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Russia and the changing world of European gas

Natural gas prices in Europe are sitting at close to five years lows. This has happened for a variety of reasons but in particular weak demand, the shale gas revolution and changes in EU policy which have increased competition across the gas markets. Europe’s major gas supplier Russia sees the low prices as a short term anomaly and believes that Europe will have no choice but to increase its offtake of Russian gas as indigenous European gas production falls in the coming years. However, I think Russia is underestimating the resolve of the EU and many of its member states to reduce European dependency on Russia gas. The coming of shale gas in the US coupled with the ability for it to be transported in the form of LNG has changed the global gas world forever. And on the demand side it is quite possible that gas demand in Europe continues to fall.

Source: Bloomberg

In 2016, European gas demand was 356 million tonnes of oil equivalent (mtoe) (see chart below) which thanks to a 50% decrease in price was 3% higher than the previous year. However, demand for gas was a massive 20% lower than in 2010 which begs the question what will happen to gas demand going forward. To answer that we have to look at why gas demand has fallen over the last five years.

The first major reason for the fall in gas demand has been a move by power producers away from gas towards renewables and to a lesser extent coal. Of the circa 85 mtoe drop in gas demand over the last 5 years some 40 mtoe can be accounted for by renewables being used to produce electricity (30mtoe) and heat (10mtoe). The vast majority of the remaining 45 mtoe is accounted for by improvements in energy efficiency, particularly in homes and businesses with the remainder coming from a switch by power generators from gas to cheaper coal.

Source: Bloomberg

Going forward these trends are likely to continue remarking that for European countries to meet their 2020 renewable energy targets another 50mtoe of renewables will be built. Interestingly though is the heat sector which is where the vast bulk of gas in Europe is used. Over 30% of all gas demand is for heating residential homes and not only are we seeing cost effective alternatives in the form of hybrid power solutions (heat pumps and solar thermal) there but we are also seeing some countries such as Denmark ban the sales of gas and oil heating systems. This trend is likely to continue noting that the Europe is also heavily pushing energy efficiency (especially in buildings) which again will impact heating and thus gas demand. And then on the renewable side, solar and wind costs, not to mention energy storage technologies, we have seen such dramatic cost reduction that even countries like Germany, who will have to replace their whole coal and nuclear fleets over the next decade, will likely do so with renewables.

As to the supply side, Europe and individual member states have done a very good job of increasing competition in the European gas market which has for fifty years being dominated by four pipeline gas suppliers in Russia, Norway, Algeria and the Netherlands. EU directives and new regulations have pushed the liberalisation of the European gas market which has increased competition. Pipelines have been opened up to allow third-party access and there is been significant investment in gas infrastructure and in particular LNG terminals (Europe technically has enough capacity to supply a third of its demand). But the real game changer has had nothing to do with Europe. It’s called shale gas. The coming of low cost and plentiful shale gas has caused US gas prices to collapse over the last ten years. Much of this is now flowing into European ports in the form LNG, and the result is that it is now possible to buy substantial volumes of gas on the spot market at regional gas hubs such as NBP in the UK and TTF in the Netherlands.

The overall impact is that many of the big gas producers are selling less gas than they were in the past and have become under pressure from their leading customers to change the pricing and nature of their supply contracts. Statoil has been the most progressive in this area and is now offering customers so called “hybrid contracts” where the pricing is not just dependent on the oil price but also on the spot market. That said Gazprom has been slow to renegotiate its long terms agreements but this will also change too. If it does not, Gazprom and Russia could be losers in a fast changing European gas market.