A european natural gas crisis that is not a gas crisis (a german perspective)
Energy gas prices are reported to have increased up to 400% since they started increasing in Q2 of 2021. For european consumers, especially those with low and medium incomes, this paints a bleak picture as they imagine their gas bill to increase about the same amount.
Nearly half of german households heat with gas. With average german cost of 1.627 Euro for gas per household in 2020, less than 40% of germans would be able to finance a 400% price increase from discretionary income.
Is there a big gas crisis ahead of us?
Prices reported and referenced to are spot prices that are determined on a gas exchange. In this particular case the Dutch TTF hub, which is considered a benchmark for european gas prices. The price is not for all gas, but for the future contracts of next month traded on this gas exchange.
Its important to note that most gas is not priced via gas exchanges. CEO of Total, Patrick Pouyanné, stated that about 85% of their gas was priced through long running contracts not via spot prices. The price they take is about 1/3 of the current spot price. Russian President Putin stated that the majority of russian gas is also priced through contracts, with german gas being priced between 230–300 Euro per cubic meter. Comparing to the TTF peak hub price of about 950$ this seems similar to the range Patrick Pouyanné described. We can therefore assume that the amount of gas in discussion for its spot price increase is comparably low to the overall gas delivered and the price increase limited to the gas priced via hubs.
More important is the factor that most gas delivery contracts seem to be bound to increasing oil prices, influencing the price of much bigger amounts of gas.
Oil indexed gas prices
Binding gas prices to oil started in the 1960s partly because there was no real market and to enable investments into transport infrastructure for gas. Oil and gas are subsitutes for energy production. It seems sensible to try and minimize incentivization to switch back and forth between them from different price developments.
Comparing price developments of oil and gas prices we can therefore see a positive correlation between them, with gas prices somewhat lagging and flattened. This is by choice as the contracts would often use averaging processes deriving quarterly prices.
Through the introduction of market (hub) based gas prices the projection power of price points in these charts starting 2010 is somewhat limited, but taking the overall price correlation as an indication, german households can expect gas prices to rise more like 10–15% on average, depending upon oil price development and not the reported 400%. Even the years 2011–2014 with oil prices above 100$ per Barrel did not lead to avg. gas prices significantly above a this range. On top of this increased VAT or CO2 taxes can additionally increase prices going forward.
Why did gas spot prices increase?
Several weather related issues influenced demand for gas. In the US a wide-ranging freeze has increased demand for gas to heat. Brazil has seen less rain creating a significant water crisis, as about 70% of their energy production depends on water. The European Union has had 40% less wind to generate electricity from, increasing the need for other forms of electricity production, such as gas. All these factors increased demand.
Adding to this the European Union failed to replenish their gas reserves to the usual levels, which makes any increase in gas demand critical much faster.
As gas demand increased globally as well, especially in Asia, the big LNG suppliers, such as Qatar or the US, started delivering to the highest paying consumers and away from Europe, lowering supply to Europe. The increase of prices only stopped when Russian President Vladimir Putin offered to supply more gas, cutting spot prices close to half.
Volatililty on essential ressources
The question at hand is not so much how high the next gas bill will be, but how much volatility we really want to accept to our supply of essential goods like energy resources.
Is this form of exchange based ‘on demand’ energy procurement the right approach? Is it more reliant and overall cheaper? How much agility do we really need?
Agility is good for changing environments and clearly the aspired change of energy production to renewable sources is demanding such. But agility comes with a price. It is quite universal that organisational forms that respond well to changes are usually not as efficient.
Adding to this, high volatility can have adverse effects that hurt the implementation of incentives for market participants. Clearly the framework for change to a more environment friendly energy production should not motivate adverse behaviour. The current increase of natural gas prices leads to a switch to coal for power production which is now comparably cheaper and a very good subsitute for gas.
Changing cost
If the initial cost of change is justified by the long-term positive impact of the investment, it creates incentive to make the investment. You may argue that “a good climate” is worth any investment, but let’s be more realistic. If you plan to change your energy source, lets say from oil to gas, and buy a gas boiler that costs several months salary, you would want to do that with a net-positive return in mind. That is the reason why new technology like solar is subsidized, to introduce the technology into the market and reach market shares that enable scaling effects.
Any reduction to the longevity of the perspective will relatively increase the importance of the initial investment, potentially imparing change. Unpredictable volatility in the price of energy sources is equally negative to a reliable outlook into the future. Rational market participants hold up investment decisions until they can be clear on which choice is reasonable.
Natural gas delivery methods (Pipelines vs. LNG)
Gas is being delivered into the European Union via pipelines, many of them coming from Russia and other countries east of it.
Pipelines require a high location dependent investment into infrastructure. Once it is build the choice is only how much gas to send through it, up to its capacity. The incentive will likely be to send as much as possible to justify the initial infrastructure cost, but are then sunken costs. Pipelines are highly dependent on the security and trustworthyness of transit countries, as well as that of the buyers of gas on the other end.
The other way to send gas is in liquified form via ships, delivered to specific LNG habours. This method is more agile but also more expensive as the gas needs to be transported with ships and have considerable energy invested to liquifiy it in the first place. Besides the higher production cost it therefore has a bigger initial ecologic footprint.
Currently russian gas, versus LNG, is about 30% cheaper and has only 1/3 of its inital footprint. From the standpoint of a change process to a more renewable energy mix, pipeline gas would seem as the more reasonable choice for as long as we need gas.
In essence both methods can be used to deliver gas, which could then be stored to cover for varying demand. As it seems LNG delivery contracts are not structured the same way allowing for the suppliers to choose who to sell to. This type of agility is not favoring the consumer and given the fact that we talk about a global cartel of suppliers, it seems questionable to assume that implementing exchanges would not make them take monopoly prices, similar to OPEC.
