investment viewpoints
Europe’s energy shock driven by the conflict in Ukraine
| Need to know • The coal, oil and gas supply shock driven by the conflict in Ukraine exposes European consumers and energy-intensive businesses to the effects of rising energy costs. |
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Europe’s energy bill is soaring
Europe is facing an energy shock, due to rising prices, that has widespread implications for equity investors. Consumers and energy-intensive industries are exposed but European banks in particular also face a challenging situation as their lending books become exposed to deteriorating business conditions.
Energy prices have soared in the wake of Russia’s invasion of Ukrainian and Europe is especially vulnerable to this dynamic. Our analysis of fossil fuel prices, including coal, natural gas and oil, reveals that Europe’s energy bill is reaching levels that have not been seen in nearly 50 years (see figure 1).
FIG. 1: Europe’s energy bill over time
Source: LOIM analysis as of March 2022. Historical annual average price for 1965-2021 and d1mth forward prices for last estimate
Europe’s primary energy demand is currently 77 exajoules, which represents 14% of global primary energy demand. Oil accounts for 34% of this demand, 25% is natural gas, 12% is coal, 10% is nuclear energy, 8% is hydropower and 12% comes from renewables. Although it has one of the lowest fossil fuel mix on a global basis for such a large region, it is highly dependent on imports as it externally sources 77% of its oil, 60% of its natural gas and over 40% of its coal.
In terms of price exposure, like any other region, Europe is exposed to rising global oil prices as it is a highly fungible market. However, in terms of gas price exposure, the global market is much more fragmented on a regional basis. The US market is largely insulated due to the shale gas revolution, even though it has massively expanded its export capacities. In Asia, gas markets are priced according to LNG prices that follow a formula indexed to oil prices, with key imports coming from Australia, the Middle East, Malaysia and the US. When it comes to Europe, gas price have been increasingly linked to European hubs , which have now been impacted by the Russia/Ukraine situation.
Indeed, Europe is currently the largest importer of natural gas in the world and its annual demand stood at 541 bcm in 2021, according to BP Statistical Review. Thanks to Norway, the UK and the Netherlands, Europe covers 40% of its need with domestic supply, but the remainder is imported via pipes and LNG. Looking more specifically at the European Union, Russia accounts for 45% of its gas imports and 40% its total gas consumption. In addition, 50% of the coal consumed in Europe is also being supplied by Russia.
According to Wood Mackenzie, buyers from all over the world have been scrambling to replace their Russian sources due to fears of sanctions but also due to declarations of force majeure on certain shipments due to lack of transport availability. This has not only had an impact on oil and coal prices, but European gas prices have been disproportionally affected.
The surge in gas prices puts Europe on a path to an energy shock similar to the one experienced in 1973, when crisis in the Middle East led to refined products shortages, rising retail prices and double-digit inflation.
The energy cost surge has broader implications for Europe’s competiveness too. In the US, energy costs as a percentage of GDP are significantly less pronounced and broadly in line with historical averages given their domestic supply. The difference in gas prices is especially notable (see figure 2). This situation puts Europe at a competitive disadvantage in terms of energy-intensive businesses and would also suggest that European consumers stand to feel the effects far more than US contemporaries. In addition, the US and Canada are energy independent, meaning that what is a cost for consumers is in fact a gain for domestic producers which then stand to reinvest proceeds in operations. This is an important macro-economic missing balance for Europe.
FIG. 2: Gas prices in the USA and Europe
Source: Bloomberg
The path forward for European energy independence
The-on-going crisis highlights the need for Europe to reconsider its future regarding increased energy independency, in particular from Russia.
In late 2021, a report on the state of the energy union suggested rapid actions to implement “profound transformation of consumption and production patterns” in order to deliver on the European Climate Law and its 2030 Climate Target Plan. Among other things, raising energy efficiency, increasing building renovation, integrating energy system (EVs, batteries, district heating), implementing the offshore renewable energy strategy while improving grid infrastructure, implanting binding targets for the use of “clean” hydrogen were all mentioned as key area of focus.
