The energy pressures created by Russia’s invasion of Ukraine are continuing to shape a new global energy future. An EU embargo on Russian coal imports going into effect today is just a part of the bigger picture.
Energy bills are soaring in places like the UK, where analysts are predicting that poverty could be an issue as early as January as Britons try to keep up with rising energy costs. But there is hope.
“If Russia’s energy war has reignited old animosity with Europe, new relationships are reinvigorating relations between formerly cool partners and old enemies,” says Cipher Brief Expert and Energy Expert Norm Roule.
“Europe has undertaken a flurry of diplomatic engagement with non-traditional partners in Africa, the Middle East, and Central Asia.”
What about elsewhere? How has the energy crisis spurred by Russia’s invasion impacted energy markets around the world and how are new geopolitical dynamics affecting the future of energy?
As China considers new pipelines with Russia and African countries look for new energy connections, The Cipher Brief spoke with Roule, who travels frequently to the Middle East, to talk about what indicators we need to be looking for to better understand how bad things might get before they get better.
The Cipher Brief: In the six months since the Russian invasion of Ukraine, the international energy map has been redefined. Where does this stand?
Roule: The ongoing global energy crisis has reshuffled what had become a fairly predictable set of energy actors and economic drivers. But it may take several years before we understand this new constellation and what impact it has on international events. The Ukraine War is far from over and recessionary pressures are mushrooming globally. Geopolitical turbulence seems to play a larger role in pricing, production, and delivery. COVID continues to dampen economies. Newly established energy relationships and projects will take, in many cases, months if not years, to come online.
I don’t believe there was ever a time – to include in the 1970s – when so many consumer nations worked so furiously to identify new producers. And they should. Global oil and gas demand is likely to grow in 2023, and there are real worries about another price spike. Competition is fierce because there are so few countries with immediate supply. Asia continues to exploit cheap Russian oil but will not want to cede its traditional suppliers to others. Europe has undertaken a flurry of diplomatic engagement with non-traditional partners in Africa, the Middle East, and Central Asia. For the latter countries, this represents a rare opportunity to lock in long-term contracts and political influence.
A large part of this new landscape will involve the development of an unprecedented range of energy distribution systems. China is looking at new pipelines with Russia. African countries are looking to their neighbors to build new energy connections. Northern and Eastern Europe are frantically restructuring energy connections to reduce dependence on Moscow. Italy has turned to Algeria. Greece sees itself as being able to profit by its connections to Europe and Mediterranean producers. Israel and its Mediterranean neighbors are looking to export gas to Europe. Africa is home to several multi-country regional pipeline projects. Iraq recently finalized plans to connect to the Saudi electric grid. The resulting construction boom associated with these projects will have its own ripple effects and supply chain demands.
The good news is that we are also watching increased focus on renewable energy sources and climate-friendly technologies. For example, the EU recently signed an agreement with Azerbaijan to double gas deliveries using an existing pipeline network to southern Europe. The EU expanded the dialogue to help Baku reduce its methane emissions and expand its renewable energy programs, especially wind and green hydrogen. Saudi Arabia and the UAE announced green energy projects with Greece and France. Several Middle East countries are expanding hydrogen programs. It seems a good bet that future energy partnerships will all become a mix of traditional and green projects. It may be that not all these green projects will succeed but we should welcome this new approach.
Energy diplomacy is now routine. If Russia’s energy war has reignited old animosity with Europe, new relationships are reinvigorating relations between formerly cool partners and old enemies. Egypt and Israel are cooperating to deliver the latter’s LNG to Europe. U.S. envoys are in frequent contact with Lebanon and Israel to help resolve disputes over the exploitation of a major gas field shared by the two countries. Diplomacy has limits, however. Libya and Iraq are major energy actors but there is no appetite in the West to involve itself in their disruptive domestic politics.
The Cipher Brief: OPEC’s recent decision to increase production by only 100,000 barrels per day disappointed some. Does this mean President Biden’s request to the Saudis and others on energy were ignored?
Roule: Let me begin with two points. First, the energy deals associated with the visit appear to have been concluded – and executed - before the President arrived in Riyadh. Saudi Arabia and the UAE began to increase their respective production in June. I think Riyadh’s production is now just under 11 million barrels a day, about the highest level in a decade.
