Drawing up emergency plans in Europe for oil and gas

Is Baron Rothschild right? The war in Ukraine is very negative for the European economy. Russia is financially dependent on oil and gas, but it has buffers to absorb a temporary drop in revenues. Despite tensions, Russia has historically kept supply contracts, while Europe is dependent on Russian oil and gas and cannot afford to do without them in the short term. Europe is therefore very vulnerable in the event that Russia decides to no longer adhere to supply contracts

Baron Rothschild is credited with the quote that an investor should buy when blood is spilling in the streets. According to tradition, he himself made a fortune by buying shares when prices had fallen sharply during the Battle of Waterloo in 1815. Whether Rothschild's wisdom also applies today, I do not know, but he is often right in later wars. asked.

The Russian invasion of Ukraine makes my usual weekly commentary less meaningful. Recent macroeconomic figures say little or nothing about the immediate economic future. Certainly, it's nice that business confidence indices improved in many countries in February, as restrictions on public life are being eased or even largely abolished. But the shock of a war in Europe and (even) higher energy prices can seriously distort that picture.

Many scenarios are conceivable
The question I want to raise is how big the effects are for the European economy. Of course, everything depends on how this goes on. Many scenarios are conceivable. For example, domestic opposition, perhaps driven by Western sanctions, may repent Putin or the Russian military's failure to bring Ukraine under control. But that's all speculation.

For now, the main channel through which the war is affecting our economy is oil and gas prices and supplies. If oil and gas prices rise sustainably or rise further from their current levels, our inflation will also remain higher and it will take longer for it to fall slightly. This directly damages our economy because purchasing power is eroded and because the costs of some companies rise to such an extent that they can no longer function economically.

Easily tear up a delivery contract
I also think it's important to think about how likely it is and what will happen if Russia cuts or even stops its oil and gas supplies to the rest of Europe. Until now and in recent years, Russia has always adhered to the contracts concluded, despite regularly rising tensions. But anyone who has always denied invading a neighboring country and then commits a full-scale invasion can easily tear up a contract. If we are suddenly deprived of oil and gas from Russia, many will not only literally be left out in the cold, but it will disrupt economic activity profoundly. Our economy cannot run without Russian oil and gas. The question is whether the Russians can do without the income.

Is Russia financially dependent on oil and gas? Yes, of course. I read that about 60% of the export revenues come from oil and gas. The numbers I find at the central bank indicate a slightly lower percentage. According to those figures, Russia's total export value was nearly US$500 billion in 2021. Of that, $110 billion was crude oil, $69 billion oil products, $54 billion pipeline gas and nearly $8 billion LNG. I read that about 40% of government revenues come from the energy sector.

Billions in foreign exchange reserve
Russia can hardly miss that income. However, two nuances must be made. Firstly, Russia can temporarily miss that income. The country has a foreign exchange reserve of more than US$600 billion. When sanctions were imposed against Russia in 2014, the foreign exchange reserve amounted to $500 billion and the country depleted about $150 billion in these resources in more than a year. Sanctions are, of course, aimed at freezing Russian assets. But whoever plans an invasion of Ukraine has ensured that the foreign exchange reserve remains available.

A second nuance is that although Russia needs the income from oil and gas exports, they do not have to come from Europe. Russia can shift trade flows, albeit not overnight.

International trade flows
Figures on production, consumption and trade in oil and gas are taken from BP's 2021 Statistical Review of World Energy, a fantastic resource. According to those figures, about half of Russian oil exports went to Europe in 2020 and a third to China. Europe has a great need for oil imports. In 2020, Europe produced about 3,5 million barrels per day, but consumed 13,2 million barrels per day. Almost 30% of European oil imports come from Russia. Since oil is relatively easy to transport, it is possible to make significant changes in trade flows fairly quickly. Russia can stop or reduce exports to Europe without losing much oil revenue for long by supplying elsewhere in the world.

The imbalance between production and consumption and future demand is nowhere as great as in Asia. That market beckons and Russia is of course already a major player there. If Russia restricts oil supplies to Europe, then Europe will probably be able to buy enough oil from other suppliers, although this will require some effort and time. But if we suddenly stop getting about a quarter of the oil we consume, part of the economy comes to a complete standstill.

Building gas pipelines
Gas is much less easy to transport. Most internationally traded gas goes through pipelines and a smaller part in the form of LNG on ships. In 2020, Russia exported 218 billion m3 of gas, of which 198 billion m3 via pipelines and only 40 billion m3 as LNG. 168 billion m3 of Russian gas went to Europe via pipelines. That was 77% of total Russian gas exports. Only 4 billion m3 went through pipelines to China. Europe also imported a small amount of LNG from Russia. Of all the gas used in Europe, 35% came from Russia.

If Russia wants to sell the gas elsewhere, it will have to build pipelines. It will take years before many pipelines to China are built. This suggests that Europe and Russia are still doomed to each other on gas for the time being. But here too it seems to me that fewer deliveries for Europe immediately imply major problems.

Finally, the aftertaste
My takeaway from these numbers is that Russia's supplies of oil and gas to Europe in the short term are much more important to Europe than the revenues from that trade are to Russia. Of course Russia cannot do without the money in the long run, but the country has sufficient financial resources to survive for a while without or with less income from Europe. In addition, in the long run, and as far as oil is concerned, it will probably be able to find and serve sufficient other markets fairly quickly. This makes Europe vulnerable and it makes sense to draw up contingency plans and to have large sizeable strategic stocks available.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

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