The current crisis is now adding a sense of urgency. Delivering on the energy union plan while moving away from Russian dependency will create an additional challenge. In early March, the International Energy Agency (IEA) published a 10 point action plan. This plan claims that over one-third (50bcm) of Russian gas can be displaced rapidly while staying compliant with the EU Climate ambitions.
These reduced volumes will be made possible by ramping up development of utility-scale wind and solar, as well as rooftop solar panels, which would account for 10% of the reduction. A further 20% would come in the form of greater energy efficiency - from insulation, heat pumps, smart thermostats, and from bringing down heating in buildings. An increased usage of nuclear and bioenergy power plants looks set to generate another 20%, while the remaining 50% would come via and new gas sources such as LNG.
However, in order to go beyond these reductions and quickly reach a 50% cut in dependency on Russian gas would require the use of more coal-fired plants or even oil-fired power plants. This would lead to an increase in emissions and would require additional medium-term efforts in terms of the energy transition, particularly when it comes to increasing the flexibility of the EU power system.
The EU commission has also just published its REPowerEU communication, which outlines European plans to become independent from Russian gas. The plan is based on two tracks: more renewable gases, and an acceleration of the clean energy transition. While very much in line with the IEA’s 10 point action plans, it puts greater focus on biomethane and hydrogen.
While we recognise the opportunities associated with such ambitions, the macro context presents a challenge to rapid implementation. The high cost price for aluminium, steel, and copper; supply chain constrains, labour availability and regulatory/legal changes are all factors that may impede investment decisions.
Industries most exposed
Rising energy costs have pushed European industries to aggressively cut their gas usage in recent months. This situation is unlikely to improve in the near term and it is clear that some industries are more exposed than others. The chemicals sector remains highly exposed to increased energy costs, as well as power generation and the production of non-metallic metals such as aluminum (see figure 3). Investors should also be aware of the second order impact the ongoing situation stands to have on the European banking sector which will likely face lower credit quality from both consumers and corporates.
FIG. 3: Industrial use of natural gas in Europe
Source: Europa, March 2022
A challenging environment for banks
The situation presents EU banks with two potential systemic risks: write-downs of Russian exposure, and a reversal of the credit cycle due to growing loan-loss costs.
The European Banking Authority’s (EBA's) adverse scenario outlines around USD 90 billion in write-downs related to Russia. In the event of loan-loss costs as a percentage of loan books rising from 0.3% today to 1.6%, there are several probable outcomes for EU banks. Over the course of 2022 and 2023, we anticipate:
- A cumulative decline in gross profit from EUR400bn to EUR190bn, in line with the European Stability Mechanism’s adverse scenario.
- Cumulative provisions for loan-loss costs rise from EUR120bn to EUR540bn.
- A cumulative fall in dividend distributions from EUR100bn to zero in order to absorb the provisions’ impact
Based on the EBA’s adverse scenario, there is also the potential for European bank’s Common Equity Tier 1 (CET1) ratio to fall from 16.8% to 12.5% in 2024. This would place CET1 below the ‘comfort zone’ of 13%, but ahead of the regulatory threshold of 10.6%.
If events unfold as expected, EU banks will have to raise at least EUR40bn – equivalent to 10% of the current market capitalisation of the sector – in order to maintain their capital buffer.
While European banks are entering an uncertain and potentially fraught period, it is worth noting that they are entering this crisis in better shape than at the outset of the Global Financial Crisis of 2008. Banks today are considerably better capitalised and can withstand shocks by either cutting dividends or raising around at least 10% of the overall sector capital.
However, given the current situation and the dynamics that are unfolding, investors would likely prefer to take a wait-and-see approach until either better clarity is provided or valuations start to seem aggressively cheap, which is not yet the case.
Investment outlook
The creation of a sustainable and affordable energy system is a priority for the EU and the current situation has only served to reinforce the importance of this goal. The transition to net-zero has not only been cemented as an environmental priority, but transitioning to renewables is also a strategic one that can help insulate and protect the region’s economy from external shocks. In this environment, we believe in the strength of companies which stand to benefit from the ongoing transition to a more energy-independent Europe.
The situation presents challenges for European banks and consumer companies that are reliant on a consumer base which is feeling the squeeze from higher energy bills. European energy-intensive businesses can also be expected to face headwinds, going forwards.
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