Winter is coming: European buyers shifting from natural gas to crude oil
- Amrita Sen, a leading oil analyst expects crude oil prices to rebound to as high as $120 per barrel this year.
- The bull case is supported by high prices of natural gas leading to substitution into oil products.
- The easing in crude prices is partly due to a strong seasonal effect with refineries closing for maintenance.
Record temperatures. An unusually hot summer and prolonged drought conditions. Even the mighty Rhine runs dry. For Europe, these strange and harsh phenomena seem to be troubling omens of the difficult road that lies ahead.
With winter approaching, and household and government budgets in the doldrums, residential and industrial customers will need to brace for impact in Europe’s messy energy market.
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But first, a quick look at inflation.
The latest data shows that consumer inflation has been on a rampage in Europe. This week, the UK saw consumer prices surging into the double digits, rising 10.1% in July, compared to the 9.4% recorded in June.
The Bank of England estimates that the situation is only likely to worsen as energy price caps expire in October, which may lead to inflation rising to as high as 13%.
The Eurozone, which delayed its policy normalization compared to its peers, registered a CPI of 8.9%, the highest level since the Euro was created way back in 1999.
Europe’s statistics body found that energy prices had a crippling effect on households, contributing 4.02%, while food, alcohol and tobacco accounted for 2.08%.
Even non-food, non-energy, core inflation was north of 5% YoY.
While it is true that monetary tightening can take time to filter down to consumer prices, Europe seems to be tussling with many of the same supply side issues, as it was earlier.
Power shortages in China are also contributing to global inflation. According to Amrita Sen, founder of Energy Aspects, this “absolutely adds to those inflationary pressures around the world.”
With China’s economy creaking under the weight of continuing lockdowns and slowing global growth, bottlenecks are likely to persist.
Natural gas prices
Natural gas markets have surged mercilessly across the world, and are now trading at all-time highs. At the time of writing, the Dutch natural gas hub, which is the benchmark for all of Europe, increased 199.6% YTD and an astonishing 431.1% YoY.
Although the European natural gas market has been plagued with difficulties over an extended period, the fear that Russia may scale down or even fully cut supplies has fueled the meteoric rise in prices.
In fact, on an average basis, the Dutch TTF was trading an incredible 10 times higher for this time of year.
Europe imports 41% of its natural gas from Russia, with some countries being nearly solely dependent on these flows.
Rising prices have most notably wreaked havoc in Germany, which is estimated to have purchased EUR 9.1 billion in energy deliveries during the first two months of the Ukraine war.
In addition, Berlin likely has less than three months of natural gas stocks in a situation where international flows are entirely cut off.
The drying up of the Rhine and the ongoing drought conditions have slowed inland water transport of commodities, including coal, which has forced electricity prices higher.
In Germany, year-ahead electricity derivatives hit record highs and were trading 500% higher on a Y-o-Y basis, largely due to fears that supply could evaporate at a moment’s notice.
Phil Carr of The Gold and Silver Club notes that given the severity of the heat wave, electricity demand to power air conditioning has skyrocketed throughout Europe and the UK.
In part due to such tightness in the energy sector, Germany, a nation perhaps most well-known for its cultural aversion to inflation, has been engulfed by 5 consecutive months of 7%+ consumer price rises.
According to Sen, the situation on the ground is so dire that the authorities have been forced to reduce sales tax on natural gas to 7% in a bid “to ease inflationary pressures on consumers.”
From the above graph, the effect of European tensions with Russia compared to the price increase in the US is evident.
In recent months, oil prices were elevated due to geopolitical uncertainties and tightness in the market for refined products. US cities faced gasoline prices at well over $5. Even though prices have come off their highs earlier in the year, the outlook for short-term demand is still clouded.
Both Brent and WTI were trending lower since Monday before recovering mid-week, but are still down roughly 2.0% in the past 5-days at the time of writing.
In the first half of the week, oil prices trended lower due to expectations of progress in the Iran deal, disappointing Chinese industrial data, and increased recessionary fears. However, later in the week, prices broke out as US industrial data came in above expectations, and China’s call for greater reforms was supported by a cut in interest rates.
In addition, concerns that a catastrophic nuclear incident may have occurred amid fighting in Ukraine pushed crude prices higher.
Despite the recovery in oil prices this week, the market is far less tight than it was even a few weeks ago.
However, this may prove to be temporary, given that the overall decline in prices is primarily a seasonal effect, driven by lower industrial production in Europe, the start of the outbound tourist season, and most importantly, the onset of the refinery maintenance period.
Throughout Europe, industrial producers have historically calibrated operations to demand lesser fuel stocks during this time easing pressures.
Crude oil forecast
With the onset of the colder months, demand for heating will rise in Europe.
Sen believes that the Iran deal is the key driver of price action in either direction.
If the US does accept Iran’s nuclear agreement, western sanctions will ease, and over 1 million barrels a day of Iranian oil would be slated to enter the market.
However, Sen stressed that she expects the crude oil market to “tighten rapidly”, and that “without Iran, we are absolutely going back above $100 come winter.”
Another key driver for the bull case is the tendency of European customers to switch from gas to oil if natural gas prices are too high. Data show that industries have already begun to transition to oil and coal to meet their energy needs.
Moreover, the US’s Strategic Petroleum Reserve injections are expected to cease in October squeezing supply.
In October, China will also host the national party meeting where covid lockdowns are expected to be eased significantly. If they are, industrial activity will improve and crude prices will see a new channel of upward pressure.
Amid all these factors, oil prices in Europe could be subject to the perfect storm when an expected 2.2 million barrels per day is shelved from the market as the Russia ban becomes fully operational in December.
Although recession would reduce oil demand, demand appears to still be robust in the US. Despite the end of the vacation-driving season, crude stocks plummeted by over 7 million barrels in mid-August. ING economists note that this decline was largely due to “a substantial increase in crude oil exports over the week” which rose to a record 5MMbbls/d, showing high appetite both domestically and in international markets.
Given these overlapping factors, Sen expects that in the absence of an Iran deal in the near term, a scenario echoed by Goldman Sachs, oil prices could rebound firmly and reach as high as $120 by the end of the year.
In terms of substitution away from natural gas, Christopher Ward of Britannia Global Markets wrote that “the scramble for gas alternatives is keeping coal buoyant.”
Diverging expectations on oil demand
According to Elizabeth Low of Bloomberg News, “the reports are indeed quite mixed”, with OPEC echoing a bearish view of short-term oil demand, while the IEA projects prices to rise due to rotation away from natural gas and towards oil and oil products.
OPEC’s main case for slowing demand rests on the impact of the Ukraine war, high inflation and policy efforts to contain the pandemic.
Sen argues, “I really struggle to call it a glut”, since, in many regions, inventories lie at 10-year lows.
Market sentiment seems to suggest that there is a high likelihood that OPEC+ would defend crude prices from sliding any further by cutting production, if needed.
Key downside risks
The key threat to the rising oil prices is if the Iran deal reaches fruition, which appears highly unlikely in the near future.
Secondly, with reports that rivers are being rejuvenated, commodity transport through inland waterways may improve.
Thirdly, oil demand could sink again if China fails to meaningfully exit covid lockdowns this year.
Another highly unlikely development that could result in a deep pullback in oil prices would be an unexpected resolution to the Russia-Ukraine conflict.