation research and actions, with energy and commodity markets a central focus currently.