Hub priced vs. Oil-indexed gas pricing
There are different arguments for and against market (hub) priced gas. The factual change away from oil products reduces substitution possibilities, so the development of its own pricing mechanism seemed reasonable. Some will surely hope for increased competition and potentially lower prices. Hub based pricing leads to higher volatility which creates its own challenges.
Gas markets see only few participants which opens up risk of manipulation from both ends, sellers and buyers. Hubs can reduce risk of moral hazard when contracts are renegotiated and some expect the contractual prices to align towards those of hubs over time.
Partnership
The current discussion is about our reliance on suppliers, mainly Russia. What we forget is that those suppliers are dependent upon the demand for their product as well. This is especially true if they invested in very expensive pipeline infrastructure.
Installing a system that only uses spot prices will diminish the opportunity for preferencial partnership, potentially increasing the price of initial providers to the level of all other providers, but reducing the scaling effects of pipelines if the amount sold is decreasing. Contracts can be preferential if the real cost of production and transport is lower for specific routes and some of this potential is given to the buyer via lower prices. Northstream 2 for example is 2000km shorter, let alone more modern, than the route through Ukraine. Ignoring added risk from transit countries, Russia would at least have the potential to offer preferential terms.
Reliability is a quality of suppliers as well as consumers. Long lasting commitments, with projectable demand will enable the usage of more efficient infrastructure and the potential for best prices.
Additionally, what we currently try to do, is to diminish demand for their product by changing energy sources and technology. As long as we do not propose an upside or possiblity of participation to our suppliers within that process, be that any of the OPEC countries, what incentive would that construct for them to support a push for a more renewable global energy production? The same is true for the whole industry of carbon energy exploration, extraction and refinement as well as transportation and storage services. The fight is currently against those that know best, instead of together for a better future.
A crisis, but not a gas crisis
Currently we struggle with the target of our change process, its timeframe, the methods used, the social impacts we expect and that leads to a lack of information from a clear plan. In a somewhat preadolecent behaviour we destroy grown structures without a clear understanding what to replace them with. We build double structures increasing agility, but one has to wonder if this is creating planned redundancy, or if we are just compensating for our own indecisiveness, simply increasing cost. We alienate our partners by threatening to substitute them, while we ask them to support us in doing so.
Right now we have failed to develop a clear path and sufficient contingency plans. Many feel that any price increase of carbon based energy is good as it will motivate substitution, but flying blind certainly is not the best way to go. In the end we have failed to accept the differences between energy production methods and not filled our gas storage over the summer. Now less wind leads to less energy and we reap what we sow. Worst of all is that we currently intellectually rely on our suppliers to solve our self-inflicted problems for us.
Our suppliers have not only offered to increase deliveries of gas to replenish the our storages, it is them that now develop plans to compensate our lack of sound planning and respect for possible contingencies. Russia assures us they are willing to sell as much extra gas to us as we order from them. The market reaction shows they are capable of following up on this promise. Have we requested more gas by now? Russia is not aware of any request. It is debatable if this is a great way to manage an alleged gas crisis.
So this might instead be an indictment to our own shortcomings, highlighting that it is an intellectual crisis, that has ideology in places it should have sound logic.
Advancement of the energy mix
We are mostly agreed that we move from oil and coal to gas and then to into renewable. We do have a discussion starting on the real ecological impact of renewable technology as many resources change its carbon footprint. Right now electric vehicles have a carbon footprint break-even against diesel that is past their average lifetime usage. So the EV does stop to work before they are more ‘clean’ than driving a diesel. That is based on the initial footprint of the battery production and the energy that is put into it. If the power plant burns coal, no EV using that power is really cleaner.
What we do need to drive is progression of our energy mix along the sketched path to leverage the potential of more sustainable technologies. Therefore incentivizing the reversion from gas to coal should be avoided. While it is not the reduction in CO2 emissions we eventually aspire it clearly is the right direction. It also counterbalances the disadvantages of wind and solar power compensating for their fluctuating power output. The procurement of energy on a higher price than necessary is also to be avoided. All added cost for energy procurement is missing investment possiblities in infrastructure that would advance the transformation into a sustainable energy provision.
It seems reasonable to lower our sights and use gas as a transition technology advancing the overall cause. Ignoring it as it constitutes carbon based energy might not lead to the targeted outcome. A process that incentivizes coal usage and ultimately makes nuclear energy seem like a solution to provide ‘clean’ energy it nothing we should be regarding favorably.
We face two core problems that stand in the way. Immense energy production fluctuations from wind and solar and an unsolved power storage problem. In both cases natural gas can provide a fitting solution. It’s hard to see why a clear commitment to cover the transition with solid delivery arrangements are not made.
A word of caution
Gas seems like a very fitting puzzle piece to the current problems wind and solar have. Moving from coal and nuclear into wind and solar, is moving away from constant base provision of energy to fluctuating and erratic energy production. Gas can be used to quickly change the output and counter-weigh this behaviour, but it is that, a redundany and needed addition to balance power provision.
Taking a look at the price of power production we can see that gas should be used only if needed. The better we become to manage energy production from renewable sources, the less we should need it. What we do need to keep in mind is, that we need more wind and solar. Building up more capacity is crucial.
Change Management
Most stakeholders would welcome a predictable change path. Private investment requires it and households in the EU don’t respond well to erratic changes in energy prices. Friday for Future and others before them did lead the way to inspire a development by showing where the journey must lead to. To get there it is time to step up and use our knowledge and experience to structure this change in a way that ensures it does works.