Second, the Saudis are certainly the leading voice in OPEC, but they can’t – and won’t – speak for the group, let alone OPEC Plus, which includes Russia as well as members like Mexico, Malaysia, and Kazakhstan. We shouldn’t forget that in recent years, some OPEC Plus members proved reluctant to accept OPEC decisions when they felt their economic interests demanded otherwise.
Next, we can’t ignore that OPEC has failed to meet its production quota for months. This is the new normal. Aging fields, mismanagement and failed capital investment are all at play here. The cartel is now producing about 29 million bpd, around 4 million bpd less than in 2016-2017. Would it matter if countries that can’t meet their existing quotas received a larger quota?
Thus, we are left with the Saudis and Emiratis as the only OPEC members expected to have significant excess capacity after this year. That amounts to around 2 – 2.7 million bpd with the bulk of that coming from the Saudis. Iraq might be able to achieve a few hundred thousand barrels a day more, but their domestic political turbulence makes it risky to rely on that.
When we speak of capacity, we need to differentiate between long term production and surge production. The Saudis could probably add another 500,000 barrels to the market, but maintenance requirements would limit this spike to a few months. Riyadh also views its excess production capacity as insurance to manage the market during a time of emergency. We should be careful about eroding this. The absence of this spare capacity could well cause traders to decide that prices should be higher to reflect a new crisis premium in these uncertain times.
You are correct that the increase was modest, amounting to the daily consumption of Tunisia or Bulgaria. But one can imagine strong arguments among OPEC Plus members against more production. Russia likely opposed any move that would reduce its revenues. Other members likely pointed to evidence that demand is dropping, and prices are deflating organically.
Recessionary pressures are mushrooming around the world. We have evidence of demand curtailment in Europe and the U.S. We have passed the summer driving season in the US and gasoline use last month was less than in 2020. China’s economy is cooling and its COVID lock downs continue. At the same time, Libyan oil is back on the market (for now) and US production is slowly increasing. The Iran nuclear deal talks continue to sputter. If some sort of deal is revived, this will also bring additional production into the market.
Last, my sense is that Gulf producers see a world in which oil will remain an important part of the global economy, but renewable sources of energy will be critical to combat climate change and to augment diminishing oil production. The UAE President and Saudi Crown Prince discussed green energy projects during their trips to Europe. I think the latter discussions, and assurances that they would do what they could to supply European energy needs were probably a response to U.S. requests.
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The Cipher Brief: Oil and gas prices have been dropping for some weeks. Are there any events or issues we should consider that might reverse this trend?
Roule: Uncertainty will remain the prevailing theme in energy markets. Economists and traders need to balance between supply constraints, recession indicators, and COVID lockdowns, and Russia-related supply chain distortions. In the near term, and in the absence of any new geopolitical crisis, the current trend is likely to continue. Gas prices are likely to continue to come down as stockpiles slowly climb and demand in the U.S. falls. Demand curtailment appears underway but not demand destruction. Diesel stockpiles remain low and that should remain a concern.
Predicting oil prices is a fool’s errand, but we should look to the end of the year for the next set of conditions that will press prices upward. In November, we will see the end of the administration’s program to release a million barrels of oil a day from the US strategic petroleum reserve. China will hold a major party congress and Beijing may loosen lockdowns or take steps to reverse its deflating real estate sector to burnish its image. December will see new EU sanctions on Russian oil and Moscow’s likely response. Beyond that, any pickup in the Chinese economy will invite significant upward price pressure.
In the long-term, gas is also likely to remain more expensive as it will be a more readily available and a more climate-friendly alternative to coal and oil in a world where renewable technologies remain insufficient or unproven solutions.
The Cipher Brief: Europe is faced with terrific energy challenges. Russia knows this is a weak spot and is using energy issues to create divisions among Europe’s countries and to prevent further sanctions. This suggests further oil and gas cuts by Moscow in the coming months. What is Europe’s strategy beyond seeking new sources of energy globally?
Roule: Europe’s strategy seems based on a blend of conservation, investment in green technology, reliance on coal and nuclear, and new infrastructure to connect to existing hydrocarbon (mainly gas) sources. None represent silver bullets, and all involve painful political decisions or years of investment. Europe could ease some of its pain by developing a unified approach to conservation and energy distribution, but this will likely be a political challenge. Even without further COVID shutdowns, a major European recession looks unavoidable. Europe’s members will experience this recession in different ways based on their respective energy sources and industrial topography.
