Europe’s natural gas crisis is a taste of things to come; the US will do better
Soaring natural gas and electricity prices in Europe give a preview of volatility during the energy transition
In February 2006, I spent my last day as the Energy Security Advisor to the US European Commander at NATO discussing Russia’s first use of its feared energy weapon against Ukraine earlier that year.
At the time, many European officials argued that Russia was locked in energy co-dependence with Europe, which would ensure Europe’s energy security, but I was far from convinced. Russia had a monopoly on supply, but Europe had not unified its purchasing to create an equally powerful monopoly on demand.
Despite the best efforts of Donald Tusk, perhaps the EU leader I most admire, to create a single European gas purchasing mechanism to balance Russia, Russia was able to divide the Europeans and pick them off one-by-one in tactics reminiscent of the salami-slicing approach by which Soviet communism took over Eastern Europe after the Second World War. Russian tactics included both preferred commercial arrangements, direct purchases of European gas infrastructure and the construction of new infrastructure, most notably the NordStream pipeline system that directly ties Germany to Russia, permanently bypassing Ukraine.
Russia’s geopolitical outmanoeuvring, and energy geopolitics more generally, have now collided with the energy transition to create an even more volatile environment. Many commentators have already discussed the immediate causes of Europe’s current natural gas price spikes: insufficient storage, Russian reluctance to pump gas through Ukraine now that NordStream II is complete, and a period of very limited wind generation in Northern Europe. Some commentators have gone further, speculating that the situation will worsen as decarbonisation makes investors wary of funding new fossil fuel projects. But I worry that the debate is missing two key factors that will make this situation much more complex: the inability to privately finance projects that keep hydrocarbon capacity in reserve and complete political dominance of future energy investment.
Hydrocarbons, and the infrastructure to support them, will become unfinanceable before they become unnecessary
The energy transition means that in the near future in many countries hydrocarbons will only be needed in emergencies. As the problems of the grid are resolved, renewables penetration will increase, and the call for hydrocarbons will become even more infrequent. This shift has been exacerbated by the failure of carbon capture and storage (CCS) to offer a commercially viable long-term role for hydrocarbons in a net-zero economy. With many countries aiming to reach net zero by 2050, any 30-year financing term should be expected to end in net zero. This makes many hydrocarbon production projects themselves and much of the infrastructure to support hydrocarbon usage, like liquefied natural gas terminals, increasingly non-viable. Capital costs should be high for any asset that is kept in reserve and is expected to no longer be required at all before it reaches the end of its useful lifecycle.
Many regulators have tried to address these problems through capacity payments, paying thermal generators to remain in reserve for when the wind doesn’t blow and the sun doesn’t shine. Leaving aside the robust academic debate about whether such capacity payments are economically efficient, I expect that they will fail for another reason: they need to reach all the way up the supply chain. Paying gas turbines to stay in reserve is no good without also paying gas fields and supporting transportation and storage infrastructure to stay on standby to produce the gas those turbines need. Although the situation in the US is perhaps more favourable, as discussed below, this is the picture that many developed countries now face.
The UK has no long-term gas import contracts beyond 2038, and none with firm, fixed commitments beyond 2025
As such, hydrocarbon investment will now only be politically driven
The lack of consistent demand for hydrocarbons and the difficulty of financing new projects mean that hydrocarbon investment will now only be political. If Europe cannot finance new gas import infrastructure, or commit to new gas import contracts, it will depend on the investment and supply decisions that Russia chooses to make. Similarly, if western companies and investors pull back from oil and gas investment, the West more broadly will be reliant on the investment decisions of national oil companies. Today, Russia is holding back gas supplies to Europe while filling NordStream II in order to pressure the next German government, which will almost certainly include the Greens, and the EU to swiftly approve operations of the new pipeline, which could easily be pushed out until next spring under the current regulatory timeline.
Investment decisions in, and driven by, the West will also be political. Germany may have more yoga teachers than coal miners, but it has still chosen to spend EUR40bn, an annual amount per miner that would be quite respectable as a salary on Wall Street, supporting the slow elimination of its coal mines by 2038, presumably continuing to burn that lignite in power stations, spewing carbon dioxide and toxic pollutants. Other western countries may be more foresightful, politically directing investment to maintain a full supply chain in reserve rather than just generation assets. Some other countries will direct investment to pre-emptively build a more robust and reliable renewable energy supply chain, by for example switching from natural gas to hydrogen and signing long-term contracts to import hydrogen by sea.
The US is best positioned to weather this transition
The US is much better positioned than Europe or developed Asia to manage this transition. The US has ample natural gas, which it is successfully using as a bridging fuel while building up its base of renewables. Crucially, this natural gas is mostly produced from shale, which has a very different production profile to the mega projects that supply natural gas to Europe and developed Asia. A typical shale well experiences a 60% production decline in its first year, and a 73% decline by the end of its second year.[1] As such, shale producers drill many cheap wells every year to maintain production. This means that the US can ramp its domestically production quickly, giving it flexibility to produce gas to feed gas turbines that are kept in reserve, without needing to commit to maintain production from those wells in the long term. The US will need, however, to ensure that it maintains the necessary transportation infrastructure and gas field drilling skills and contractors to enable these production ramps while not allowing hydrocarbon production to excessively delay its energy transition.
Investment implications: Expect volatility, partner with governments and look to the US
These investment constraints support my longstanding view that the hydrocarbon era will see an expensive endgame, as oil prices, and indeed internationally traded gas prices, will rise substantially through the energy transition.
Investors need to be positioned for an increase in both average prices and price volatility. They should also focus on political logic, rather than commercial logic, when assessing any project involving hydrocarbons and seek opportunities to partner with governments for political solutions. And they should bear in mind that the US is best placed to maintain hydrocarbon generation through the energy transition, supporting US economic growth.
[1] Guo, Keqiang & Zhang, Baosheng & Wachtmeister, Henrik & Aleklett, Kjell & Höök, Mikael. (2017). Characteristic Production Decline Patterns for Shale Gas Wells in Barnett. International Journal of Sustainable Future for Human Security. 5. 12–21. 10.24910/jsustain/5.1/1221.
This article first appeared on Tellimer.com. To read the report in full, go here.
