Steno Signals #16 – A (semi)-permanent energy GDP-shock in Europe?

Developments through 2022 have exposed the interlink between macro, geopolitics and markets. We see a risk of a (semi)permanent European GDP-shock due to a lack of energy.

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We have recently covered how this winter is not the issue for Europe. Russian gasflows since the Ukrainian invasion have actually been decent, which allowed Europe to partly frontload the supply. This will save the winter of 2022, but what about next year and the year after? A semi-permanent GDP shock is likely due to the lack of energy resources, but before we get to that let’s have a look at situation right now.

Electricity pricing in Europe

Besides actions on national levels, the European Commision is proposing an emergency intervention in energy markets to tackle the dramatic price rises. Price rises which stem from a severe mismatch in demand and supply - largely contributed to the continued weaponization by Russia of its energy resources. At a glance it seems that the market has responded to the probability of such interventions. Albeit, not really in France. 

Chart 1: Electricity prices in major European countries

In 2020 the average price per MWh in Germany was around 50 EUR. Though the prices in electricity have corrected lower recently, broadly speaking, they remain well elevated. From 50 to some 500 EUR/MWh - it does not take a genius to do the math or imagine the consequences. If not under current circumstances, when would government interventions be called for?

European Electricity Futures

According to the market, the worst is yet to come. Seasonality is obvious, and the winter on our doorstep could spell trouble for those having to pick up the electricity-tap. With limited options to increase supply, demand is the only variable in our control.

This could entail digging out and dusting off the good old oil lamps and getting used to washing one’s dishes the old-fashioned way. Well, assuming that we won’t rewind our standards of living some 100 years and given that Russia will not 180 and come to our aid, someone has got to cough up. Especially in the short- and mid-term.

Chart 2: Electricity futures (months ahead on the x-axis)

As depicted in the above chart, the futures market figures that the demand/supply mismatch will align and stabilize at a significantly lower price point around two years from now. Positive reading indeed, but nothing that offers immediate comfort or spark optimism going into the winter months.  We by the way find such a forward-pricing optimistic given the lack of natural gas.

How about the Gas situation?

With Russia having played their hand and the ‘collective west’ refusing to capitulate and comply with Putin's request for sanctions to be lifted, the base case has turned into compressors on indefinite hiatus. Counterintuitively though we see indications that prices are easing. It seems that the market is anticipating some resolution - whether that is due to imposed legal actions, Russia and the EU reaching common ground or alternative sources coming online cannot be deduced. We already see LNG shipments destined for Europe ramping up and terminals being approved in North America.

The straight forward conclusion is probably that Europe frontloaded via spot TTF purchases through August, which currently means that the price pressure isn’t imminent until the cold winter months truly kick in.

Chart 3: Natural gas futures (Germany)

As I have pointed out many times; gas and electricity are closely correlated. Given the relation between gas input and electricity output, that's not a hard one to wrap one’s head around, hopefully. Hence, the similar looking futures curves for electricity and gas respectively.  

It is no secret that Russian gas supplies have contributed to Europe’s steady drop in energy intensity over the last 25 years. This embedded leverage is now coming to haunt us. Higher energy prices due to lower Russian supplies means lower output which in turn hurts trade. It is no coincidence that when Russia started its gas war back in 2021, Germany was hit on its trade balance. The more disruption that Putin created in the gas markets, the more he could hit European economies. More specifically, Zoltan Poszar has calculated that approximately 1.9 trillion EUR of Germany’s manufacturing output is dependent on 27 billion EUR of Russian energy inputs. 

The European industry has been one big levered Russian Nat Gas bet, which is the exact weakness that Putin exploited.

Chart 4. Nat gas up = German trade balance down

Higher energy costs, falling trade balances and a weaker Euro result in a hit to GDP. The latest projection from Deutsche Bank suggests a real GDP contraction of 2.2 % in the Euro area and 3.5 % in Germany. We consider such guesstimates to be too conservative. The energy costs as a % of GDP in the Euro Area will be around 8-12 % this year alone. Either private households and corporates take a yuuuge hit or governments step in to intervene and kick the can down the road.

The European Commission is already planning major changes to EU fiscal rules whereby annual structural deficit targets would be abandoned and debt sustainability would be assessed over a 10yr period. This opens the door for governments to take the energy hit, but as it remains to be seen how Europe will solve the lack of natural gas over the course of the next 2-3 years, we probably need to prepare ourselves for a medium-term hit to private wealth instead.

This is inevitable unless we magically find a new source of energy within 12-24 months. The increase in energy costs from 2019 to 2022 is around 5-7% of GDP depending on the country. This is not sustainable without a loss of private sector wealth. It is as simple as that. We are going to get poorer in Europe due to this energy crisis.

The reaction function of the ECB depends on the outcome above. Either way the medium term outlook looks like a bumpy road for Lagarde & co. It is damned if you do, damned if you don’t when it comes to rate hikes: Hike into a weak economy and make a Trichet 2.0 or don’t hike and fear that inflation will become even more sticky.

Chart 5. Who is picking up this bill?

Russia out, China in?

There can be no two opinions about the historical interdependence between Russia and Europe. While Europe has benefitted from Russia’s abundant energy resources, Russia has gained wealth on the back of these transactions. In 2021 Europe accounted for 52% of total Russian exports, while 43% of Russian imports came from Europe (according to UN COMTRADE) - major revenue streams the two inbetween.

The wake of war on European soil has impacted the relationship with a magnitude justifying harsh sanctions - an embargo really. The question is now; With Russia in the ‘sin bin’ and, presumably, an expedited transition towards renewables, are we simply handing over the reins to yet another geopolitical superpower with whom our interests are not always aligned?

Chart 6: Refining and processing of key metals

Taking the Chinese dominance in refining and processing of key metals into account, it could very well be. The above illustration sure stipulates such a Chinese dependence, should we transition.

But let’s not opt in on yet another doom prophecy. Prophecies I have outspokenly been against. Where money flows, competition goes. While natural resources are embedded in one’s soil and hence pose near impenetrable barriers to entry, I will argue that it is not unreasonable to think that competition can mitigate the risk of a monopoly-like market structure in metal refining and processing space, but cobalt needed for electric vehicles comes from DR Congo and we know how China is on top of that situation.

Damned if we do, damned if we don’t in Europe. We will all be poorer medium-term due to this energy crisis. That is the sad reality. If I hadn’t parked my excess cash in USD and CHF this year, I would have been really bad off in markets as well. Maybe that is the thing to do, given this crisis in Europe? I struggle to find better solutions right now.

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