Europe’s first priority is to build its storage of natural gas to get through the coming winter. In general, it is making good progress and has begun to reduce its reliance on Moscow even if Russian gas shipments continue to be critical to Europe’s success. Yet, even if storage capacity reaches 90%, Europe won’t last more than a few cold months if Russia ceases shipments. We shouldn’t be surprised if some European countries may have insufficient gas supply this winter as well as significant energy-related inflation and the political fallout this invites.
This leads to the second priority: conservation. It will be difficult, probably impossible, for Europe to meet its energy needs without cutting consumption. Brussels proposed that members voluntarily cut gas use by 15% between August and March 2023, but about half of the EU’s members are rejecting the idea. The EU might try to impose such a cut, but this will anger members who believe such decisions should be based on each member’s storage capacity and gas sourcing.
Europe’s next task is to exploit existing EU energy sources, to include those rejected in the past for environmental reasons. This will mean extending the operation of nuclear plants, use of coal, and increasing Dutch gas production.
Environmentalists will oppose the first two steps, probably unsuccessfully. Dutch citizens will oppose use of the gas field because doing so produces damaging micro-quakes. A compensation fund for the latter may be necessary.
The EU will also invest billions to expand gas delivery infrastructure. Some of these projects have been underway over the last decade but their completion has taken on new importance following the Russian invasion.
North-South connections are especially important. Examples include the soon-to-be-completed Baltic Pipeline between Denmark and Poland, another pipeline connecting Lithuania and Poland, and a third between Poland and Slovakia. Some projects will come on line in a few months. But it will take several years to complete the construction of most of the LNG terminals and pipelines planned in Europe.
The Cipher Brief: The energy crisis is likely to hit Central Europe hard this winter. How is this playing out in Germany?
Roule: You are correct. These countries are about to pay the price for their over reliance on Russian energy and a lack of capital investment in their own energy systems. Germany’s large industrial base and lack of LNG architecture makes it particularly vulnerable to a recession that will quickly impact those neighbors connected to German industrial growth. I think the chemical, plastics, and automotive sectors will be among the hardest hit. Berlin is also facing a drought that has dropped Rhine water levels to the lowest levels in 25 years. This limits the Rhine’s capacity to cool nuclear reactors as well as slowing the delivery of coal to power plants. France also faces similar drought issues with its major river systems.
Berlin is juggling multiple competing and complicated social and financial problems. What financial support should it offer its poor to deal with high energy bills? Berlin also approved $15 billion in loan guarantees to its struggling energy giant Uniper. To what extent should these costs be passed on to consumers? Germany is attempting to expedite decision making for renewable energy projects but this won’t happen quickly. In the meantime, Berlin is attempting to encourage conservation. Germany has banned heated private swimming pools, is encouraging telework to reduce office energy bills, and is suspending minimum temperature mandates in apartments.
The Cipher Brief: Where does this leave emerging markets and developing economies?
Roule: They are being hit hard and have few options in a spiraling dynamic that began with the supply distortions even prior to the Russian invasion of Ukraine. These countries lack the reserves to compete with wealthy nations in the international energy market and any domestic economic mismanagement is now being amplified by inflation and energy shortages. These countries are often reliant on now depressed tourism and commodity prices.
As the US and other countries raise interest rates, emerging companies face a double blow. First, these countries rely heavily on foreign investment. If they don’t match the rate hikes, they risk capital shifting to other markets. Turkey would seem to be particularly vulnerable here. Second, they will face higher costs as they seek foreign loans and the US dollars needed to repay past loans.
Unfortunately, we have plenty of recent examples of energy and inflation-related unrest around the world. Bangladesh offers a good example of how this is playing out. Dhaka relies on imported gas for more than 50% of its power generation. Diesel accounts for another 6%. So, the current crisis has hit Dhaka hard. To deal with the energy crisis, it has shut diesel power plants, cutback the operation of gas stations, introduced power rationing, closed government offices and shops, and initiated rotating closure of factories. India and Pakistan have also started to ration to industrial users. Pakistan is another candidate for economic turbulence. Turkey, Mongolia, Myanmar, Cambodia, and Laos should also be watched closely.
One issue we should keep in mind is jurisdictional risk for strategic assets such as mines. As revenue becomes scarce, some governments may seek to squeeze more money from these assets by demanding new contracts with foreign investors. There is plenty of history to highlight this possibility despite the potential impact these steps could have on foreign investment.
The Cipher Brief: How does Africa fit in the international energy picture? Is a new emphasis on African energy justified?
Roule: Certainly. With appropriate investment and successful development, Africa could replace about a fifth of Russian gas exports to Europe by 2030. However, Africa will need to satisfy investor concerns regarding corruption and offer investment and regulatory protections.
The continent is receiving considerable attention from consumer countries. This focus not only includes traditional producers in Nigeria, and Angola, but also energy source newcomers such as Congo, Mauritania, Mozambique, Namibia, Kenya, Senegal, South Africa, Tanzania, and Uganda.
African operations will need to deal with the security threat posed by militant groups active in more than a dozen African countries. Total has discovered promising oil holdings in Namibia and indicated that it is willing to restart a massive $20 billion LNG project in Mozambique if concerns over militant attacks can be provided.
We should also think about the foreign policy baggage that comes with new partnerships. For example, Italy has concluded a major energy agreement with Algiers in which the latter will supply Rome with sufficient gas to allow Algeria to replace Russia as Italy’s largest source of natural gas. The deal also includes collaboration on green hydrogen and other climate friendly energy production. So far so good. But Algeria is a strong supporter of the Polisario. Relations between Algiers and Rabat are also at a low point. It will take careful diplomacy by Rome to avoid being drawn into a contentious dynamic in which Algiers has in the past, shown a willingness to cut energy deliveries as a political tool.
Within Africa, many countries are now reaching out to see how they can cooperate to develop energy infrastructure for their local needs as well as to transport gas to Europe. For example, Algeria, Nigeria, and Niger have signed an agreement to build a gas pipeline from Nigeria to connect to Algeria’s existing pipeline to Europe. Proposed almost 40 years ago, this project has stalled since 2009. A 13 country Nigeria-Morocco Gas Pipeline has also begun to move forward.
Moscow won’t allow its important commercial and security ties to Africa to fade. Around the same time that French President Emmanuel Macron travelled to Central and West Africa, Russia’s Foreign Minister Sergey Lavrov toured Africa to reassure partners on food deliveries, energy supplies, and arms deals while soliciting their neutrality on Ukraine and Russia’s access to lucrative mining projects.
The US has talked for years about developing a broader engagement strategy with Africa, but any new announcements will likely be held until the December US-Africa Summit. It will be tough for the Biden administration to offer much outside of green energy projects. The administration is unenthusiastic about financing gas and oil projects.
The Cipher Brief: What is the status of the U.S. oil industry? Can we expect more production from US energy producers?
Roule: US natural gas production has reached new records and the U.S. was the world’s largest LNG exporter in the first six months of this year with more than 2/3 of production going to Europe. U.S. oil production is also increasing, but will remain around a million barrels a day below previous record levels. U.S. producers remain committed to rewarding long-patient shareholders and paying down debt. But the industry faces genuine challenges as well. Equipment costs are up significantly. Critical equipment such as steel and pipes are sometimes difficult to obtain. It is also hard to find workers, particularly truck drivers. Beyond that, they need to worry that a recession could bring down prices and leave them with significant capital debt. Federal criticism of the industry leaves them suspicious of Washington’s intentions and worried they could face costly new restrictions once this energy crisis passes.
The Cipher Brief: Could you explain the issue of refinery impact on the oil market?
Roule: The short answer is that whatever oil you may bring to the market, you need refineries to turn it into the fuel we use. Fewer refineries mean higher costs for that fuel and even less gasoline as refiners focus on the most profitable line of distillates. We are paying for years of insufficient capital investment, the pandemic impact on refinery operations, and the Russian invasion of Ukraine. Refineries are hugely expensive, they inevitably invite lengthy public debate and require years of operations to make themselves worth the investment. They are susceptible to weather damage, and they are periodically shut down for maintenance. U.S. refinery capacity dropped significantly in 2020, as the pandemic chewed away at global demand, and we closed unprofitable facilities. In general, global refining capacity declined by around a million bpd during 2021. As the global economy picked up steam in recent months, we unsurprisingly saw an increase in the price difference between a barrel of oil and distilled products.
New refineries are planned to come online in 2022 and 2023 albeit in Nigeria, China, Malaysia, and the Middle East. Among others, the Saudis continues to invest in refinery projects and a couple of these should come online soon. Some smaller refinery capacity will appear in Iraq, Mexico, and France. No new refineries are planned in the U.S., but some expansion of existing facilities is likely next year. Our continued refusal to expand our refinery architecture may please environmentalists, but it is a recipe for energy instability.
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